Reading a preferred prospectus is not the same as pricing off the right yield

Take a fixed-to-floating preferred from a mortgage REIT, bought at $26.30 against a $25 par. Fixed coupon 7.75 percent on par, so $1.9375 a year, $0.4844 a quarter. The reasoning that draws people in is that the fixed period has a couple of years left and the float reset afterward looks attractive relative to where short rates are expected to sit. Then the issuer calls it at par nine months in, on the first call date, which was disclosed in the document all along. Run the numbers on 1,200 shares: $31,560 in, $30,000 back, plus three quarterly payments of $581 each, $1,744. Net $184 on $31,560 across nine months. That is roughly a 0.8 percent annualized return on capital priced for something yielding near 7.4 percent at cost. The premium paid above par evaporates on a date the issuer gets to pick. The mistake at the document level is common: read the call provision, understand it, then price the position off current yield anyway. Current yield at $26.30 was about 7.4 percent. Yield to call, using the first call date and a $25 redemption, was somewhere near 1 percent. Those are the same security. The bigger number gets the attention because it's the one printed on the screen. The second miss is holding a view on where short rates will go with no view on where the issuer's cost of new preferred capital will go. Those are the same question from opposite sides. If the reset favors the holder, it's expensive for the issuer, and the issuer holds the right to make it stop. The fix: price any preferred trading above par off yield to call and treat current yield as marketing. Read the call schedule as a statement about who owns the optionality, because it is rarely the buyer.

dmitri_248 CB2CPRO 11

Answer

aliyah_bActivePRO

You sold the issuer a call option and didn't charge for it. The $1.30 above par is exactly what that option cost you, and you paid it to them.

That's the whole mechanic. Every preferred trading over par is a bond where the borrower gets to end the deal at $25 the moment ending it is worth their while. They end it when their cost of new capital drops below what they're paying you. Which is precisely the environment where you'd most want to keep receiving 7.75 percent. So the security pays you well when it's about to be taken away and pays you badly when nobody wants it.

Practical version for anyone reading this and thinking about preferreds: if it trades above $25, work out the yield to the first call date before anything else. If that number is worse than a short treasury, you're being paid to take call risk and receiving nothing for it. If it trades below par the math flips and the call becomes something you want.

@dmitri_248 the part I'd push on is that you said you had a rate view. A rate view doesn't help here because the call decision is made on the issuer's funding cost, and that is a credit spread question as much as a rate question. A mortgage REIT under stress won't call even when rates fall, because it can't reissue. So the security you thought you owned changes shape depending on how the company is doing, which is a strange thing to hold if you were reaching for it as a fixed income substitute.

aliyah_bActivePRO

4 replies

raj_mehta14 PF4BPRO 10

Worth spelling out for anyone reading this later. Yield to call is the return if the issuer redeems on the earliest date it is allowed to, rather than the return if the security runs forever. Because $26.30 was paid for something the issuer can take back at $25, that $1.30 comes out of the return no matter what the coupon is. The one remaining question for the thread is whether the redemption paid accrued dividends through the call date, which moves the final number a little and is worth confirming against the notice.

raj_mehta14 PF4BPRO 10

stephen_ok9ActivePRO

I did a near identical thing with a different issuer, except mine didn't get called and I convinced myself that meant I'd been right. I paid about $25.90 and sat there for two years feeling clever about the coupon. Then the fixed period rolled and the reset landed lower than I'd assumed because the spread over the benchmark was set years earlier at a level that made sense in a different rate world. Coupon dropped, price dropped, and the security stopped being the thing I bought.

So my version of your lesson is that not getting called isn't the good outcome either. You get called when the terms are good for you and you get left holding it when they aren't.

stephen_ok9ActivePRO

dpatel_re CP3APRO 22

@aliyah_b has it. The one thing to add is that redemption terms sit in the specific certificate of designation for that series, and they vary a lot between issuers and even between series from the same issuer. Some carry change of control provisions that create an additional redemption right, and a handful have language covering what happens if the reference rate stops being published, which mattered a great deal when the benchmark transition ran through. Read the series document itself rather than a summary page. @dmitri_248 $184 on $31,560 with the principal returned intact is a cheap tuition bill for this particular lesson. The expensive version is where the same instinct puts you into a non-agency name at a premium and the call never comes because the company is in trouble.

dpatel_re CP3APRO 22

Reply Anonymous