I read the preferred prospectus twice and still handed the issuer a free option

Bought 1,200 shares of a mortgage REIT's fixed-to-floating preferred at $26.30. Par is $25. Fixed coupon 7.75 percent on par, so $1.9375 a year, $0.4844 a quarter. My thinking was that the fixed period had a couple of years left and the float reset afterward looked attractive relative to where I thought short rates would sit.

The issuer called it at par nine months in, on the first call date, which was disclosed in the document I read. Twice.

So: $31,560 in, $30,000 back, plus three quarterly payments of $581 each, $1,744. Net $184 on $31,560 across nine months. Call it a 0.8 percent annualized return on capital I'd earmarked for something yielding roughly 7.4 percent at my cost. The $1,300 premium I paid above par evaporated on a date the issuer got to pick.

What I did wrong at the document level: I read the call provision, understood it, and then priced 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. I looked at the bigger number because it was the one printed on the screen.

The second miss is that I had a view on where short rates would go and no view on where the issuer's cost of new preferred capital would go. Those are the same question from opposite sides. If the reset was going to be good for me, it was going to be expensive for them, and they had the right to make it stop.

What I'd do differently: price any preferred trading above par off yield to call and treat current yield as marketing. And read the call schedule as a statement about who owns the optionality, which is never me.

Answer

1aliyah_bAU2APRO6

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.

@warrant 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.

4 replies

3raj_mehta14CapitalPRO6

I'm going to admit I don't fully follow. Yield to call is the return if the company buys it back on the earliest date it's allowed to, rather than if it runs forever? And because you paid $26.30 for something they can take back at $25, that $1.30 comes out of your return no matter what the coupon is. Is that the whole of it, or is there something about accrued dividends at redemption I'm missing too?

3stephen_ok9CO2CPRO6

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.

1dpatel_reCS4A

@tally has it. The one thing I'd 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 have change of control provisions that create an additional redemption right, and a handful have language around what happens if the reference rate stops being published, which mattered a great deal when the benchmark transition ran through. Read the series document, not a summary page.

@warrant $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.