Charles Schwab: The Real Value Lies Hidden In One Of Its Preferred Stocks

We usually post our articles to members of our service 1 week before we publish them to the public. This article was first published on Jun 15, 2023.

The bank sector crisis in March 2023 caused a lot of volatility in the market, especially in its financial segment. The elevated fluctuations in the price and the increase in the traded volumes affected not only the common stocks of the companies but also the products that are higher in the capital structure. This kind of trading behavior of financial products in a troubled sector is typical and expected by the market participants and forces them to be more cautious with their picks. However, seasoned investors know better and are looking for the big relative mispricings in similar securities that are associated with such turmoil.

The average market participant is usually mostly invested in the common stocks, and as a rule, the preferred stocks receive a lot less attention. This fact, in combination with the increased volatility in recent months, creates real bargain opportunities among the fixed-income securities, and it is up to the investors to put a little more effort to find them out and respectively profit from them. With this short article, we would like to present to your attention exactly this kind of pair trading opportunity that The Charles Schwab Corporation (NYSE:SCHW) preferred stocks are offering us.

Long leg

The preferred stock we like as a long leg for our pair trade is the OTC traded 5.00% fixed-to-floating rate perpetuity issued by Charles Schwab Corp. on Oct 31, 2017. If your broker allows you to trade on the Bond Market, it should be easily found by its CUSIP 808513AR6.

The security is redeemable after Dec 1, 2027, and if not called, it will trade with a floating rate equal to three-month LIBOR (the corresponding SOFR) plus a spread of 2.575% per year, payable quarterly. It is rated Baa2 by Moody's and BBB- by S&P. At the moment of writing this article, it trades at 76.75% of par.

Short leg

For the short side of our pair trade, we like the 4.45% fixed rate exchange-traded perpetual preferred stock (NYSE:SCHW.PJ) issued by Charles Schwab Corp. on Mar 23, 2021. It is rated Baa2 by Moody's and BBB- by S&P.

At the moment of writing the article, SCHW-J trades at 5.54% CY at a price of 20.11 USD.

The trade

In the pair trade we have in mind, we have two securities that are not identical: as a long leg, we have fixed-to-floating rate perpetuity, and as a short leg - fixed-rate perpetuity. In our recent article, "Bank Panic Creates Old-Fashioned Arbitrage Opportunities, 13% From KeyCorp Preferred Stocks," we compared two fixed-to-floating products. However, now the case is a little different, and we are not comparing apples to apples. In order for us to be able to set side by side the current two investment vehicles, we need to make some adjustments to equalize them.

When comparing securities with floating interest rates, we choose to use swap rates in order to make them fixed-rate comparable. More information about the swap model we use to evaluate floating-rate securities is given in our recent article, "Annaly And AGNC Preferred Stocks - Crazy Mispricings Create An Opportunity." As the OTC-traded Schwab preferred stock, we are considering for the long position in our pair trade is perpetuity, we are using the USD 30 Years Interest Rate Swap for a three-month LIBOR (USDSB3L30Y=), which is 3.48% as of the moment the calculations are made. For the calculations of the fair value of the OTC preferred, we are using the CY of SCHW-J as a rate of financing for the Charles Schwab Corp. and therefore as a discount rate for determining the present value of future cash flows of this security.

We accept that the fixed-rate preferred stock SCHW-J is fairly priced, and the calculations that follow are meant to determine the fair value of the OTC-traded security relative to the price of SCHW-J. We are discounting the cash flows for both preferred stocks up to the redemption date of the OTC traded one, and after that date, we are calculating the terminal value for each security.

With such a discount rate, LIBOR swap rate and the calculated above XIRR for SCHW-J, the calculations we made are pricing the long leg of the arbitrage - the OTC-traded preferred stock with CUSIP 808513AR6 is fairly valued, as shown here:

Calculated this way, XNPV represents a "fair price" for the 808513AR6 issue, with SCHW-J set as a benchmark. This type of calculation gives us a relative evaluation of one stock with the other set as a basis. At this point, the huge market mistake in the prices of the two securities is pretty obvious. The OTC-traded preferred stock is clearly undervalued to the exchange-traded one, SCHW-J.

As a final note, we would like to mention that it is extremely difficult to predict whether LIBOR-based security will transit to SOFR, or not. STT-D and STT-G are recent examples that even securities from the same issuer can have different transition clauses. That being said, if the OTC pref remains fixed rate, it should trade at 90% of par, based on the CY of SCHW-J. Even in this worst-case scenario, we have a rather decent arbitrage opportunity.

Conclusion

As long as our model of evaluation of fixed-to-floating securities and the calculations associated with it are correct, investors have a really good opportunity to lock credit risk-free pair trade between two preferred stocks issued by The Charles Schwab Corporation. Our thesis is that as the two securities stand in the same place in the capital structure of the issuing company, there is no reason for the market to love them differently. One of the securities offered to your attention is trading OTC, and that fact makes this trade available only for investors that have access to the bond market.

Trade With Beta

At Trade With Beta,

we discuss ideas like this as they happen in more detail. All active investors are welcome to join on a free trial and ask any question in our chat room full of sophisticated traders and investors.