Preferreds Weekly Review: Morgan Stanley Is Keeping Its Fixed-For-Life Preferreds

Welcome to another installment of our Preferreds Market Weekly Review, where we discuss preferred stock and baby bond market activity from both the bottom-up, highlighting individual news and events, as well as top-down, providing an overview of the broader market. We also try to add some historical context as well as relevant themes that look to be driving markets or that investors ought to be mindful of. This update covers the period through the fourth week of September.

Be sure to check out our other weekly updates covering the business development company ("BDC") as well as the closed-end fund ("CEF") markets for perspectives across the broader income space.

Market Action

Preferreds were down on the week as a higher-for-longer message from the Fed pushed Treasury yields significantly higher. In credit spread terms, preferreds have retraced much of their bank tantrum related weakness, which has supported prices and total returns.

Preferreds yields remain well above 7% - an attractive level historically.

Despite much noise and volatility in the sector this year, preferreds total return has beaten many other fixed-income sectors like investment-grade corporate bonds, external EM debt, Munis, Agencies, TIPS and Treasuries. This is a testament to the resilience of preferreds shares and a relatively high-quality of the financial sector.

Market Themes

Morgan Stanley is not redeeming its preferreds that it previously fixed for life. The last day to redeem the 7.125% Series E (MS.PR.E) on the first call, the date came and went quietly. As of this writing, the stock is trading at par in clean price terms (nearly all of the price above par is the accrued coupon due to come off on an ex-div date in a couple of days). A yield of 7.125% is very attractive for a high-quality bank preferred - other MS preferreds and its bank peers are nearly all trading at significantly lower yields.

Recall that the bank chose not to transition their Fix/Float Libor preferreds to SOFR as did most other issuers. Another large bank - Wells Fargo - also fixed its Libor Fix/Float preferreds however it then followed up by redeeming the preferred on its first call date.

This redemption by WFC suggested MS might do the same, but it chose not to. The one big difference between MS and WFC is that WFC fixed its preferreds in an unusual way by double-counting the spread over the base rate, which increased the likelihood of redemption as it made it uneconomical to keep the preferred.

On the other hand, the fixed-rate coupons on MS preferreds are below where they can refinance, which looks to be the main reason they are not redeeming.

Market Commentary

Mortgage REIT PennyMac (PMT) is issuing 8.5% 5YNC2 (i.e. 5-year maturity, non-call 2Y i.e. first call in 2 years) bonds (PMTU). Recall that PMT became notorious recently for fixing their Fix/Float preferreds - something that certain commentators think is obviously wrong and will take 2 minutes to reverse in the courts, but yet mysteriously keeps not happening.

The bond looks attractive relative to the preferreds which are trading at yields of 9.2-9.3%. The company’s book value has held up relatively OK - better than many other mREITs. It did particularly well over the COVID period, where many mREIT book values were slammed.

PMT also managed relatively well over 2022 - another very difficult period for mREITs The combination of its MSR assets and mortgage origination gives its book value a more stable profile.

At the moment, mREIT Arlington and Ready Capital bonds (e.g. AIC, RCC) are a bit more attractive however if we see some weakness in PMTU once it starts trading, it’ll be worth a closer look.

One thing to keep in mind is that mortgage REITs (as other REITs) are carved out of the 1940 Act asset coverage rules. In other words, there is no legal limit to how high leverage can go and how low bond asset coverage can go. This makes them somewhat less attractive than BDC and CEF bonds, so extra care needs to be taken in evaluating them.

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