This Is Still My ‘Preferred’ Style of Investing

“Jesus, man!”

I just uttered those words — with a smile — when checking a stock quote. I was looking up Valley National 5.50% Fixed to Floating Rate Preferred Shares Series B (VLYPO) , which, trading at $22.44, has now risen 35% since I initiated a position for my largest client on May 2. And VLYPO is yielding 13.47%. That is based on our cost basis and the second-quarter dividend of $0.558/share, which was declared on May 23, and will be paid on June 30th to shareholders of record as of June 15.

So, that’s the goal in fixed-income land. To acquire equity-like returns without taking equity market risk. Yes, that still exists, even though it may not seem that way on a Green Day like today. If you are feeling too happy about the U.S. economy, go back and listen to Dollar General’s earnings call from yesterday. Ugly, ugly, ugly.

But when bonds are trading at below their par value, a simple mathematical “what if” makes projecting returns quite simple. What if they were trading at par? I used that math to calculate a 54% return for my FAITH model portfolio, which I introduced this week and mentioned in my last column. VLYPO is a part of FAITH, of course.

So, the skill in fixed-income portfolio management lies in divining what circumstances would be needed to bring below-par securities back to par. First and foremost is always the call date. VLYPO is callable, and has been since June 30, 2022. I have never met Michael Hagedorn, Valley National’s CFO, but if he is as happy to be paying 13.47% on small tranche (around $98 million) of preferred shares as my clients and I are happy to be receiving that yield, then he is delusional. Valley National is a very well-run bank, so clearly he is not.

The other side of that equation is that VLYPO counts as Tier 1 capital — as do all the bank preferreds I have bought for my customers and included in my model portfolios like FAITH and WYLD — for Valley National. In the aftermath of Silicon Valley Bank, Signature and First Republic, it behooves bank managements to show as much regulatory capital as possible when the regulators arrive to check the books.

So, there is paper out there that is fundamentally mispriced, and actually shouldn’t be trading at all … but is. And I am loving the returns.

The other half of the returns equation is the level of market interest rates, and that is a trickier calculus. The CME’s FedWatch tool is now showing a 72.4% chance of no hike from the Federal Open Market Committee at its next meeting on June 14, a huge turnaround from a week ago, when that same indicator was showing a 64.2% chance of a 25-basis point rate hike at that FOMC meeting. The bond market is as unpredictable as ever, and the market’s shift in perception to comprehend a lower chance of a rate hike at the next FOMC meeting, has fueled this week’s equity rally.

So, VLYPO and all the WYLD names pay quarterly based on three-month LIBOR plus a spread (3,578 basis points, annualized, in VLYPO’s case) but trade based on long-term interest rates. The usual benchmark there is the 10-year U.S. Treasury note. The yield on that benchmark is 3.67% as of this writing. Really, long rates have done very little this year, as the 10-year UST yield was 3.88% as of Dec. 31, 2022.

So that is the sweet spot for fixed-income investors like myself. That also at least gives us a chance of keeping pace with the raging bulls driving the equity markets.

VLYPO was just incredibly mispriced at ExCap’s in-price of $16.58 (66 cents on the dollar) and I bought it with both hands. Are there other such opportunities still remaining?

Sure.

Here are two that I have mentioned many times in previous columns. Gladstone Commercial’s “GOODO” and “GOODN” 6% and 6.6.25% perpetual preferred shares  (GOODO)  ,  (GOODN) . GOODO is trading at $15.49, so priced to yield 9.7% based on its monthly dividend rate of $0.125/share. This is as wacky to me as VLYPO was two months ago, especially since Gladstone Commercial is not a bank holding company. Gladstone Commercial owns bustling industrial parks and sleepy little office complexes in out-of-the-way places like Scranton and Salt Lake City. Gladstone owns nothing in the New York City metro area, nothing in California at all, and crucially, no skyscrapers. No matter how much scorn market prognosticators heap on the prospects for urban, skyscraper-dominated commercial real estate markets like San Francisco and New York City, Gladstone Commercial will be fine.

So I dutifully buy more GOODO and GOODN for myself and my clients on the last day of every month when I receive the monthly dividends. That brings down my cost basis and brings up the average yield of my portfolio.

Lather. Rinse. Repeat. It seems boring, but when it produces around 50% returns, even that boring strategy can induce an investor to utter mild-profanities. In a good way. Enjoy your weekend!