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Don't Like Being Called? Neither do Preferreds

Flaherty & Crumrine, Incorporated

August 13, 2021

In the preferred market, call protection allows investors to tolerate lower interest rates for a period of time without reinvestment risk – and we place a high value on call protection in process. Low interest rates and tighter credit spreads arrived as non-call periods ended for a wide swath of the broader preferred market, resulting in advantageous refinancing opportunities for issuers over recent months. Many securities have been refinanced into lower coupons, but part of the market has been redeemed without replacement. Recent redemptions resulted in a large reinvestment exercise across the preferred market, adding demand to an already technically strong market.

We have long touted the benefits of having more call protection; it provides greater control of reinvestment timing and more stable portfolio income. Additionally, and perhaps most importantly, in today’s low interest rate environment where most preferreds trade at a premium, preferreds with longer call protection can sustain higher prices since they have more time to amortize price premiums before being called at par. To understand why this is the case, see the hypothetical illustration below:

Imagine there are two securities that are identical in all respects except call protection. Both are priced at 105 and can be called at their par value of 100. Between now and when they are called, the price on both will decline to 100, resulting in a roughly 5% price loss. However, the security with longer call protection will spread this 5% price loss over a longer period of time, all the while continuing to earn its coupon, and thus resulting in a higher economic yield. From this example we can conclude that, at any given price above par value, the yield-to-call will be higher for a security with longer call protection, precisely because the price premium will be amortized over a longer time period.

Ultimately, one should expect the benefits of longer call protection to be borne out in performance, particularly over longer time periods. However, it’s important to note that longer call protection (particularly 5+ years of call protection) is a feature that is found more commonly among institutionally structured fixed-to-float preferreds, which explains why we also have a positive bias towards those structures.

This information was provided to Destra from Flaherty & Crumrine, it has not been independently verified and is subject to change.