Co-produced with Preferred share dealer

Introduction

It was a scary time for investors in 2020. For many, it has been very painful. Despite the risks in the market, most investors did not abandon the markets because yields on treasury bills, bonds and certificates of deposit were not very high. This article focuses on relatively conservative investors seeking a good flow of after-tax income while trying to minimize risk. In our research, we found preferred shares of 3 companies that we believe should be core holdings for any fixed income portfolio. These 3 companies are :

  1. ARES Management (ARES)
  2. Apollo Global Management (APO)
  3. PartnerRe Ltd. (PRE).

Methodology

In order to find relatively safe but high yielding preferred shares, we searched a preferred share universe to eliminate only fixed-rate preferred shares :

  1. Who pays an eligible dividend
  2. Have an investment grade rating from Standard & Poors (excluding ratings from Fitch and Moody’s).

Once we identified the preferred shares that met these criteria, we then refined our list by eliminating the preferred shares that :

  1. Are already refundable,
  2. Which have a return of less than 3% (YTWs)
  3. And those with current yields below 5%.

After all of the above research, you can find the results of our research in the chart below which shows both the current yield of strip bonds on the Y-axis and the yield to market (YTW) on the X-axis.

Source: EQH-A, ACGLO and WFC-G (right side of chart) have high call yields simply because they are trading below par while all other preferreds on the chart are trading above par: Author and Beta Trading

As shown in the chart of all preferred shares that met our criteria, the seven preferred shares in the top half of the chart met all of our criteria :

  • APO-A (APO.PA) – Yield 6.2% – Yield 7.0% – Yield 6.9% PRE-H (BBB rated)
  • APO-B (APO.PB) – Yield 6.1
  • ARES-A (ARES.PA) – Yield 6.9
  • PRE-H (PRE.PH) – Yield 7.0
  • PRE-G (PRE.PG) – Yield 6.4
  • BHFAO (BHFAO) – Yield 6.7%, issued by Brighthouse Financial (“BHF“)
  • BHFAP (BHFAP) – Yield of 6.5%, issued by Brighthouse Financial (“BHF“)

The above values are clearly the best in the “investment grade space”. ATH-B, PRE-I, EQH-A, ACGLO and WFC-G (on the right hand side of the chart) have high call yields simply because they are trading below par while all other preferred stocks on the chart are trading above par.

We then did further research on these preferred shares and found that we really liked the APO, ARES and ERP preferred shares. We decided to exclude BHF’s preferred shares because of their lower rating than an investment from Moody’s and Fitch. In addition, BHF’s balance sheet is highly leveraged and we believe that Moody’s and Fitch are right while S&P is wrong. BHF’s common shares have also been weak (see chart below). Therefore, we do not recommend BHFAO and BHFAP.

Graph of BHF’s price over 3 years

Source: Etrade

Graph of performance measures for APO-A, APO-B, ARES-A, PRE-G and PRE-H and peer comparisons

Source: Author – July 2

The above table is generally self-explanatory, except perhaps the last column. This column represents the higher return you should receive from a bond or preferred share that pays common dividends, to match the after-tax return on qualified dividends paid by the listed preferred shares (using the 32% tax bracket).

For example, to get the same after-tax yield as ARES-A (current yield of 6.9%), you need to find a bond or common preferred share with a current yield of 8.6%. This demonstrates the higher after-tax yields on these recommended preferred shares due to the favourable tax rates offered by eligible dividends.

You will never find an investment grade security with a current yield as good as the preferred shares we recommend. For those unfamiliar with “qualified dividends”, in a taxable account, an investor in the 32% tax bracket will only have to pay a 15% tax rate on dividends from shares that pay “qualified dividends”.

Choice #1: Apollo Global Management Preferred Shares

Apollo Global Management (“APO”) has two preferred shares outstanding, APO-A and APO-B :

  • Apollo Global Management, 6.375% Non-Cumulative Redeemable Preferred Shares Series A (“APO.PA“)
  • Apollo Global Management, 6.375% Non-Cumulative Redeemable Preferred Shares Series B (“APO.PB“)

Both pay the same “qualified” dividend of $1.59 per year, for a yield of +6%.

These preferred shares are rated BBB+ by S&P, the highest of all the preferred shares they rate. APO is a private equity firm managed by the well-known and highly respected Leon Black. It has had a strong track record with a share price that has more than doubled over the past five years, while continuing to pay a high dividend on its common shares. In addition, it has fully recovered from the sale of the COVID-19 stock exchange.

APO 5-Year Price Table

Source: Etrade

To our knowledge, only three other companies have preferred shares that also received a BBB+ rating from S&P at the time of the IPO.

  1. One of them is KKR & Co. (KKR), another private equity firm, but their preferred shares have a yield at worst of less than 3%, making the APO preferred shares much more valuable.
  2. Another example is the Alabama Power Company preferred ALP-Q (ALP.PQ) with a yield of only 3.1% over the market price.
  3. And the final BBB+ preferred share is Northern Trust Corp. (NTRS). APO’s preferred shares are destroying NTRS’ preferred shares (NTRSO) with a current 33% higher yield and a much higher worst-case yield.

Compared to its peers NTRSO, ALP-Q and KKR, APO-B is clearly a good deal.

We prefer APO-B to APO-A because of its higher yield and the fact that it is not redeemable until March 2023 (APO-A is redeemable in March 2022).

We believe that APO preferred shares present little downside risk to prices, other than the possibility of temporary price declines due to panic selling. Therefore, they are excellent for conservative and/or nervous investors.

In addition, as shown in our Yield Metrics chart, the APO 2024 bond offers a very low yield to maturity of 1.7%, which indicates how much investors consider the APO as a safe bet and also underlines how good the yield on preferred shares is, especially when one also takes into account the tax advantage that only preferred shares receive.

The APO-B hit $27.90 in February, almost $2.00 higher than its current price. So don’t think that this preferred share can’t also offer a price increase in the short term.

Choice #2: ARES Management Preferred Shares

Ares Management Corp, 7.00% Non-Cumulative Redeemable Preferred Units Series A (ARES.PA)

Like APO, Ares Management (“ARES“) is also a private equity firm, but due to its higher leverage, it is rated BBB- by S&P. ARES has an excellent track record, having doubled its share price in the last three years and having almost fully recovered from the sale of COVID.

ARES price table over 3 years

Source: Etrade

ARES has one preferred share outstanding. ARES-A pays an annual “qualified” dividend of $1.75. As shown in our bubble chart, ARES-A has the highest current yield of all investment grade preferred shares rated by S&P, with the exception of PRE-H, but its scrap yield is higher than that of PRE-H.

The thesis on ARES-A is almost identical to that of APO-B. It is significantly undervalued on the basis of current yield and would trade at a much higher level were it not for the fact that it could be called when it becomes due in June 2021. As you can see in the table above, its performance parameters are much better than those of its peers, both on a current yield basis and on a yield to market basis. ARES bonds maturing in 2024 have a yield to maturity of 2.5%, demonstrating the low risk that institutional investors see in ARES, and again underscores the quality of the current yield on preferred shares compared to bonds. After-tax, the current yield on ARES-A is more than three times that of the ARES bond.

As recently as March, just before the sale of COVID, ARES-A traded at $27.15, leaving room for a short-term price increase and a large “qualified” yield.

Choice #3: PartnerRe preferred shares

PartnerRe Ltd. owns four preferred shares that pay eligible dividends and are rated BBB by S&P. In addition, the company is rated A+ by the insurance rating agency A.M. Best. PartnerRe’s 4 preferred shares are as follows:

  • PRE-F – (PRE.PF): – $1.47 per annum Non-cumulative dividend, redeemable at any time, yield 5.8
  • PRE-I – (PRE.PI): $1.47 per annum Non-cumulative dividend, callable on 4/29/2021, yield 5.8
  • PRE-G (PRE.PG): $1.625 annual cumulative redeemable 4/29/2021 dividend, yield 6.4%
  • PRE-H (PRE.PH): $1.81 annual cumulative dividend, callable on 4/29/2021, yield 7.0

PartnerRe is a property and casualty insurance company that is extremely friendly to preferred shareholders. It was privatized in 2016 by EXOR, but did not call its preferred shares at the first opportunity, which would have made the most sense with high-yielding companies like PRE-G and PRE-H. Instead, it allowed shareholders of PRE-I, PRE-G and PRE-H to exchange their preferred shares for identical preferred shares and provided them with a five-year call protection. Surprisingly, EXOR also proposed to increase the yield on their preferred shares by 1%. When the IRS rejected this offer, it instead made a cash payment to the preferred shareholders of approximately $42.7 million. In 2016, the highest yield, PRE-H, skyrocketed to more than $31 per share. It is hard to imagine that a company would not take the opportunity to call these preferred shares very expensive and instead pay them more money. The PRE-F has been redeemable for over two years and there have been times when it would have made sense to redeem the PRE-F, but that was not the case. In addition, although PartnerRe is now a private company, it still provides insiders with financial information about the company at Financial Information. And if this is not enough, they continue to pay to have their preferred shares valued.

As shown in the bubble chart above, PRE-H is currently the highest yielding investment grade preferred share with a current yield of 7%. While the yield to market price ratio may not look very good to some, it is actually quite decent for a preferred share with a call date of less than one year, and given the history of PRE, it may not call when that date arrives. Even if they were to call it, the “qualified” yield of 3.1% is quite decent for a 10-month paper. We have a few other preferred shares in the above performance measures table with similar call dates to PRE-H, namely First Republic Bank Preferred G (FRC.PG) and Bank of America Preferred A (BAC.PA). Despite their lower credit ratings, PRE-H has a YTW that is competitive with these lower-rated preferred shares.

The reason we say that PRE-H is safe is that it has the highest coupon of all “qualified” and investment grade preferred shares, which cushions the decline. Without the possibility of redemption, it would trade at approximately the same yield as PRE-F, which would put PRE-H at a price of $30.70 per share. The likelihood of it trading permanently below par is therefore difficult to see at this time. If the PRE-F fell from $4.00 per share to $21.14, it would have a 6.9% return, still below that of the PRE-H. So it will take a huge sale to bring the price of PRE-H down to a level well below what it is now.

The PartnerRe 2029 bond shown in the graph above currently has a yield to maturity of 2.5%. As with ARES and APO, this shows how the market views PartnerRe as a safe bet and how good the current yield on PRE-H is – more than three times the YTM of the PRE bond on an after-tax basis. A price increase is also possible as PRE-H traded as high as $27.80 in January and reached $27.25 in early March, just before it was sold during the VIDO debacle in March.

While we think that PRE-G is also very attractive in this area, and its higher YTW yield may be attractive to some, the higher dividend provided by PRE-H adds a huge level of security with which PRE-G simply cannot compete at its current prices. With the huge qualifying dividend provided by PRE-H, we see that it is the safest preferred share in terms of downside price risk (aside from the CEF Type A preferred shares such as the preferred shares of the Gabelli mutual funds).

Comparison between APO-B, ARES-A and PRE-H and non-qualified dividend payers

There are very few non-investment grade preferred shares that are rated by S&P, and none approach the yields of APO-B, ARES-A and PRE-H, even without taking into account the tax advantages enjoyed by these “qualified” dividend payers. KIMCO’s BBB- preferred shares (KIM) are one of the few non-qualified investment grade preferred shares. KIM-L (KIM.PL) and KIM-M (KIM.PM) have a current yield of approximately 5.5%, which gives an after-tax return well below that of our recommended preference shares. And while APO and ARES common shares are near their highest levels, KIM is well below its highest and is directly in the line of sight of COVID-19.

Summary

As a result of our extensive preferred share research, which compared all fixed-rate preferred shares rated by S&P, we found 3 preferred shares that really stood out from all the others. These are the following shares:

  1. APO-B (BBB+ rating) – yield 6.1
  2. ARES-A (rating BBB-) – yield 6.9
  3. PRE-H (BBB) – yield 7.0

They will be three of the most stable preferred shares in terms of price if we see a general sell-off, and they offer excellent after-tax returns. The reason these three preferred shares will be so resistant to a preferred share sale is because these preferred shares would trade several points (dollars per share) higher if not for the fact that they may eventually be called.

And a look at our “Yield Metrics” graph above shows that the equivalent unqualified before-tax unqualified yield you would need to match the after-tax yield of APO-B, ARES-A and PRE-H are 7.6%, 8.6% and 8.8% respectively. The after-tax returns on these three preferred shares are simply excellent, given their quality.

We believe that these 3 stocks should be core holdings for any fixed income portfolio. The yields of the APO, ARES and PRE bonds are 1.7%, 2.5% and 2.5% respectively and mature in 2024, 2024 and 2029 respectively. The very low bond yields of these companies show how safe investors consider these companies to be and underline how much better the returns of their preferred stocks are than those of their bonds; especially the after-tax returns since bonds have no tax advantages.

Finally, APO-B, ARES-A and PRE-H are still trading on average close to $2 below their 2020 highs.

Thank you for reading! If you liked this article, please scroll down the page and click “Next” next to my name to receive future updates.

 

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Disclosure: I am/we are long APO.PB, ARES.PA, PRE.PH. I wrote this article myself, and it expresses my own opinions. I receive no compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose actions are mentioned in this article.

Editor’s note: This article deals with one or more securities that do not trade on a major U.S. stock exchange. Please be aware of the risks associated with these securities.

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2020-07-12