The Unstoppable Rally Creates A Broken Market Where No One Is Watching (And A Look At PFF)

seekingalpha2024-10-25

Misconceptions in fixed-income investments include overreliance on the Fed Funds Rate, misunderstanding call options on preferred stocks, and ignoring NAV premiums and discounts.Credit risk premiums ...

Source Link

Disclaimer: Investing carries risk. This is not financial advice. The above content should not be regarded as an offer, recommendation, or solicitation on acquiring or disposing of any financial products, any associated discussions, comments, or posts by author or other users should not be considered as such either. It is solely for general information purpose only, which does not consider your own investment objectives, financial situations or needs. TTM assumes no responsibility or warranty for the accuracy and completeness of the information, investors should do their own research and may seek professional advice before investing.

Comments

We need your insight to fill this gap

Leave a comment

{"i18n":{"language":"en_US"},"isChannel":false,"data":{"share":"https://ttm.financial/m/news/2478515642?lang=en_US&edition=fundamental","thumbnail":"https://static.seekingalpha.com/cdn/s3/uploads/getty_images/1222778351/image_1222778351.jpg","is_english":true,"pubTime":"2024-10-25 00:33","share_image_url":"https://static.laohu8.com/5a36db9d73b4222bc376d24ccc48c8a4","id":"2478515642","market":"sg","top_or_hot":-1,"title":"The Unstoppable Rally Creates A Broken Market Where No One Is Watching (And A Look At PFF)","media":"seekingalpha","content":"<div>\n<p>Misconceptions in fixed-income investments include overreliance on the Fed Funds Rate, misunderstanding call options on preferred stocks, and ignoring NAV premiums and discounts.Credit risk premiums ...</p>\n\n<a href=\"https://seekingalpha.com/article/4729081-the-unstoppable-rally-creates-a-broken-market-where-no-one-is-watching\">Source Link</a>\n\n</div>\n","source":"seekingalpha","html":"<!DOCTYPE html>\n<html>\n<head>\n<meta http-equiv=\"Content-Type\" content=\"text/html; charset=utf-8\" />\n<meta name=\"viewport\" content=\"width=device-width,initial-scale=1.0,minimum-scale=1.0,maximum-scale=1.0,user-scalable=no\"/>\n<meta name=\"format-detection\" content=\"telephone=no,email=no,address=no\" />\n<title>The Unstoppable Rally Creates A Broken Market Where No One Is Watching (And A Look At PFF)</title>\n<style type=\"text/css\">\na,abbr,acronym,address,applet,article,aside,audio,b,big,blockquote,body,canvas,caption,center,cite,code,dd,del,details,dfn,div,dl,dt,\nem,embed,fieldset,figcaption,figure,footer,form,h1,h2,h3,h4,h5,h6,header,hgroup,html,i,iframe,img,ins,kbd,label,legend,li,mark,menu,nav,\nobject,ol,output,p,pre,q,ruby,s,samp,section,small,span,strike,strong,sub,summary,sup,table,tbody,td,tfoot,th,thead,time,tr,tt,u,ul,var,video{ font:inherit;margin:0;padding:0;vertical-align:baseline;border:0 }\nbody{ font-size:16px; line-height:1.5; color:#999; background:transparent; }\n.wrapper{ overflow:hidden;word-break:break-all;padding:10px; }\nh1,h2{ font-weight:normal; line-height:1.35; margin-bottom:.6em; }\nh3,h4,h5,h6{ line-height:1.35; margin-bottom:1em; }\nh1{ font-size:24px; }\nh2{ font-size:20px; }\nh3{ font-size:18px; }\nh4{ font-size:16px; }\nh5{ font-size:14px; }\nh6{ font-size:12px; }\np,ul,ol,blockquote,dl,table{ margin:1.2em 0; }\nul,ol{ margin-left:2em; }\nul{ list-style:disc; }\nol{ list-style:decimal; }\nli,li p{ margin:10px 0;}\nimg{ max-width:100%;display:block;margin:0 auto 1em; }\nblockquote{ color:#B5B2B1; border-left:3px solid #aaa; padding:1em; }\nstrong,b{font-weight:bold;}\nem,i{font-style:italic;}\ntable{ width:100%;border-collapse:collapse;border-spacing:1px;margin:1em 0;font-size:.9em; }\nth,td{ padding:5px;text-align:left;border:1px solid #aaa; }\nth{ font-weight:bold;background:#5d5d5d; }\n.symbol-link{font-weight:bold;}\n/* header{ border-bottom:1px solid #494756; } */\n.title{ margin:0 0 8px;line-height:1.3;color:#ddd; }\n.meta {color:#5e5c6d;font-size:13px;margin:0 0 .5em; }\na{text-decoration:none; color:#2a4b87;}\n.meta .head { display: inline-block; overflow: hidden}\n.head .h-thumb { width: 30px; height: 30px; margin: 0; padding: 0; border-radius: 50%; float: left;}\n.head .h-content { margin: 0; padding: 0 0 0 9px; float: left;}\n.head .h-name {font-size: 13px; color: #eee; margin: 0;}\n.head .h-time {font-size: 11px; color: #7E829C; margin: 0;line-height: 11px;}\n.small {font-size: 12.5px; display: inline-block; transform: scale(0.9); -webkit-transform: scale(0.9); transform-origin: left; -webkit-transform-origin: left;}\n.smaller {font-size: 12.5px; display: inline-block; transform: scale(0.8); -webkit-transform: scale(0.8); transform-origin: left; -webkit-transform-origin: left;}\n.bt-text {font-size: 12px;margin: 1.5em 0 0 0}\n.bt-text p {margin: 0}\n</style>\n</head>\n<body>\n<div class=\"wrapper\">\n<header>\n<h2 class=\"title\">\nThe Unstoppable Rally Creates A Broken Market Where No One Is Watching (And A Look At PFF)\n</h2>\n\n<h4 class=\"meta\">\n\n\n2024-10-25 00:33 GMT+8&nbsp;&nbsp;&nbsp;<a href=https://seekingalpha.com/article/4729081-the-unstoppable-rally-creates-a-broken-market-where-no-one-is-watching><strong>seekingalpha</strong></a>\n\n\n</h4>\n\n</header>\n<article>\n<div>\n<p>Misconceptions in fixed-income investments include overreliance on the Fed Funds Rate, misunderstanding call options on preferred stocks, and ignoring NAV premiums and discounts.Credit risk premiums ...</p>\n\n<a href=\"https://seekingalpha.com/article/4729081-the-unstoppable-rally-creates-a-broken-market-where-no-one-is-watching\">Source Link</a>\n\n</div>\n\n\n</article>\n</div>\n</body>\n</html>\n","isBrief":false,"type":0,"news_type":1,"symbol":"BK4585","symbol_name":"ETF&股票定投概念","start_time":0,"source_url":"https://seekingalpha.com/article/4729081-the-unstoppable-rally-creates-a-broken-market-where-no-one-is-watching","article_id":"2478515642","we_media_id":null,"thumbnails":["https://static.seekingalpha.com/cdn/s3/uploads/getty_images/1222778351/image_1222778351.jpg"],"rights":null,"url":"https://stock-news.laohu8.com/highlight/detail?id=2478515642","pubTimestamp":1729787634,"columns":[],"sourceInfo":{"source_id":"seekingalpha","name":"Seeking Alpha"},"weMediaInfo":null,"summary":"Misconceptions in fixed-income investments include overreliance on the Fed Funds Rate, misunderstanding call options on preferred stocks, and ignoring NAV premiums and discounts.Credit risk premiums a","collect":0,"end_time":0,"defaultTopTitle":"seekingalpha.com","property":[],"viewcount":null,"language":"en","relate_stocks":{"BK4585":"ETF&股票定投概念","BK4588":"碎股","PFF":"优先股指数ETF-iShares S&P"},"translate_title":"不可阻挡的反弹创造了一个无人关注的破碎市场（看看PFF）","themeId":null,"isJumpTheme":false,"ttsUrl":null,"symbols_score_info":{"PFF":0.9},"content_text":"Misconceptions in fixed-income investments include overreliance on the Fed Funds Rate, misunderstanding call options on preferred stocks, and ignoring NAV premiums and discounts.Credit risk premiums and duration are crucial for evaluating fixed-income securities, with a focus on spreads rather than absolute yields.The market inefficiencies in preferred stocks, CEFs, BDCs, and MREITs highlight mispricings, with ETFs contributing to a mini-bubble due to irrational buying behavior.Current investment strategy: Long TLT vs. short 5% CY preferred stocks, long ECC-D and NCZ-A vs. short PFF and PGX, and short RCS and AGNC with partial hedges.   PM ImagesIt's strange how anything can become invisible when we close our eyes. Apart from all the suffering in the world, I want to bring your attention to the inefficiencies created in the fixed-income part of the market. To do this, I will show some apparent mispricings in preferred stocks, closed-end funds, preferred stock ETFs, and some common stocks that should be easier to evaluate. Before going to the examples, it's essential to understand some basic principles of assessing different exchange-traded products and to make sure the reader is not infected with false information and misconceptions. Hopefully, you don't think that:   The Fed Funds Rate is the only yield in the market that's the benchmark for everything else. It's the ultimate monetary policy instrument, but there's a whole yield curve, and any fixed-income instrument has its own duration and credit risk. 30-year corporate bonds have a completely different duration compared to the overnight borrowing rate. When looking at credit spreads to the so-called risk-free benchmark, you have to look further than the Fed Funds Rate. For example, the Fed funds rate may go lower while the 30-year Treasury yield can move higher simultaneously. A 30-year corporate bond is expected to move with the 30-year Treasury yield rather than the fed funds rate.  A call option on a preferred stock is somehow beneficial for the holder of the preferred stock. When you own a redeemable preferred stock, the embedded call option is never an asset for you, regardless of the price of the preferred stock. You are just short a call option, which is always a liability. Preferred stock may trade at 40% of par value, and the call option may have a value very close to 0, but it's still a positive value. A company will redeem a preferred stock only if it has determined that the value of the preferred stock is higher than the redemption price.  Premiums and discounts to NAV are irrelevant as long as a CEF, MREIT, or BDC has a high distribution yield. One must always disregard this metric. It means absolutely nothing in terms of fair value. Ultimately, any investment distributes its value and not its current yield metric.  You read a headline available to anyone with an IQ above 60 in the world, and it gives you an advantage in the market. Amazingly, it's not that simple. We live in a world where competitive advantage is tough to achieve. The market is not an exception. Imagine participating in a professional boxing match after practicing how to throw a jab for some time. You cannot expect anything other than going to the hospital.  I should never sell my positions in fixed income, BDCs, and MREITs. The whole buy-and-hold idea is really questionable. When we talk about fixed income, it's more than absurd. Fixed income instruments very often have a strict, easy-to-understand pricing model that's not questionable. Imagine a preferred stock that's callable at $25 in one month that trades at $28 due to a buy imbalance at the close of trading. Not taking advantage of selling at an unreasonably overvalued price is plain dumb.  There are many more misconceptions, but these are the most important ones in the article. Before proceeding with the examples of our broken market, I find it essential to explain duration and credit risk premium. Credit risk premium in the USA fixed-income securities. There's only one debt issuer that is considered to be \"risk free.\" As Buffet famously stated, the US will always be able to pay its debt in US dollars. All other issuers in the US economy cannot print US dollars. They have to earn them somehow, which increases their credit risk. The more risk there is, the more expected return there is, and any debt issuer has to pay a premium above what the US can finance its debt. This is the famous risk premium. If there's a lot of data, one can theoretically and practically determine what the fair value of this risk premium is for every debt issuer. Credit rating agencies are doing a great job of evaluating credit risk, which the public then uses when it determines credit risk premiums. Usually, you will see a corporate bond IPO priced in relation to its benchmark Treasury bond. Imagine that the 10-year Treasury note is trading at 4%, and a bank issuer is selling bonds to the public at 5%. The 1% risk premium would be the risk premium the public is willing to pay for taking the extra risk in comparison to the US Treasury. Very often, fixed-income traders will concentrate on the spreads rather than the absolute value of the yield metric. Financial thinking is relative, and all that matters is that your investment is good on a relative basis. You cannot do better than the best option out there. Duration of a fixed-income instrument. When this term is used, one usually opens Investopedia and looks at the formulas to calculate the most famous durations given. Of all the traders I know, very few draw the price/yield chart to determine the exact functional behavior of the price to the yield. As much as I like standardization, one needs to know that the standardized formula of modified duration, as an example, is always an approximation. I will quote Investopedia about the modified duration:  Modified Duration The modified duration of a bond helps investors understand how much a bond’s price will rise or fall if the YTM rises or falls by 1%. This is an important number if an investor is concerned that interest rates will change in the short term.  Modified duration is a linear approximation of the price/ YTM relation. This is a functional relation, and usually, it can be calculated more precisely with a simple Google sheet:   Price/Yield Chart (Author's spreadsheet)Once you have done this, you can simply calculate the percentage change in the price for any given change in the bond's yield to maturity. The largest misconception here comes from the fact that, very often in the explanation, one can read that duration measures how the price reacts to a percentage change in interest rates. The big question here is which rates. While the YTM vs. Price of a bond has a functional relation in which you can precisely calculate the price given the YTM and vice versa, the same is not true when we talk about interest rates in general. I have had a lot of traders thinking that a 20-year bond will fall a certain percentage based on the Fed funds rate change. Duration does not measure this and the relation here has to be examined statistically. It all depends on the yield curve and how credit spreads change for products of similar duration. This is a complex task, and it is way harder than calculating the duration. In general, one has no clue how the treasury yield curve will shape on any given Fed funds rate decision, and this has been proven through the years. One has even less clue how a Fed funds rate decision will affect your 20-year bond-holding. Most importantly, knowing that the Fed will cut rates should not blindly allow you to buy any long-term fixed income in the market because the big rally of lowering rates is coming. A more sophisticated approach would be to concentrate on the risk premium. It gives you the real picture of whether a fixed-income security is undervalued or overvalued. If you're patient enough and have read all the information above, it's time to get to real-life examples of how broken the market is. Preferred stocks credit spreads as narrow as 0.6% At the time of writing, there are a lot of fixed-rate preferred stocks that trade at around 5% current yield:   Preferred stocks current yield (proprietary software)At the same time, the 20-year and 30-year Treasury yields are around 4.4%:   US Yield Curve (Investing.com)The duration of a perpetual preferred stock with a current yield of 5% is very similar to that of a 20-year or 30-year bond. The one big difference here is that the price appreciation potential of the preferred stock is extremely limited by its redemption clause:   Price/Yield Curve of a callable instrument vs plain vanilla instrument (author's spreadsheet)On the downside, preferred stock is expected slightly to underperform the Treasury bond (all else being equal), and on the upside, there simply isn't any comparison, and this is just the beginning. In 2022, interest rate risk was all over the news. Any comment you read on Seeking Alpha was about how dangerous it is to buy preferred stocks. I do agree, but let's take a look at what happened. We will use JPM-M as our role model. The preferred stock was issued back in 2021 with a 4.2% coupon, while the 20-year Treasury yield was around 1.85% at the time, or a spread of around 2.35%. The 20-year now is at 4.45% while JPM-M is at 5%. This is a spread narrowing of around 1.8%. Are banks safer now compared to 2021 after some of history's most significant bank failures? I seriously doubt it, but it is what it is. Since the time of its IPO, JPM-M has significantly outperformed the 20-year treasury bond represented by the ETF TLT:   TLT vs JPM-M performance (proprietary software)Including the dividends, JPM-M is rock solid compared to TLT. I don't remember a single person predicting this back in 2022. It looks like JPM-M does not have the expected duration risk. Now that this has happened, people are trying to rationalize it. One effort to rationalize it is the after-tax yield spread. Let's assume 30% taxation on the Treasuries and 15% on the preferred stock. The after-tax spread at the IPO date was around 2.27%, and now it's around 1.17%. 1% is not that much, but when it comes to an instrument with a downside duration of around 15, it's a huge number. And it's not only JPM-M. Almost any fixed-rate preferred stock has seen its credit spread narrow to unseen levels. How is this even possible? It's also very important to note that on the upside, the spread will have to go back to where it was, so even if the tax rationalization is on the downside, it's definitely not rational on the upside. The way these products trade, there's no downside. ETFs, sentiment and the Fed Funds Rate. At the time of writing, the market cap of US companies is around $55 trillion. The exchange-traded fixed-income part of the market is roughly $180 billion. The US bond market is estimated to be around $46 trillion. An ETF like the US Preferred stock ETF (NASDAQ:PFF) owns 8% to 10% of all the issues of the instruments it holds. PGX holds 3% to 5% of the entire issue of its constituents. These two fixed-income ETFs don't have yield criteria for their constituents. It's perfectly fine for their managers to buy instruments with negative yields to call. It's regular for them to buy a preferred stock from the same issuer at a lower yield. In reality, they act like an AI without any thinking involved whatsoever. And it's a truly bad programmed AI. We have a situation in which the biggest players in the preferred stock market are not only dumb, but are also not willing to maximize returns. The result of their actions has no bearing on anyone other than the holder of the ETF. A holder of an ETF is also not very interested in real analysis. The way investment works is that the general public is certain they cannot outperform the stock market (which is probably true for common stocks), so they buy ETFs without paying attention to what they buy. And here we are in 2024 when, finally, the Fed started lowering its Fed funds rate. The general public is interested only in this rate. It's all over the news. It's the single most important rate discussed by Fed officials. And finally, we all know that \"rates are going lower.\" Which exact rates? It does not matter. We must invest in fixed income because it rises when interest rates decrease. We need to do that fast. Any other idea - let's see what preferred stocks of the big companies trade below par. These have to go higher when rates rise, don't they? Imagine what happens when this is the thinking of the general public. This is a public that has seen its savings do this in the last few years:   SPY chart (Google)If you're an investor, you're making abnormal returns. You need to save some of these returns by investing in something safer, such as fixed income, and the rates are going lower. As stated above, the common stock market is around 300 times bigger than the preferred one. Now imagine what happens to a market niche so small that it gets some attention, and your smart money is PFF and PGX, who don't even look at yields. It's a recipe for a mini-bubble. It's a bubble that will likely not hurt anyone, but it's still something we call a broken market. We have monitored these stocks every single minute for the last 15 years, and PFF has never been that bullish without any reason whatsoever. A fund like PGX is up 13% for the year, while TLT has been flat:   TLT vs PGX (proprietary software)This has resulted in the unseen narrowing of credit spreads in any single preferred constituent of the ETFs. And this is not all. There are preferred stocks not in the ETF that have not narrowed that much regarding credit spreads. NCZ-A is a CEF preferred stock (superior in credit rating to any PFF constituent) issued in 2018 at a 2.5% spread to the 20-year. This current spread is around 1.85% (primarily because of our buying, to be honest). There's no actual volume on the buy side. Even more interesting is that recent IPOs of preferred stocks don't come at spreads so much different than historical spreads:   Recent IPOs (proprietary software)ALL-J, MTB-J, and RF-F were issued recently, and all came at historically typical spreads to the 20-year Treasury yield. Somehow, the market sees the credit premium differently compared to sophisticated underwriters pricing these things for decades. CEFs and BDCs Here, just look at premiums close to 70% for companies that just manage a portfolio. High distribution yields are not what you earn. A portfolio manager in a CEF or a BDC will never be able to gain some insane return. It's all about what asset class is being managed and what the asset class does. Management simply has no discretion in using their superhuman abilities to generate extra returns, even if they have them. If you're constantly fully invested in a diversified portfolio with regulatory leverage, there's very little you can do to deserve a 70% premium to net asset value. The market eventually questions such premiums, and the long-term holder pays the price for not selling when the valuation goes crazy high. I will just show the charts of RCS and HTGC as an example of extremes:   RCS price/NAV chart (Cefconnect.com)There's nothing to justify such a crazy pump in a CEF that's earning 5% a year for the last 10 years:   RCS performance (Cefconnect.com)No reasonable investor will be willing to pay a 70% premium for an NAV that has been giving you 5% per year with some nasty deviations. HTGC is in a similar situation with a somewhat better return:   HTGC discount/premium chart (Cefdata)And one needs to understand that when you invest in high yield, you get high yield as long as nothing happens. You took the risk and earned the reward, but it does not make your return \"alpha.\" The BDC sector is a place where companies manage to benefit from financial regulation, and as with all similar entities, profitability will slowly and surely return to more normal levels as more and more competition will eat up the alpha generated. This is a very long topic, but in general, be very careful when you pay 70% above NAV for someone to manage a portfolio, especially when this is a historical extreme. Finally, MREITs are trading at 20% premiums to NAV. Buying agency mortgage-backed securities, leveraging a spread that's hard to manage, and getting lucky because downside duration does not hit you as expected by the models, and trading at a 20% premium to NAV. How is that even possible? This is the story of AGNC and some of the other agency MREITs. Whatever expectation one has about the spreads upside potential of the MBS portfolio of a certain company. The 20% premium puts you in a position in which you expect a big positive surprise. Almost anything positive is always in the price. The only surprises that happen in MREITs are, unfortunately, negative:   AGNC snapshot (Seeking Alpha)Although the chart is not fair for not being dividend-adjusted (AGNC is a company that's earning money for its shareholders), it can be seen that there are sharp drops through the years and steady climbs. Twenty percent premiums, historically at least two years of regular performance. It's around four years for the typical Mreit company, and can also be distributed to some kind of hyper-bullish expectation based on the same old \"rates going lower.\" One that has a sophisticated enough reasoning of why AGNC or any other of its rivals deserves to be trading at a premium can certainly find a way to benefit from these dynamics using different products and not paying the premium to NAV present by current valuations in the agency MREIT sector. Conclusion Rates are going lower; buy anything you can find with a Google search at whatever the price or valuation. Do it before others do because you can simply miss the moment. You cannot miss this once-in-a-lifetime opportunity to buy preferred stocks at a 0.6% spread to the Treasuries, CEFs, and BDCs at 70% premiums and Agency MREITs at 20% premiums. Trends are your friend. I almost forgot; if you missed buying Meta (META) at $80, don't worry - you can now buy it at $600. It is a bit more expensive, but it's a brand-new company now (somehow). What can go wrong? Hopefully, I have made it clear that this is all ironic. My largest bets Heavily long TLT vs. short 5% CY preferred stocks; waiting for the spread to widen. Long ECC-D and NCZ-A vs. Short PFF and PGX Short RCS partially hedged with PHK long Short AGNC partially hedged with MBB long  The article was first published to members of my service and prices are correct as of the close of the market on Friday 18 October 2024.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.30.2","shortVersion":"4.30.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2478515642"}