The Fixed-to-Floating Rate Preferred Conundrum

As we have watched interest rates go down, down, down over the last few years it was only a matter of time before fixed-to-floating rate preferreds began to be impacted.

Up until this point we have had just a few issues that were in their respective ‘floating rate periods’ where the coupon would reset every quarter–normally to 3 month Libor plus a fixed spread.

As most of you know 3 month libor has been on a downward trend for years and now is in the .3% area. This means that almost all fixed-to-floating rate issues which were issued years ago will see falling coupons when they enter the floating rate period.

We have a list of all the issues with their ‘potential’ coupons here.

Even worse these issues have no floor to the 3 month Libor reset level–if 3 month Libor goes negative coupons will keep right on falling.

So let’s look at the most recent example and that is the Customers Bancorp 7% Fixed to Floating non cumulative preferred (CUBI-C).

This issue was tooling along with pricing in the $26 area all the way until March 1, 2020–of course shortly thereafter we had the COVID 19 disruption and the share price fell to $14—but now recovered to $21.24

The terms of the issue would become 3 month Libor plus 5.30% on 6/15/20 — the first dividend payment date would not be until 9/15/2020 under the floating rate structure. If 3 month Libor remains at .3% the new coupon will be 5.60% for the next payment in September.

Knowing what we know today about interest rates the conundrum is whether the CUBI-C issue is a good buy at $21.24? With a coupon of 5.60% the current yield would be 6.60%.

3 month Libor has never traded at negative levels (going back to 1986), but these are not normal times we live in and one should never say never when making a forward looking forecast.

If 3 month Libor falls the coupon will fall for this issue and share pricing would likely follow.

But let’s make this a little more complex. What if interest rates generally and the 3 month Libor in particular jump by 1%? With bond like securities you would normally expect price to move in the opposite direction to rates–but not here. If 3 month Libor moved higher it is likely the share price would move higher, although it probably is more complex–meaning the level of the 10 year treasury would affect pricing as well.

In the case of CUBI-C if 3 month Libor moved sharply higher while the 10 year treasury moved only modestly higher it is possible that Customers Bancorp (CUBI) could potentially redeem the issue in which case a huge capital gain could be realized by the investor. It is hard to fathom this scenario occurring–but as I wrote above never say never.

Currently this is the only fixed-to-floating rate issue that Customer Bancorp has that is in the floating rate period, but they have another 3 issues that will go into the floating rate period in the next 18 months–all currently priced in the $19 to $22 range–all of which are already factoring in reduced coupons.

So it is quite the puzzle—and your action really depends on your personal outlook for interest rates.

Currently only a handful of fixed-to-floating rate issues are trading in the floating rate period–but in the number of years we will see bunches of issues go floating.

As noted by many we are starting to see large spreads coming with the new issues. Additionally as DoubleV pointed out we have the Fixed-Rate Reset issues coming with large spreads–for instance the newer Wintrust 6.875% non cumulative preferred comes with a spread of 6.507%.

What we are still missing is a ZERO floor in the variable portion of the coupon–if 3 month Libor–or alternatively SOFR or the 5 year treasury goes negative–the rate is zero—I won’t hold my breath for this in preferred stocks.

49 thoughts on “The Fixed-to-Floating Rate Preferred Conundrum”

  1. Nustar’s subordinated note maturing in 2043 (NSS) is also a fixed-to-floating rate issue which didn’t make Tim’s list. NSS currently floats at 6.73% + 90day LIBOR, and trades at about 20% discount to par.

  2. I own many issues with f-f/reset rate, generally I try to keep at least about 25% of the portfolio in such securities. But only that I was able to buy much lower their call price.
    My point is that even if at the time of their transition to floating mode (or next reset date) the rates are around 0, I will still be interested to keep these securities, which will bring me 4-5% per annum. Just because if rates are so low, then the average market return will decrease and these 4-5% will be considered good returns. Of course, most of those issuers that now have higher fixed yields (and are trading above their call price), by then will withdraw their expensive issues and replace them with the same 4-5%. So I see no reason to hunt the fixed-rate securities, and even more so to pay for them above the call price.

    1. Yiriy, A few additional comments re: floaters:
      I recently pulled out my old “sheets” from Oct 2018 and on the CN floater page I wrote, “single digit prices would be an obvious signal to look closer.” Well, well!
      Without going into some point by point consideration, most here are capable of that, I think that the put-value and relative scarcity of floats and resets will…at some point, reassert. We know what that will take. For instance: I think people underestimate USD decline or more debt to support a deeper recession?
      Can negative rates, say below a reset premium demand a payment from the holder? OR a default of the security to $0 or below? Is there any value left? I do not believe the contracts were written to consider sub-zero index rates, but I am shouting at the sky.
      Of ALL CN floats there are only 18 IG floaters indexed to the 3 month, 5 of those cumulative. Also what is 50% or 70% of a negative Prime? Can prime go negative?
      Of course there are resets of which five just reset end June 2020. All were IG, buying five puttable, paying (hopefully) years, or until a year AFTER the NEXT election. The yields were ranging from 4.2 to 5.9% for next five years.
      What can change in five years? YIKES!
      Here’s to hoping we see it and in good health and order my friend!!

  3. Merchants Bancorp has FF with a zero floor. There has been a lot of concern about LIBOR as an index. After Powell’s announcements I am not any surer that short term Treasury rates will fully reflect the market.

    I like FF’s because of the trillions that are being thrown around, the steady rise in gold prices for the last twelve months and that few have been offered this Spring. Medium to long term bonds are unattractive so I tried to avoid getting fixed in with all of my preferreds.

    1. George – you are correct–they have 2 of them in fact–they are ahead of the curve.

  4. FWIW, when you think of it, these issues are actually misnamed as fixed to floating rate because they’re really fixed to short term reset date issues and never actually “float.”… In other words, once their fixed rate periods end, they reset based on a specific rate determined on a specific day and then that rate remains in place for the upcoming quarter or actually until the next reset date which is normally a day or two before the coupon payment date.. I’m not sure this is exceptionally valuable info to be sharing, but it did occur to me when trying to figure out what CUBI-C will be this quarter… Fixed rate reset is the term used for those that reset for longer periods such as 5 years at a time, but these are the fixed rate reset only for 3 months not 5 years. Zzzzzzzzzz………..

    1. 2WR, Far be it for me to interject on terminologies because I am the worst on precise use of terms. But I do notice on the Canadian resets the owner has a right at end of reset term to convert to a “floater” instead to the 5 year reset. The terminology they use in prospectus is “Quarterly Floating Rate Period”. There precision is better than mine which isnt that hard to do, ha.

    2. Yeah, all kinds of terminology that depends on who or what banker you talk to. I work for a bank, and we call them floating and then adjusted (daily, weekly, quarterly,…)

      1. Tim – Thanks for the link to your chart which I had not visited… FYI I noticed you missed the floor cpn for XAN-C. “floating rate shall not be less than the initial rate of 8.625%.” That is, of course, only if they aren’t suspended as they are right now which has to be why your $.54 is highlighted in red…

    3. If they change rates every quarter that sounds like floating to me. Doesn’t have to float every day to behave like a floater.

  5. Not sure if I post here or over on sandbox, but has to do with capturing interest. B. Riley has a few bonds all paying higher rates and several came up for early redemption which has come and gone. I had originally purchased RILYZ to lock in a good rate as far out as I could with them, but to me and again its just my gut feeling the economy is looking uncertain so I decided to sell at a small profit with the intention of moving down in call date but taking a little less dividend and re-buying the RILYI
    Monday the market was down 100 million in volume and DJ 30 up for the day as it was yesterday. I did sell but I haven’t replaced it with anything yet.
    I am beginning to think this week traders will be on vacation with lower volume and market up. Will see

    1. I bailed out of RILYZ and I may or may not buy one of them back if the price drops. Priced below par means investors think there’s some risk of nonpayment or default. When there’s risk I want the shorter maturity, which also has higher YTM if all goes well.

    1. Charles, I hadnt noticed, so I just looked. Funny but I noticed it changed on the main TD website, but under Sink or Swim platform it doesnt register. I find it odd that Sink or Swim doesnt even use same ticker set up as the regular account does either.. My WCC-A has crashed and burned on Ally, its worth $0.00. That Mickey Mouse outfit changed its own ticker to WCCPRA instead of WCC.A they use so its unrecognizable now. It will stay like this until the end of time unless I call it in. Im getting used to this so I dont get in a hurry anymore,

      1. Gridbird:
        Re: TDA
        “SinkorSwim’ sometimes uses different stock symbols than are
        displayed on the normal site.
        The symbol for Granite Reit is
        GRP/U, which can be traded,
        while two ‘other’ symbols shown
        on TDA’s normal site display
        under quotes, with all data ,but
        if attempting to trade will state
        Just informational.

  6. So we have 4 issues here. Fixed to floats, Libor, interest rate directions and CUBI. A couple years ago brexit was a known issue and many desks still recommended them vx fixed. One thought being that rates were going up. I mean the fed dot plots kept telling us so! So floats made some sense. Now we are going the other way. Perhaps the fed will be wrong again and rates will rise. For whatever reason most the floats I see are 2023-2024 and longer horizons.

    Then there’s libor vs fixed. Prices of fixed up/float down so much some are also calling the float structure a contrarian buy here. What’s almost laughable is how desks recommended float structure in 2017-2018 and never articulated the opps we screwed up sell em out and go fixed calls in 19. But the pricing was telegraphing that!

    And then there’s CUBI whose trading has always been wide spreads and thin volume. I have no idea about how the bank is doing. Decades ago I was very in tight with all bank financials and you could just ‘see’ the deterioration in loan quality coming thru the loan loss reserves. What I do know is that ‘newer’ banks can get too eager for loan growth and they put on loans that in retrospect were too aggressive risk wise. Hopefully Jay Sadu didn’t repeat that…

    And then there’s volume in general. Reg BI has the potential to volume nationwide

    1. It can be called many names FF/FFF or whatever but at he end of the day you can put lipstick on a pig and its still a pig. These companies are always going to give us terms that benefit them not us. Anything extra is for their bottom line not ours.

      1. Max – I would tend to look at it a little bit differently. To generalize (not always), when a f/f rate issue comes out, the underwriters set the premium over LIBOR to be a number that backs out the current LIBOR rate from the coupon rate necessary to market the issue. For example, if LIBOR were at 1.00 and the issue had to come at 6%, then the premium over would be set at 5.00 approx. When that’s the case, the issuer is essentially just willing to take the other side vs, what the marketplace is giving them. Thus they are betting interest rates will go lower (and they win) while those buying are essentially betting rates will go higher and they will win… Obviously over the last few years when so many of these f/f issue came out, the issuers have won that bet, but that doesn’t make them pig issues… Under the premise that the house (aka issuer) always wins, what really puts the odds in favor of the issuer always is the built in “terms that benefit them not us” feature, the call feature. One can argue there’s a cost to the issuer in the issue’s price attached to their including a call feature, but I think in real life that’s just justification jargon in the eyes of most real people.

        1. 2whiteroses
          Thank you for your most excellent explanation, appreciated. I now understand how they work, and it makes much more sense to me. Plus I can check now if the deal is fair. My explanation was wrong because I didn’t understand them!

        2. 2WR, it’s my impression that there is a cost to the issuer for the call feature. That is, the rate being paid is higher than it would be hypothetically absent the call feature. How much higher, I have no real evidence. For some reason, I think it’s something like 25 basis points, in “normal” circumstances but I don’t know. Know of any research on this?

          1. Nh – The key word in what you’re saying is “hypothetically,” and theoretically, you and I are saying the same thing. But I call it “justification jargon” in the sense that given hardly anyone issues non callable issues anymore, it’s hard to test the theorem in the real world. So in a practical sense, it’s more like there’s a premium incentive hypothetically (ahem) for an issuer to issue noncallable than there is a discount imposed for having issued a callable…Whatever that premium might be, it’s hardly ever enough these days for the issuer to take advantage of it.. Sure “potato” “pottado” in a way but callable is more the given than the exception, so the market price starting price is really for callable imho. Boy I sure am full of essentially trivial minutia to be talking about right now.. and to quote Grid, “ha.”

          2. NH, I think your 25 BP premium on callable versus non callable is a good generalized estimate. If you are looking for data on this, you could compare the debt issued by FNMA, FHLMC, and the Farm Credit Banks. They issue callable and non callable debt on a regular basis with terms from 1 to 10 years (and longer). From my recollection as a former Farm Credit treasurer, the call premium ranged from 5 BP and up to 75+ BP. Every model we used to value the call option generally indicated that the market value was less than the economic (calculated) value. This means that the buyers of the debt were not being compensated for the call risk. AAA bonds will definitely be much different than IG preferred but it can be a start to an analysis ( not one that I will be doing). Getting data to support this would be a challenge.

            1. JDC
              Thanks much. Really helpful.
              Just to follow up, with regard to the models to value the call option, is there anything generally available that you can refer to me in particular? If the models are proprietary or something not subject to disclosure, I fully understand.

              1. NH, yes the option valuation models we used were proprietary and very complicated. Inputs include interest rate volatility, yield curve models (Ie Hull & White), mean reversion factors and a bunch of variables titled with Greek letters. As a practitioner, the models had limited value because of the complication of understanding the inputs. The better analysis in my opinion was tracking the call spread in a graph. For buyers of debt that means buy when call spread is high and sell when it’s low. Exactly opposite of what we did as an issuer.

                1. Thanks JDC. If a lot of integral calculus, I probably wouldn’t understand anyway. Everything I’ve seen so far has been either overly simplistic or esoteric papers written by academics for other academics.

  7. In other news….can anyone explain why every time PSA issues a preferred at rock bottom yield it soars?….I bought the newest on OTC under call and it’s almost to my flip of $26 already lol…it makes no sense to me…but I know this is what happens

    1. PFF (ETF) is buying this issue. This is one of the main reasons why its price went up, but if you see the rest of PSA members you will notice that the situation is the same.

  8. I prefer not to own these…but I do own a ton of them…AGNC, NLY, CIM…..the spreads are big enough

    1. Low floating rate has become less of a factor in the pricing of REIT preferreds. I haven’t figured out why. Moved out of those with lower float rates.

  9. I hold a corner a handful of longer-dated FTFs/resets as a small hedge against fixed holdings – useful if rates turn north.

    However, in calculating a YTC for the FTFs/resets, I use a variable redemption value (anticipated price at FTF/reset). The redemption value adjusts daily, based on the current index plus margin v current market yields. Through this, it continuously projects the anticipated price when FTF period begins. Incredibly useful in making the FTF issues transparent on a daily basis.

    As an example, this tool got me out of EBGEF in the 20s. Then in March, if not already loaded up with higher-quality CNs, it would have gotten me back in around 14.

    1. Alpha, it looks like I own about 10% in F/F and resets. Most presently have almost a 5 year run way before floating or resetting. Things can change a lot in 5 years, but as a general rule I personally lean hard fixed issues.

      1. Grid, yes I agree. Just a small corner. Though if the prevailing winds for rates shifts north, FTFs will become prized possessions. As we know, some of the best LT holdings can be rummaged from the unwanted bin when they are out-of-favor.

        1. Alpha, I agree. Just think how rates (and just as important expectations of rates) have changed in past 2 years. Many times one can trade these just on expectations game. Unfortunately my skills/luck are not as fortunate in this area as I have been with fixed issues though. But I will never totally surrender!

    2. A8
      Thanks for this post. I own some FTF and have been trying to figure out how to factor that feature into my valuation models. Now that you have pointed it out, it seems obvious, but it wasn’t before.
      One place where we depart is what happened back in March. With the mass carnage, my methods were rendered pretty much worthless. (I nearly was as well. I’ve been feeling much better lately.)

      1. nhcoast, Glad you’re feeling better. Episodes like March I think ultimately are a gift. For any given issue, if we liked it at $25, we should love it at $20 or lower – but only from the best balance sheets. Buying hard at the lows of Dec 2018 made my 2019 (+17.2%) and March 2020 +9.6% YTD (preferreds only). The problem now is being forced out of some issues because over-bidding is rampant again, and what to do with a couple of commons that took me to the woodshed.

          1. nhcoast, So agree with that! All my success over the years is due to what I’ve learned from all the smart a**** I’ve come across especially on this site. I want to be a smart a** too. Tim, can I have a smart a** badge? Am I there yet?

            1. Alpha, Camroc is charge of distributing them. I think he needs a nomination form first and then he evaluates it. He just doesnt send them out unless you are worthy.

            2. With homage to the Treasure of Sierra Madre, Blazing Saddles and others:

              “Badges? We ain’t got no badges. We don’t need no badges. I don’t have to show you any stinkin’ badges!”

    3. Great move on EBGEF. I am holding huge position, too late to sell. Dividend probably still safe. Missed selling my legacy CUBI-D believing that they will convert to Floating for E first. In the latest Earning Call Transcript, one analyst asked CEO why he does not call in the E. The new CFO proudly explained that both E and D will convert to floating when it becomes callable. Stuck with 5% when converted to Floating. Tax loss but I have huge tax loss on the GMLP common. I will probably hold on and hope that LBOR does not go negative. Iberia Bank (IKBC) apparently merged with FHN (Horizon National Corp). All IKBC preferreds do not show in Schwab and Fidelity. I suppose it will shown as FHN- .

      1. Looks like FHN’s own preferreds were rated slightly lower than IBKCN BB according to SP. Oh well.

  10. Tim – maybe I’m just not that smart, but I just never liked these Fixed to Floating preferreds because there are just too many unknowns and how they will play out in the future. As I’m retired now (unless my old CPA firm wants me to work a few days during tax season) overall, I like to know what my dividend income will be during the next 12 months. It helps me plan for monthly expenses. These things are possibly very dangerous, depending on interest rates in the future. However, I don’t think anyone really knew how rates were going to be.

    1. kaptain–I seldom have owned any of them–but I have been watching for an ‘angle’ to potentially buy some–like you I like a little certainty–of that is even possible in the times we live in.

  11. Definitely, the fixed-float products should be impacted but the recent IPO-s are coming with a great spread over the treasury/LIBOR rates. Even if the rate is 0% they will be competitive. WTFCP is a great example of what I mean.

    1. Hi DoubleV–sorry that got out before I was finished–I will republish later tonight.

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