These 7%+ Yielding Senior Securities Have Proven Resilient

This article was first released to Systematic Income subscribers and free trials on Apr. 13

Last week we highlighted a number of CEFs with attractive yields that have remained resilient this year. In this follow-up we focus on senior securities i.e. preferreds and baby bonds that, similarly, have been able to withstand the sharp rise in interest rates this year. The key risk for investors is that we see more of the same, leading to further weakness in the income market. And although the same pace of rising interest rates is not our base case scenario, a partial allocation to more resilient securities can make a lot of sense in the context of a diversified portfolio.

Where We See Value

Generally speaking, senior securities with the following features have remained relatively resilient so far this year:

• Term securities – bonds and preferreds with relatively short maturities, a feature which caps their duration or sensitivity to interest rates
• Fix/Float preferreds – preferreds whose coupons will typically get a bump if/once they move past their first call date at the current level of rates
• High-coupon securities – the higher the coupon the lower the duration of a given security, all else equal
• Pinned-to-par securities – these securities trade near or past their first call date and are often anchored closer to “par” due to a likelihood of being redeemed

The mREIT Chimera Investment Corp. 8% Series A (CIM.PA) is down 1.9% so far this year in total return terms (vs -6.2% for the average preferred) and trades at a 8.2% yield with a stripped price of $24.38. It is currently redeemable by the issuer which allows it to benefit from a pinned-to-par element. The underlying loan portfolio boasts relatively low economic leverage of 0.9x with 4x equity / preferred coverage which is pretty healthy for the hybrid-focused mREIT subsector.

The Priority Income Fund 7% Series K (PRIF.PK) is one of a series of preferreds of this private CLO Equity CEF. The stock trades at a 7.47% yield. Unlike its sister series, this one has no maturity. However, and for this reason, it does have the highest coupon and yield which helps to lower its duration profile. It is down 2.5% in total return terms so far this year. Investors who want to achieve a lower duration footprint should have a look at Series F (PRIF.PF) which has a 2027 maturity and trades at a 6.62% yield-to-maturity. It is flat year-to-date.

The Sachem Capital 7.125% 2024 Notes (SCCB) are trading at a 7.08% yield-to-maturity and are up 1.6% year-to-date. The company is in the business of making short-term secured loans to real estate investors for the purpose of acquiring or renovating properties. Debt asset coverage is around 1.95x which is not high, however, continued housing demand, sub-70% loan-to-value underwriting along with the bond’s short maturity provide a margin of safety. The bonds are currently callable so acquiring them closer to a $25 stripped price mitigates the potential loss on a surprise redemption.

Takeaway

Taking a look at historic performance is a great way for investors to gain an intuition about how securities have performed in practice in different market regimes, offering a kind of “proof-in-the-pudding” analysis.

A key takeaway here is that it makes sense for investors to approach income allocation from a thematic, top-down perspective rather than a scattershot / bottom-up perspective. This is because the latter approach can result in a portfolio with an undesirable risk profile and a broadly undiversified set of exposures, particularly with respect to duration.

Investors should also be careful that, to paraphrase, though market history rarely repeats itself, it often rhymes. Inflation has remained high and persistent while the Fed has turned increasingly hawkish. This, plus the fact that the Fed will likely be embarking on balance sheet reduction this year, creates a real risk that interest rates will keep moving higher.

And although it’s not our base case for rates to keep moving higher at the same pace, we don’t have a crystal ball. In our view it makes sense to have allocations in the portfolio that can perform across a wide range of market outcomes. For this reason it makes sense to have some allocation to securities that have proven relatively resilient to the market environment of 2022.

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