Market Dislocations Create Opportunities

Whenever the bond market encounters these periods of dislocation, like it is currently experiencing, opportunities often present themselves. Given the state of the fixed income market, I'd like to highlight one segment that has been particularly hard hit. What area of fixed income has long stated maturities, relatively small institutional participation and is heavily weighted in bank/finance paper? The sector is preferreds.

Although there are now preferred funds and ETFs, preferreds are generally the bailiwick of individual investors. They're created to look like stock, and some have tax advantages like stocks, but they should be viewed and treated like fixed income instruments. A typical preferred will have a $25 par amount, pay quarterly, and is listed on the NYSE. Preferreds usually have a 30yr or longer maturity, with a par call feature that generally comes into play after five years. With the hybrid nature of their structure, preferreds are usually rated a notch below other debt instruments of a given company. Without going too much into arcane details, the majority of issuers are bank and finance companies, but there are also utilities, industrials, etc. The characteristics of the product make it more attractive and easier to understand for individuals. Except for the natural buyers listed above (funds and ETFs), institutions (hedge funds and the like) don't participate in the preferred market to the degree of other fixed income instruments. Let's just say it gets overlooked by that group of investors.

These factors (long maturity, low institutional participation, structure, nature of issuer) combine to create pricing anomalies in the preferred market. However, there is one counterintuitive element of preferreds that exaggerates the pricing anomalies; the fact that they are listed on the NYSE. Unlike most fixed income instruments, preferred trades either occur on an exchange or are reported to it on a timely basis, like a stock. Unlike a stock, a preferred issue doesn't have a specialist maintaining an orderly market. Dealers and customers are providing bid and offer prices on the floor via orders. If news comes out or the market is in turmoil, the bids on the floor get hit or pulled in rapid fashion, which can produce wild price swings. For example, (oversimplification for illustration purposes) if a preferred bid gets hit at 25, the next bid lower might 24. If the 24 bid is then hit, that is the equivalent of a 4 point move on a bond, given the $25 par value of the product. While the market will eventually step in and smooth out all the price discrepancies, that may take a considerable period of time (days, weeks, months) given the nature of the market problem.

Before putting any money into this, let me remind everyone that the current market condition is not something everyone should be involved in. It is certainly not for those of the faint of heart or for those who don't realize that an investment in most anything can lead to a loss (yes, there are people like that out there). As for the preferred market, it would be advisable to seek out the advice of someone who is very knowledgeable about this market in particular. Finally, the above discussion refers solely to the secondary market in preferreds, not new issues which has different market characteristics.

P.S. This will be my last entry this week. For those of you that live outside of New Jersey, Thursday and Friday is the state teachers convention. For those with kids, it is basically a holiday here.