Redwood Trust Series A Preferred: Harvesting A Scarce 10% Yield-To-Call (NYSE:RWT.PR.A)

Until very recently, our efforts to optimize results from fixed income investments in a changing interest rate environment have focused not only on securing high current yields but also on potential capital appreciation. Fixed-to-floating rate preferred stocks trading at big discounts to par have been the assets of choice. But now that we have reached the Fed’s pivot point of turning from raising rates to cutting rates, those discounts have shrunk, and the floating rate yields will likely begin to decline. These market changes have made us reconsider an old favorite and reevaluate its appeal in the current environment: Redwood Trust, Inc. 10% FXD RT PFD A (NYSE:RWT.PR.A).

The Preferred Market Today

When Jerome Powell began his inflation-fighting campaign of interest rate hikes in March 2022, the fixed income investment markets were brutally buffeted, and thinly traded preferred equities took a particularly severe beating. While Treasuries and investment-grade credit markets enjoy liquidity that lets them quickly find a pricing equilibrium, a lopsided wave of selling pressure can send small, unrated preferred equities into pricing dislocations that are at once both painful and opportunistic. Within that dislocation, opportunistic investors turned to purchase fixed-to-floating rate preferreds and were rewarded with contractually rising yields and prices that recovered to par.

As the Fed Funds rate rose, issues converted to floating rate coupons on pre-specified calendars and dividends rose with the Secured Overnight Funding Rate (SOFR). Issues with early conversions to floating rates saw their quarterly dividends soar. For example, Annaly Capital Management, Inc. 6.95% PFD SER F (NLY.PR.F) saw its dividend rate jump from the 6.95% face coupon ($1.7375/annum) to an annualized rate as high as 10.645% ($2.6612/annum) against its $25 par value. Similarly, AGNC Investment Corp. CUM 1/1000 7% C (AGNCN) rose from a 7.00% face coupon ($1.75/annum) to an annualized rate as high as 11.01% ($2.7536/annum) as measured against par.

Both of these issues and many other issues have floating rates that are linked to three-month SOFR. SOFR rates have recently declined significantly in anticipation of imminent rate cuts. The table below summarizes the spectrum of SOFR rates on the morning of Sept. 18, before the Fed’s interest rate decision.

Source: CME Group

Portfolio Income Solutions’ preferred stock monitor incorporates current rate data to provide a forward-looking estimate of yields. Based on current information, it appears peak rates are in our rearview mirror and that floating rate yields will fall back into the single digits.

Source: Portfolio Income Solutions

Source: Portfolio Income Solutions

While we wrote this, the Fed announced a 50-basis point rate cut. It’s probably time to reevaluate our investment priorities and options.

How Low Will Rates Go and How Fast Will They Get There?

For more than a year, investors have speculated and postured on when the Fed would cut rates. Now the conversation will shift to how fast and how far the cutting will go. When markets and rates change directions, we have to remind ourselves of the particular terms governing the existence and operations of each individual issue.

The Annaly and AGNC issues discussed above have already converted to floating rate and each is also already callable. If rates/SOFR decline further, the quarterly dividend payments of each issue will decline at a similar rate. If rates fall significantly and capital markets favorably open up to issuers, callable issues may be redeemed. If your issue gets called, you want to have a plan of favorable redeployment.

In a declining interest rate market, our focus shifts to certainty and duration. Plainly said, what’s our baseline yield, and for how long can we count on that yield? This is a simple triangulation of coupon rates and call dates measured against market price.

While it is not the only solution, Redwood Trust, Inc. 10% FXD RT PFD A (RWT.PR.A) is a familiar choice and presents a compelling option for new-money, fixed income investment. We first became interested in RWT.PR.A in 3Q2023 when, suffering an absence of market support and general obscurity, the new issue’s share price traded to as low as $22.50. With a long-duration 10% face coupon, this was a discounted preferred that compared favorably in a disjointed fixed income market. We bought shares, but as the issue stabilized, we sold now par-valued shares to pursue what we perceived as better opportunities.

Today

Like AGNCN and NLY.PR.F, RWT.PR.A is a fixed-to-floating rate mREIT preferred equity. As such, when it converts to a floating rate, RWT.PR.A will adjust its dividend rate to the prevailing 5Y T Note rate plus 627.8 basis points. Unlike the other two issues, RWT.PR.A does not convert to a floating rate until 04/15/2028. In the interim, it will pay its $2.50/unit dividend, which holds up very well against its $25 par price and the current 3.47% 5Y T Note.

Source: Portfolio Income Solutions

Readers wishing to split hairs will note that purchase at the Sept. 18 $25.35 closing price produces a yield of only 9.86%, but that reasoning fails to recognize the nature of preferred stocks’ dividend cycle. RWT.PR.A goes ex-dividend on 10/01/24, paying the 09/18 purchaser $0.63/share. This quick dividend receipt effectively brings the share cost back below par to produce a carrying yield just north of 10%.

We can not fully predict the future, but if the issuer survives, RWT.PR.A will produce a 10.0% dividend yield over the next 3 ½ years, which most expect to see lower interest rates.

The Issuer

As part of our standard underwriting process, when we became interested in RWT.PR.A in 3Q23, we measured the financial fitness of its issuer, Redwood Trust, Inc. (RWT). We liked the niche RWT had created for itself in the jumbo mortgage market and how it was trying to improve its posture in an environment of stricter banking regulations. We took a long position in RWT.

One year later Redwood Trust has advanced its penetration into the jumbo mortgage markets and expanded its relationship with originating banks. It’s still early days in the process, but RWT’s experience gave them the confidence to raise their 3Q24 dividend by 6.25%. We are encouraged by their prospects.

The Future

The FOMC cut interest rates by 50 basis points on 9/18/24 and in coming weeks pundits will speculate about how much more and how fast rates will need to decline to successfully fend off recession.

We’re active fixed income investors trading in the same market as everyone else. There are no inherent advantages, it’s just about pivoting to where market opportunity presents itself. If rates decline, floating-rate preferreds will produce a lower dividend yield while their upper-end price is tethered to par value.

While it offers no upside, purchased near par, RWT.PR.A is an attractive, 10% yielding placeholder for the next 3+ years while we figure things out.