Many financial commentators have suggested investments which would benefit if global rates rise, such as financials or possibly gold/miners if hikes are due to inflationary concerns. However, what happens if global rates stay low for years and risk spreads stay very tight?
This question has sparked a renewed interested in Closed End funds (CEFs) trading at a discount to NAV from news publications such as Baron’s to hedge funds such as Saba, which recently raised capital for a new fund to target and invest in closed end funds.
Popular strategies include buying CEFs trading at a discount and selling a basket of securities similar to the funds holding, allowing an investor to lock in the discount, which could take a few years to realize. Additionally, investors can start a proxy fight with the fund in an attempt to either liquidate the fund or convert to an open-end fund, allowing investors to realize the discount to NAV quickly. These strategies are becoming more popular in the low rate, low return environment (over $12 trillion in government securities currently offer negative yields) as investors hunt for yield.
Another strategy is to bet on corporates to optimize their capital structure in this lower rate environment. Many international companies have small issues of preferred stock outstanding, which typically have the same economics has underlying common stock minus voting rights. For example, BMW has preferred shares which trade at 64 euros (an 18% discount to the common) while the common trades at 78.5 euros.
Tendering or buying these shares in the open market makes much more sense for companies in an extended low rate/low growth environment than it did when interest rates were much higher and growth prospects were greater. It also offers better economics for shareholders than simply buying back common stock, which has been popular over the last few years.
Korean Preferred Stocks are another example. Korean preferreds, which have been mentioned by numerous investors and publications in the past such as VIC, Grant’s Interest Rate Observer, and Manual Of Ideas, are nothing new to a well read investor. They have traded at a large discount to common stock for years (typically 30-60%), generally have an equal claim to earnings, receive a slightly higher dividend than the common, and have no voting rights. Most preferred were issued in the early 1990s when the government pressured companies to de-lever. These preferred shares are very illiquid and typically represent ~10% of shares outstanding, which depending on the discount is 3-7% of a company’s market capitalization. There are over 100 preferred stocks in Korea, below are some of the most liquid:
|Company||Stock Price||Pref. Price||Discount|
|Samsung Electronics Co||1,640,000||1,354,000||17%|
|Samsung Fire & Marine Insurance Co||278,000||182,000||34%|
|Hyundai Motor Co||132,500||94,800||28%|
|SK Innovation Co||154,000||87,700||43%|
|Samsung SDI Co.||119,000||63,200||58%|
|Samsung Electro-Mechanics Co.||61,300||30,050||51%|
|LG Household & Health Care||938,000||511,000||45%|
|CJ Cheiljedang Corporation||394,500||204,500||48%|
|LG Electronics Inc.||53,100||26,550||50%|
|SK Chemicals Co.||69,700||29,650||57%|
|Daelim Industrial Co Ltd||85,000||29,400||65%|
While preferred shares have remained cheap for years, there never has been a real catalyst for them to appreciate besides simply being cheap. In the past few years, companies such as Doosan Corp, Samsung F&M, Samsung Electronics, and Hyundai Mobis, have tendered for preferred stock. Given the current low rate environment and tight credit spreads, companies could tender for these preferred shares at an accelerated rate. Tendering for preferreds at a 20% discount to common is a great use of capital for almost all of these businesses and would be accretive to earnings, especially when most can issue debt at sub 5%.
A basket of these preferreds provides an investor some downside protection (you are creating the company at roughly half the common valuation) while maintaining a free option on any corporate action / tender offers. Additionally, a discount of 50% looks much more appealing when the alternatives are investing in negative yielding sovereigns, the 0.001% Toyota Finance Bond (JP363360AG63), or Unilever zeros yielding 0.08% than it did when global rates where much higher. In the case of the common stock appreciating 10% and the preferred stock discount closing from 50% to 30%, an investor holding preferred shares would earn a 54% return.
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