For much of the last 10 years, interest rates sat at 60-year lows. With the Federal Reserve firmly engaged in taming the inflationary dragon, interest rates are rising rapidly. The Federal Reserve almost got involved yet another 75 basis point bump in rates at the November FOMC meeting. This combination of coming from a period of historically low rates to a period of accelerated rate increases sets up a unique investment opportunity for a particular class of fixed income securities.
There are some big opportunities in securities with fixed to floating conversions in the next couple of years, especially those securities that had their IPO during the period of historically low interest rates. Preferred shares of Aspen Insurance Holdings Limited (NYSE:AHL.PC) is one of those opportunities.
Aspen Insurance Holdings Limited (formerly trading under symbol AHL) initially offered AHL.PC in a prospectus dated April 1, 2013. The AHL.PC preferred shares are non-cumulative, perpetual, fixed-to-float securities with an initial coupon rate of 5.95% ($1.4875). The conversion to three month floating rate is after 7/1/23 with 3 month LIBOR plus 4.06% and the stock is currently priced at $22.32 with $25 to par value. In early 2019, AHL was acquired by Apollo Global Management (APO). AHL is now wholly owned by APO.
At the time of the IPO, AHL.PC carried a credit rating of Ba1 from Moody’s and BBB- from S&P. Today, APO’s corporate credit rating is A from Fitch and A- from S&P. AM Best and S&P rate AHL as A (excellent) and A- (strong) respectively. Typically, preferred stock carries a credit rating two to three notches below the corporate rating, which would place AHL.PC at BBB or BBB- (S&P scale). I could not find a current credit rating published for AHL.PC. However, with APO and AHL’s corporate credit ratings at A-, I won’t lose sleep over holding AHL.PC.
I expect the full 75 basis point increase in overnight rates after the November FOMC meeting and another 25-50 basis point increase in December. That would put the overnight Federal Reserve rate at 4-4.25% and should put the 3-month LIBOR rate at 5.25 to 5.5%. We could also see further, but likely smaller increases in early 2023. To be somewhat conservative in this investment thesis, I will use the 5.25% estimate for the 3-month LIBOR rate.
The current and possible future returns of AHL.PC are as follows.
- Current yield based on price of $22.32 is 6.66%
- A floating rate based on 3-month LIBOR of 5.25% would be 9.31%
- Coupon rate after conversion to the 9.31% floating rate would be $2.33
- Return on cost based on the price of $22.32 would be 10.4%
- Yield to a call based on the price of $22.32 would be 25%
With a new floating rate over 9%, I expect AHL to choose to call AHL.PC on or shortly after the 7/1/23 first call. With an inverted Treasury yield curve, it will be cheaper for AHL to refinance with a long-term interest rate. If called on 7/1/23, the investment in AHL.PC will provide investors with three dividend payments of $0.372 plus the $2.68 difference between the current price and par value, a 17% total return over approximately 8 months. That 17% total return translates to an annual YTC of 25%.
This opportunity looks like a win, whether AHL calls the preferred stock on or shortly after the 7/1/23 call date, or whether AHL decides to pay the dividend at the new and much higher floating rate. Investors will either receive a YTC of 25% or dividend payments of ~$2.33 initially and float quarterly thereafter. There are other fixed-to-floating securities offering higher potential total returns and higher YTC (eg RITM.PB and AGNCM) but these higher yielding securities also carry higher credit risk. Potential AHL.PC investors should consider that AHL.PC provides high double-digit returns from a company with solid investment-grade credit. This is an investment in sleeping well at night.
The AHL.PC IPO was for 11M preferred shares and the typical daily trading volume is 10,000 to 14,000 shares, so liquidity is decent. I accumulated a small position and plan to accumulate more after the November FOMC meeting, as I expect the typical volatility to be assured after the FOMC announcement.
The Federal Reserve’s fight against inflation has hurt stocks in recent months, and the expectation in financial circles is that the risk of a recession in 2023 is growing. I believe that common stocks will continue to be volatile, and the current bull breakout is unlikely to last, with more rates in the offing and the risk of an imminent recession growing. I’m not going to try to fight the Federal Reserve, rather, I’m going with the obvious opportunities that the Federal Reserve creates.
Fixed income opportunities in fixed-to-float securities like those available today are rare. I plan to take full advantage of them.