Drilling Down a Bit on Floating Rate Preferreds

We have recently had some notes from readers asking about floating rate preferreds (as well as ETD floating rate notes) and whether there is wisdom in purchasing some at this point in time?  Our short answer is ‘we don’t know’.  While we have listed the floating rate and fixed to floating rate issues for years we have not studied them close enough to know what kind of downside protection they will give an investor when interest rates rise.  Oh yes, we know in a general sort of way that they will be helpful as downside protection, but we don’t have exact proof of how much that will be and  honestly after the markets we have been through in the last 5 years we do not believe that anyone has a perfect answer to the question. Fixed to floating rate preferreds have not been available in large enough numbers of issues for long enough to have firm available data

We are aware that there are senior loan etf’s and closed end funds out there that include floating rate debt–but honestly the senior loan funds are a bit scary as the quality of the portfolios seem to be marginal (at best) and we don’t want to have the leverage of a closed end fund for our ‘experimenting’.  Fortunately Powershares has helped us a little by starting a ETF, launched in May, 2014, called the Variable Rate Preferred Portfolio (ticker: VRP) which tracks the Wells Fargo Hybrid and Preferred Securities Floating and Variable Rate Index.  VRP is a relatively new ETF, but has made 3 monthly distributions which are at an annualized rate of 5.25%.  Obviously you are going to give up 1-2% of income to buy a security that gives some level of downside protection–this is true in all sorts of investing–there is no free lunch.

So the question is—Is it worth a reduced current income for future potential downside protection?  We have no firm answer.  If you are looking for current income without regard to capital preservation then the answer is that you probably want to stay away from floating rates.  If you are in the position we are in where we are not ‘taking’ income–just trying to continue building capital then VRP (or an individual security) may be worth looking at for purchase. 

Relative to whether floating rate preferreds will give you much downside protection we question whether they are a ‘silver bullet’ against rising interest rates.  We believe they will give some protection, but one must remember that the fixed to floating rate issues almost all base their floating rate on 3 month libor plus a fixed percentage.  3 month libor today was at .23% (less than 1/4%).  Looking at a mid quality issue like Regions Financial 6.375% Fixed to Floating Preferred (ticker:RF-B) the rate is fixed until 2024 at 6.375% and then is floating at 3 month libor plus 3.536%.  It is going to take a 3 month libor increase to 3% (from .23% today) just to get back to the 6.375%.

Thus there is no answer with any degree of certainty to the question of whether Floating Rate Issues give enough downside protection to accept a reduced current yield.  We would suggest that anyone considering making this move to purchase an issue or the new VRP etf and observe.  We are going to take our own advice and buy a 200-300 share position in VRP tomorrow (Wednesday).  Our intent is to receive a fair yield while observing the behavior of the share price.  We always pay close attention to issues that we have money invested in and we believe that this is a low risk experiment (buying VRP).