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Market Melt Ups Give Us Time – Perpetuals versus Term Preferreds or Baby Bonds

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If nothing else these giant sized daily gains in the stock market give us time to reflect and plan. Since we don’t react too much to day to day changing prices of common stocks (although not a day goes by that we don’t ponder an option trade–most likely one in which we would lose money) it does give us time to ponder moves to help us reach our 7% annual goal.

Today with the strong move up in 10 year interest rates we decided to review the model again to determine which perpetual preferreds to sell and which debt issue or term preferred to buy. Yesterday we mentioned “does the change in crude oil prices also signal a change in interest rate directions?” Today we could ask the same question. What this means is that time may be running short for getting to the safe side of the fixed income spectrum (term preferreds and baby bonds-$25 exchange traded debt).

Tomorrow we will sell 2 perpetual preferreds from the 2014 model and use the proceeds to purchase Gladstone Capital 6.75% Term Preferred (ticker:GLADO) and Gladstone Investment 6.75% Term Preferred (ticker:GAINO) in which we already hold a position. It is likely our positions will become more concentrated as we eliminate most of our perpetual preferreds.

Now, lest some folks think we are crazy for moving to issues that yield 1/2% to 1% less than the perpetual preferreds let us walk though the logic and math. 1st off we believe that rates will finally move higher — maybe a full point in the next year. Given this thought we look at the return of a term preferred yielding 6.50% versus a perpetual preferred yielding 7.50%. We have to assume that once rates begin to move higher most perpetual preferreds will not be called for 10 years or more. We also assume that the term preferreds or baby bonds will run to maturity (6ish years)

After year 1 the math is this (with our assumptions). In a year the perpetual preferred issue has a total return of about -5%.  A baby bond maturing in 6 years will have a total return of 2%. So the math is that the baby bond with a coupon of 6.5% will outperform a perpetual preferred issue with a 7.5% coupon by 7% in 1 year. 

Let’s go further. Assume that rates move toward historical norms 2 years from now. That would put the 10 year treasury in the 5% area. Over the 2 year period the perpetual preferred would have a capital loss of 20-25% and you would earn 15% in dividends–total return for 2 years would be around -7-8%. The Term Preferred or baby bond will have a total return around 2%. So over the 2 year period the fixed maturities will outperform by around 10%.

Now we could run these numbers out for 6 years, but more key is that after 1 year a person reevaluates based upon the information available at that time.

Now we could be wrong, but we have to make some type of logical assumption and we have–so now we see if we are correct.

It is cautioned that the above is purely a mathematical exercise and there are potentially other factors that can affect the pricing of fixed income instruments at any given time–i.e. the 2008 financial crisis.

We have positioned our personal funds in term preferreds and baby bonds–with a sprinkling of REITs and perpetual preferreds. We have a list of available issues maturing in the next 10 years here.

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