Pain Continues to be Inflicted on Income Investors

After last weeks beat down on preferred stocks, exchange traded debt and REITs we thought we might see a little bit of respite from the pain this week, but thus far that has not been the case.

With the 10 year treasury opening in the 2.26% area this morning it signaled further pain ahead and that has been the case with the average preferred or baby bond issue down 1% again today.  REITs are bouncing as bargains become apparent in many sectors and in particular in the lodging sector which has been out of favor for months.

Where has the pain been largely avoided?  Short duration term preferreds and exchange traded debt issues. There is no surprise that perpetual duration securities, which includes most preferreds stocks, have been knocked down 5, 6 or 7% (or more).  We have written for 2 years that this would be the case, although like everyone else we had no real idea when this would occur.

It was almost exactly 2 years ago (on October 13, 2014) that we started the Short/Medium Duration Portfolio which has now just started the 3rd year of existence.  This model was constructed to address what we perceived was the interest rate risk in the market (the risk that rates would rise and asset values of income securities would be destroyed).  Like most everyone else we thought rates would start to rise much sooner than in fact was the case, but just the same, we felt strongly that it was just a matter of time before the rate increase occurred and there would be no horn sounded or bell rung when it started.  It has now started with a vengeance.  The only way to avoid having your holdings soundly trounced was to shorten up the duration of your holdings.  Reviewing the Short/Medium Duration Portfolio we see that the 1st year the portfolio had a gain of 6.2%.  The second year saw a gain of 6%.  25 months into the model there is a total gain of 12.62%, which is about ½% below where it was a couple of weeks ago showing that short/medium duration securities firmly outperformed perpetual instruments.  Of course to realize this performance you had to believe that rates were going higher and that you would be willing to sacrifice short term performance in order to avoid severe pain at some point in time.  

We personally were positioned in mostly short/medium duration baby bonds and term preferreds and thus we have taken only a 1 ½% hit to our net asset values.  This would have been better but we did hold a couple of long duration securities that have been slammed.

As we survey the perpetual preferreds we see so many issues that are off 10%–the recent Public Storage perpetuals (the PSA-D and PSA-E) are trading at $21.41 and $20.90 respectively–current yields of 5.78% and 5.86%–almost a full percent above coupon. All the Gabelli fund perpetuals are trading at very attractive levels for high investment grade issues.  If investors hold issues they like and are holding they should be considering adding a few more shares in here since we don’t know what the future holds, although it is likely that junky issues will outperform quality issues for the time being.  We wouldn’t get carried away with purchases, but a little buying here might be appropriate.  All investors should have been sitting on “dry powder” since this has been advised by all for a long time.   Remember that any perpetual preferred or very long duration baby bond held right now is at risk of further capital loss as no one can predict the future with certainty and investors need to understand their tolerance of watching net asset values evaporate.

Our list of short/medium duration securities is here (it loads slow) and there is a decent selection of issues that provide maturities in 2019, 2020 and 2021.  Most of these issues are not investment grade and investors should do their due diligence before purchase.  Volatility should be minimized in these issues (although not guaranteed), while providing a very fair interest payment to owners.

For investors convinced rates are heading further higher (likely over the next year) a goodly amount of “dry powder” is recommended.   For others who are more concerned with a good income stream you should be looking for bargains with acceptable yields without placing all of your concern on potential capital losses.

For ourselves personally we will buy some bargains when they appear, but mostly we will remain in short/medium duration securities for the next year as the current interest rate increase environment will take at least that long to shake out.

X
Bryan Perry

Limited-Time Free Report:

Collect a Fat Dividend Check Every Month from the World's Biggest Companies (without having to buy their expensive shares)

Get my top monthly dividend payer... a company boasting a dividend yield of more than 10%, and whose portfolio holdings feature some of the biggest and most successful companies on the planet (Google, Apple, Nike, etc.). Simply enter your email to claim your free report.