Preferred Stock and Baby Bond Owners Have a Rough Year

Thus far 2018 has been a rough year for many preferred stock and baby bond investors.

Of course, the reason is simply because of the increase in interest rates during 2018. In contrast, 2017 ended with the 10-year treasury trading with a yield of 2.4%, compared to a high of 3.24% in October 2018.

Simply put, as rates move higher, the price of a preferred stock or baby bond moves lower as investors demand higher yields. During the course of 2018, the average $25 preferred stock or baby bond fell by a mind-blowing $2.04 a share, which is around 8%.

Assuming the investor collected an average 6% dividend/interest payment on their shares during 2018, the losses were substantially mitigated to a more manageable loss of 2%. It has been years since income investors have seen this type of loss.

We have gotten spoiled by the never-ending fall in interest rates which pushed prices of securities up year after year and, honestly, the last 10 years has been a “Goldilocks” period for income investors.

It is interesting to note that investors in either “term preferreds” (preferreds with a stated mandatory redemption date) or baby bonds with maturity dates in the next five years had gains during 2018 in the 4% area. That return is 6% higher than the gains of holders of “perpetual preferreds” (preferred stocks with no stated redemption date or maturity) or baby bonds with maturities 20 or 30 years in the future. This is exactly why we had advocated for the ownership of term preferreds and short-dated maturity baby bonds for the last couple of years.

For those investors who are somewhat concerned with interest rate movements in the months and years ahead, the term preferreds and short-dated maturity baby bonds still present a relatively safe way to invest, while removing most of the volatility from the share price movement. We have an updated list of securities with these nearer-term maturities, which can be found here. While one may have to accept a coupon that is ½% to 1% below desires, sometimes it is worth it for the “date certain” return of principle (assuming the issuer doesn’t go bankrupt).

So, while the average preferred stock and baby bond fell in price by 8% last year, it is somewhat of a mystery what the shares will do as we look ahead, since no one has a perfect crystal ball.  At some point when one believes that interest rates have stopped going higher, it is beneficial for an income investor to move into some perpetual preferred shares simply because the total return outlook is superior to holding shorter-dated maturity shares. Quality preferred stocks are now yielding ½% to 1% more than they did a year ago and they present an opportunity for capital gains as many are trading at very low prices.

It is our personal intent to purchase the highest quality perpetual preferred issues consistent with our annual goal of achieving a 7% total return. Of course, each and every investor sets goals based upon personal risk tolerance, but for us a slow shift to these higher-yielding preferreds fits the bill. By moving slowly, let’s say 1 perpetual per month added to our portfolio, we can change directions quite easily if we are wrong on the timing of interest rate stabilization.

Last week, we made our purchase for the month of a perpetual preferred and we chose to purchase the CHS (Cenex Harvest States) 7.10% reset preferred stock (NASDAQ:CHSCN).  This issue is currently trading in the $25.20 area with a current yield of about 7%. The coupon will remain fixed until 2024, when it will reset to float at 3-month Libor, plus a spread of 4.298%.

The issue has a maximum coupon ceiling of 8%. We consider this issue to be of relatively high quality, despite some management issues which have cropped up lately. We do note that this perpetual issue has fallen $2 a share in the last couple of months and has fallen $4 a share in the last year. We expect this downtrend to end as interest rates stop rising. The fall in pricing reflects the perpetual nature of the shares, as well as the management issues noted above.

With this purchase, we begin to increase our monthly income while maintaining decent quality.  Most preferreds we have owned have current yields in the 6-6.25% area, which reflects the “date certain” of redemption of term preferreds and short maturity baby bonds. If we are able to safely, over time, move our current portfolio yield to the 7% area, we gain meaningful income from our income portfolio.