Preferred Stocks and Baby Bonds Back to Old Highs
By: Tim McPartland,
It has been a pretty incredible 2 years for income investors. We have had 4 Fed Funds rate hikes from a low of 0-1/4% to the current rate of 1-1 1/4%. 2 years ago the 10 year treasury was at 2.2% before falling to 1.5% a year ago, then rising to 2.6% and subsequently drifting back down to 2.1% a few days ago.
A couple years ago we began positioning for higher interest rates (as measured by the 10 year treasury) by limiting perpetual preferred stocks and targeting shorter maturity baby bonds and term preferreds. Honestly this has worked out just fine, but there is no doubt we have given up at least 1% annually in portfolio returns. Knowing what we know today (with great 20/20 hindsight) we would have had a boat load of perpetual preferreds giving us an extra boast in income. Oh well, at this point in time we will not likely change what we have been doing since we have added a few extra perpetuals–although mainly from the fixed-to-floating rate area.
As our headline noted preferred stocks and baby bonds are right back at new highs with the average $25 preferred hitting $26.20/share a few days ago. If I remember right the highest the average share hit in the past was $26.25. Of course this is kind of a worthless observation as the universe of available issues is changing daily as high yield issues are called and low coupon issues are sold into the marketplace. Maybe a more interesting (and telling) statistic is that the average Yield to Worst for $25 preferred shares is 2.78% !!! This is incredible–the risk/reward is out of balance here–perpetual preferreds in general have too high of a risk for the reward that income investors are being paid. Of course I hope that readers aren’t holding shares with really negative yields to worst–(and an average as low as 2.78%) meaning holding shares trading multiple dollars above $25 with approaching 1st redemption dates. We hold issues that many times are trading above $25, by up to 75 cents–it seems like there is no choice as there is such a limited selection available. This is simply a known risk we are willing to take.
At this point in time we see no obvious threats to the “goldilocks” income market we have been living with for the last couple of years, but you can be certain there is a “black swan” swimming out there. We do see some potential bumps in the road–the most obvious is the probable movement of the State of Illinois to junk rating status as they have had no budget for 3 years and are building liabilities tremendously fast. Tax revenues for this year are already down by almost $1 billion as companies and individuals flee the state. The budget that is currently being worked on raises taxes by $5 billion/year and needs to be passed by next week (7/1). Seems to me that S&P should have downgraded them to junk already–they have $15 billion in unpaid bills and pension liabilities that are unfunded of near $200 billion. And there are many more states in poor financial condition.
For now we will proceed as we have been while watching inflation and GDP—we are looking for variation from “goldilocks”–and honestly we would be surprised to see any in the next couple of months.