Sharply Higher Interest Rates – What Now?

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It has been almost 3 weeks since Donald Trump won the presidential race and we have been through plenty of pain in the income investing arena since that time.  Honestly I believe this was simply a knee jerk reaction without any basis in fact–darn little has changed in fundamentals and future economic change is likely a long way off.  Loose talk of trade barriers, infrastructure improvements requiring significant new debt, and questionable liquidity by big treasury traders has caused the longer term version of a “flash” event.  Selling begets selling and we had plenty of that in the income markets this month.

Preferred stocks of quality took some of the heaviest poundings–in some cases losses of 15% were experienced. The magnitude of this loss was surprising, although the fact that quality issues took the biggest hit was no surprise as serious preferred stock investors know that quality issues incur the largest hits when under these types of circumstances.   High yield and floating rate preferreds lost less, but generally they were still losers.  Quality baby bonds lost 2-4%, while the junkier baby bond issues lost 1-2% and then jumped back up to recoup the losses.  One must remember that many quality baby bonds while having maturity dates, do not mature until 2060 and after. While this is not “perpetual” it is pretty close, so while baby bond pain is muted it is still there.

Investors need to remember simply that the speed of the interest rate move coupled with the lack of a maturity date on the perpetual preferreds caused the strong downdraft in prices. While one can never really predict the future it is very possible that many of the low coupon preferreds issued a couple of months ago may never, ever be redeemed.  The Public Storage 4.90% –preferred (PSA-E) which was issued just last month is now trading at $21.37 with a current yield of 5.62%–72 basis points above issue price.  Can you imagine where this will trade if the 10 year treasury moves from the current 2.37% to 3% or higher?  A move to 3% on the 10 year treasury is going to move the price of this issue down to $16-$17–do you want to hold on for another fall?


So what does an investor do if they have suffered losses?  If you are the holder of significant high quality (investment grade) perpetual preferreds you need to absolutely understand that if rates move higher you will continue to lose capital–it simply is a fact of life.  Are you a pure income investor and care only about your cash dividend and income flow without regard to capital loss?  Our observation is that while many investors claim that they only care about income eventually they cave in to “protection of capital” and sell.  They then sit on the side lines earning no income–sometimes for years–it happens every time there is a setback in pricing.

If an investor has a portion of investments in perpetuals they should consider swapping out for either a short duration debt issue or to a term preferred issue.  We have a list of short duration issues here.   Of course you have to do your due diligence on each issue, but the majority of these issues have moved only a percent or two in reaction to higher interest rates and given their duration they provide some level of protection against steep, fast capital losses.  Additionally some issues that are fixed-to-floating rate provide some level of protection against higher interest rates–one such issue might be the NuStar 8.50% fixed-to-floating preferred issue which is a new issue from last week.  The issue is trading 50 cents over par at this time.

Our Short/Moderate Duration Portfolio performed superbly during the recent downdraft.  It lost only a couple tenths of a percent during the month and was originally set up to deal with exactly the rising interest rate environment we are experiencing.  The current yield of the portfolio is 6.78%.  As always whether this type of portfolio fits your needs only you can tell, but for the most part it is how we are invested.

So what is ahead?  No one knows for sure of course, but we can speculate a bit.  In general we are counting on a 1/4% increase in the Fed Funds rate in December-this is now the most expected rate hike ever.  By all rights this increase should be “built in” to current rates meaning that the actual announcement should have a somewhat limited impact on current rates–although we would bet that it would have a small affect.  Additionally we think it is a fair assumption that economic data in the next few months is likely to be just ok–not fantastic–just ok.  Logically it would be a year before we see any boost from the next presidency–by the time all new office holders get in place and the arguing begins it will be a year.  Even considering that the marketplace looks ahead 6 months we would be surprised to see any real stimulatory action from the politicians anytime soon.  Remember that rising rates tend to dampen economic so the higher rates we are now seeing may already be having a very modest dampening economic affect.  We will get our first bit of meaningful economic news on Friday, December 2nd when the employment report for November is released.

Regardless of the economic news ahead our approach will be the same.  We will hold mostly short/medium duration issues with the possibility of receiving a modestly reduced income stream in order that we maintain capital.  No real change in our plans.   We will supplement with limited REITs and/or MLPs.  In general we will hope to maintain a return in the 7% area.


Tim McPartland

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Tim McPartland
Tim McPartland is a private investor with over 45 years of investing experience. His analysis, research and writing is devoted to the hunt for income producing securities of all types, but in particular specializing in preferred stocks, exchange traded debt and Master Limited Partnerships.
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