Surviving Interest Rate Volatility

Interest Rate

By Tim McPartland

It has been 37 months since we built our original Short/Medium Duration Income Portfolio, which was created in anticipation of the time when interest rates would begin to rise.

At that time, we expected that higher rates were just around the corner. As income investors, we waited a long time for rising rates to arrive.

With the recent arrival of higher interest rates and a hint of inflation in the air, holders of perpetual preferreds and very long-term maturity baby bonds found out in earnest what we were worried about.

In the last month, we have seen the highest quality, low coupon preferred stock issues fall by as much as 15%. Some of the hardest hit were the preferreds of giant self-storage real estate investment trust (REIT) Public Storage (NYSE:PSA). For instance, the PSA-E issue, which carried a coupon of 4.90%, fell from the $25.50 area to as low as $22.40. This is a massive loss for a fixed rate preferred that only pays about $1.20/year in distributions. This security was issued in October 2016, so someone who purchased at the initial public offering (IPO) is saddled with a $2.60 capital loss and they only have received $1.20 in dividends.

An even better example is the Kimco Realty (NYSE:KIM) 5.25% perpetual preferred, which was issued just 60 days ago. Not even a single dividend has been paid and the share price for KIM has fallen to $22.50.

The above examples are typical and serve to illustrate that quality is inferior to a higher coupon. Junky is preferred when interest rates are moving higher. While junky perpetual preferreds will fall, it will be much less than the high quality, low coupon issue. This is a fact that we have written about many times. While it seems counterintuitive, it is simply that investors will move to higher coupon issues to try to preserve a higher income stream when rates move higher.

Even better to help survive getting caught up in a sharp share price downdraft, income investors should consider moving to short and medium duration baby bonds and “term” preferred stocks. Because of the imminent redemption of the shares, or baby bonds, at $25, purchasing these securities at $25 or just above $25 is a superior way to preserve capital while receiving a reasonable rate of income.  

This is what the Short/Medium Duration Income Portfolio is all about. In exchange for the shorter maturity date, the investor will have to accept a slightly lower current yield, which we estimate is about 1% annually as compared to a fixed rate perpetual preferred. But when interest rates begin to move higher, such as during the last month, the holder of the short maturity baby bond or term preferred will rejoice at the modest losses they take compared to investors holding perpetual preferreds.

To help investors find securities with maturity dates in the next 10 years, we have two spreadsheets with Term Preferreds and Short Maturity Baby Bonds and they can be found here. 

While there are just 11 term-preferred issues to choose from, there are over 50 baby bonds with relatively short maturities. Current yields range from 3.30% to 8.5% and many of them are priced right around $25. Like all investments, the higher the current yield, the higher the risk. And one must still do their due diligence.

Fixed-to-floating rate preferreds offer another alternative that is superior to perpetual preferreds.  Some fixed-to-floating rate preferred issues give you the combination of high yield, plus the reduced interest rate risk that the floating rate promises. While likely not as stable as term preferreds and short maturity baby bonds, they are preferable to perpetual preferreds. We have a spreadsheet with the available fixed-to-floating rate issues here.

Investors will not get rich with these methods. But for us, the plan is simple. Collect a relatively decent level of income, while maintaining capital balances. When the term preferreds or baby bonds reach maturity, and are redeemed or called, there may be clarity on interest rates in which an investor can deploy capital into whatever seems most suitable at that time.

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