The Preferred Stock Owners Dilemma

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Actually it is not just the preferred stock owner that has an issue, it is also the holders of exchange traded debt (baby bonds).

We are all struggling to hold onto our best income producing securities, while issuers are bound and determined to call them away from us as quick as they can do so.  We are doing our “job” by trying to make a reasonable return on our investment and they are doing their “job” by trying to cut expenses and thus maximizing profits for their owners (shareholders).  We know that you all are struggling with this problem.  Here is how we are dealing problem.

As you can see if you peruse the Short/Medium Duration Portfolio here you will see that 10 of the 18 issues in this model are now redeemable (or callable) at this moment. 1 of these issues has now been called (Kayne Anderson 4.60% Mandatory Redemption Preferred–KYN-G) leaving us 9 issues that are vulnerable to a call.  Now we have to remember that this model is not one to be traded except on rare occasions–the concept is to have a a portfolio with short/medium durations  producing minimal volatility.  To this end this model has been successful and has produced a low stress 7% annual return.

As you look down the list of issues that are now redeemable most of them are around 2.5% over par (50 to 75 cents over $25 par).  These issues pay between 40 and 50 cents/share quarterly dividends so we need about 3-4 months worth of dividends to compensate us for the potential redemption.  Since these issues have been callable for between 3 and 17 months we have covered our price risk to a large degree. So the question becomes why not sell and pocket the premium over par?  That is a legitimate question and if we had a bunch of available issues which we could turn around and purchase as replacements that is what we would be doing, but that is not the case.  Newer issues that have come out are generally at lower coupons or in the rare instance that a higher coupon is issued  it may be a longer duration (such as a perpetual preferred issue or a baby bond with a maturity of 2056).  If we want to stay within the confines of our rules for this portfolio we will be attempting to stay with only short or medium duration (maturities out to 2030) securities.

So if we could have had better results with high yield perpetual preferreds why have a portfolio devoted to short and medium duration securities?  It all goes back to why this website was originally conceived and published– it is a learning vehicle.  Recall that the “smart people” banged the drum hard for 2, 3, 4 or 5 years about how higher interest rates were coming any minute (and they never did).  Of course higher interest rates likely will cause perpetual preferreds or long duration baby bonds to fall sharply in value. The original intent of this portfolio was to protect against higher interest rates.  Securities that mature within a few years will show only minor capital losses since they will be redeemed at $25 in the near future, thus they protect you from large capital losses.  The flip side to this protection is that you forego some potential earnings by not holding high yield, perpetual securities.  There is always a trade off.

So here is what we are doing.  Any security that is presently callable (redeemable) and trades over $26 (or 4%ish over par) will be sold and replaced.  Most issues likely will be held knowing full well that one could incur a small capital loss upon redemption.  Generally, except when there is “irrational exuburance”, preferred and baby bonds will trade below $26 once call protection ends so we would expect few issues to trade over $26.

Lastly we must all remember that as investors not everyone is a “active trader”.  We wish we could be more active in the market, but given that we have a “real job” beyond our occasional writing on here we simply don’t have the time to spend on investing everyday.  Better results could be produced (and are being produced) by many “active” income investors as they have time to monitor and capture small swings in preferreds, but the majority of us simply don’t have that time.  The short/medium duration portfolio closely tracks one of our own portfolios and we are more than happy to have 7% annual gains–remember that the vast majority of individual investors produce very small gains annually (in spite of their smart talk over beers).

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Bryan Perry Dividend Income Expert Bryan Perry

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