Fed Policy Fails On Jobs But Highlights Opportunity For Income Investors

Includes: PRE, SIGI
by: Doug K. Le Du

The experiment to see if monetary policy (rates, money supply), rather than fiscal policy (taxes, spending), could stimulate employment began in December 2008, only to have unemployment remain stubbornly high (7.7% at the end of February 2013).

With respect to employment, the idea behind the Federal Reserve's near-zero federal funds rate was that cheaper money costs for U.S. companies would result in savings and, in turn, more hiring. But employers hire new workers in order to meet an increase in demand for their products and services; the notion that employers would use the capital cost savings to hire workers who would produce products and services for which there were no additional customers has proved to be unrealistic.

Alternatives for Income Investors

This chart shows the effect of the Fed's monetary policies on income investors. Bank Certificates of Deposit (CDs) are now paying an average APY of 1.1%; investment grade corporate bonds are offering 3.9% while high quality preferred stocks [1] are at about 6.0%. Recent preferred stock examples include PRE-F from PartnerRe (NYSE:PRE) and SGZA from Selective Insurance Group (NASDAQ:SIGI), both at 5.875% with Moody's Baa2 ratings.

Alternatives available to income investors

After inflation and taxes are subtracted, the net returns provided by today's bank CDs and investment grade corporate bonds are underwater.

But as investors, we must invest in the market that is being offered to us; not the market that used to exist, the market that we wish existed nor the market that might exist some day in the future.

Of the three alternatives shown on the chart, that leaves high quality preferred stocks for those looking for income [2].

What about Falling Prices?

Future increases in interest rates can produce a lowering of market prices for fixed-income securities (bonds, preferred stocks).

While preferred stock investors are often cautioned about future rate increases triggering lower prices, many preferred stock investors view a period of falling prices as a welcomed time to buy more dividend paying shares.

Take a look at how preferred stock market prices reacted the last time the Fed implemented a policy of gradual but prolonged 1/4 percent increases in the federal funds rate between July 2004 and June 2006 [3].

Preferred stock prices react to increasing federal funds rate

In the weeks leading up to the rate increases overly fearful sellers, nervous about a massive rate increase from the Fed, pushed prices down. Bargain hunting elated buyers stepped in, immediately pushing prices back up. But after two or three quarters of consistent 1/4 point rate increases from the Fed, the market fell into an equally consistent pattern of very gradually decreasing prices.

Interestingly, high quality preferred stock market prices took twenty-two months to fall back to their $25 starting point (grey diamond); a net reduction in preferred stock prices did not occur for twenty-two months after the Federal Reserve started increasing the federal funds rate.

High quality preferred stock dividend rates were flat during the three years covered by this chart (2004 - 2006), paying about 7% ($1.75 per year per share) or $5.25 per share in total dividend income to preferred stock investors. Preferred stock market prices started 2004 at $26.83 and fell to $25.47 by the end of 2006, a drop of $1.36 per share over the same three year period leaving preferred stock shareholders ahead by $3.89 per share despite a whopping 4.25% increase in the federal funds rate.

What is True of Direction is also True of Magnitude

While there is a relationship between increasing interest rates and decreasing preferred stock market prices, the above chart illustrates the nature of the relationship in terms of degree and reaction time.

The types of rate increases that we see as we emerge from a struggling economy are more likely to be minor, gradual and announced in advance than major and sudden. It therefore seems likely that any downward pressure on preferred stock market prices, once rates start heading back up, would be just as minor and gradual.

When it comes to the relationship between interest rates and preferred stock market prices, what is true of direction also appears to be true of magnitude.

It would be hard to argue that the Federal Reserve's experiment at increasing employment by lowering capital costs has been a big success. And the same policy has decimated savers, pushing bank CDs and bond yields into a position of little or no net return.

Many Wall Street analysts and pundits are not expecting interest rates to start increasing for at least another two years. Today's 6% high quality preferred stock shares will provide $3.00 per share of dividend income over that two year period.

While it is not possible to know for certain how the market will react once interest rates start back up, it is not clear that preferred stock investors are best served by giving up today's 6% annual returns for fear of the effects of future rate increases.


[1] "High quality" preferred stocks are those that meet the ten risk-lowering selection criteria from chapter 7 of my book, Preferred Stock Investing. For example, high quality preferred stocks have investment grade ratings and the cumulative dividend requirement.

[2] Source for all preferred stock data in this article: CDx3 Notification Service database and Preferred Stock Investing, Fourth Edition (PreferredStockInvesting.com). Disclosure: The CDx3 Notification Service is my preferred stock email alert and research newsletter service and includes the database of all preferred stocks and exchange-traded debt securities traded on U.S. stock exchanges used for this article.

[3] To see the relationship between the dividend rates offered by newly introduced high quality preferred stock and U.S. Treasury bond yields please see the article titled "How Well Do Government Money Rates Predict Preferred Stock Dividend Trends?"

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Securities identified within this article are for illustration purposes only and are not to be taken as recommendations.