Seeking Alpha
Bonds, dividend investing, income, retirement
Profile| Send Message| ()  

With President Obama's announcement of nominating Janet Yellen as the next Fed chairwoman, investors are still not exactly sure what her plan will be for QE. Either way investors should plan accordingly and there are several ways to do so.

Fixed-floating preferreds have been hitting the markets over the course of the year. Companies are issuing these because it is easier to attract investors by promising the potential of hedging against rising rates.

Just a few days ago, I wrote an article about two preferreds that I liked. The preferreds were issued by Morgan Stanley (MS) and Citigroup (C), both of which are amongst the largest financial institutions in the world. The yield on cost is around 7% since both are trading a few percentage above par value. This is still a good deal considering investors will have the opportunity to hedge against rising rates. However, there is still one issue I have with these preferreds. The neither preferred becomes floating until 2023. That is still a decade away. I am not an economist, but I think most people can agree that rates will rise well before then.

So what exactly does it mean for holders of these preferreds?

Well assuming that rates rise before 2023, there will be several years where the principal value of these investments will decline in such an environment. Investors would have to endure an unrealized loss on the value of these investments. However, I am not concerned about the unrealized loss as much as the opportunity cost here. As income investors, we want to maximize our dividend returns. In this scenario, plenty of income investors would miss out on a rise in rates temporarily. If you are okay with this, then these preferreds are for you. I still believe these investments to be an attractive option.

While I was doing some digging around, I ended up finding another fixed-floating preferred, which I believed to be interesting. Unlike the new Morgan Stanley and Citigroup preferreds, this one will switch to a floating rate in 2018. So only five years out compared to a decade of the previously mentioned preferreds.

The other plus is that floating is 3 month LIBOR + 639 bps. Not bad at all, but given the higher spread I realized there were certain risks associated with this security.

The preferreds I am referring to are issued by Synovus Financial (SNV). The Synovus series C preferred has a yield of 7.875%, but wait a minute that is just the yield on par. If investors wanted to purchase this preferred now, it would be more like 7.2%. This still isn't bad if investors have the option of hedging rising rates in a few years, but that is the problem. For most preferreds, the floating rate is not a guaranteed event that will occur. Preferreds only switch to floating if the issuing companies don't call them.

Synovus' preferred can be called in 2018. This presents some call risk because the security is trading at a decent premium over par. It is trading around $2.17 over par. This is more than a year's worth of dividends for this security. Now investors will be likely to make money on this for the most part as long as the company continues to pay the dividend, but I believe it is a matter of risk. The market may be getting overexcited on this and believe that it could potentially go floating. A scenario that is likely. However, another likely scenario could be the company calls them before they become floating.

This would happen if Synovus could issue a new preferred at a lower rate than the floating. Given that the company made $830 million in net income in 2012, improving credit quality could allow for cheaper financing in the future.

If we subtract out the premium above par, investors will stand to gain a total of $5.67 of dividends per share until the preferred can be called. This is a 5.67% annually, which just doesn't look that attractive anymore.

So knowing this, should you buy?

Well it depends on the investor. If investors believe that Synovus will not call the preferreds, I think it would be a good investment. However, if not called, it would just mean investors got 5.67% annually. In this case, the money would have been better invested elsewhere.

I think the preferreds for Synovus, Morgan Stanley, and Citigroup all present unique opportunities. However, if you are a more patient investor and willing to wait until 2023 to see these securities float, I think that is a good option as well. I believe Synovus' series C is more for risk-averse investors who don't want to take a short-term hit in their portfolio if rates rise. Investors should assess their risk profile and proceed accordingly.

Note: Synovus' series C has different names for certain brokers. Examples include SNV-C, SNV PRC, SNV-PC, etc. Please check with your brokers regarding this.

Source: A 7.2% Yield That Rises With Rates, Should You Buy?