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Summary

  • Fed is about to end QEIII and the consequences for investor perceptions.
  • Analyst and investor perceptions are creating opportunities to buy preferred stocks.
  • Preferred stocks can be a substitute for the bond portion of one's portfolio.

On June 8, 2014, David Malpass wrote in the Wall Street Journal that now is the right time for the Fed to begin raising interest rates. Bloomberg reported on June 10, 2014, "The chance of a rate increase to 0.5 percent or more by March 2015 is 16 percent, according to data compiled by Bloomberg based on federal fund futures. The odds of an increase by December of next year are 72 percent." On June 9, 2014, Matthew Hornbach, head of global interest rate strategy at Morgan Stanley (NYSE:MS), wrote in a note to clients that the growing economy will spark inflation expectations, which will force the Fed to raise borrowing costs sooner than the market anticipates.

The Fed has begun the process of tapering the purchase of bonds and mortgages, or QEIII. John Williams stated that he expected that the purchase program would come to a halt by year end. Richard Fisher, head of the Federal Reserve Bank of Dallas said in a speech to bankers on May 9, 2014:

Speaking only for myself as a voting member, barring some destabilizing development in the real economy that comes out of left field, I will continue to vote for the pace of reduction we have undertaken, reducing by $10 billion per meeting our purchases and eliminating them entirely at the October meeting with a final reduction of $15 billion.

These comments as well as other similar comments and news items have led analysts and investors to conclude that the Fed will be raising interest rates in the near future. While the Fed has not specifically indicated that it will raise rates, the perception of many investors is that it will happen sooner rather than later. This perception has begun to impact the prices of many interest rate sensitive stocks and therefore has a profound effect on the price of preferred issues. Many of the preferred stocks that I have recommended and hold in my own portfolio have gone down as a result of this perception.

I think that investors and analysts are mistaken about the consequences of the direction of the Fed. The Fed is not lowering the money supply or increasing interest rates. By the Fed stopping QEIII, it only means that purposeful growth of the money supply by Fed action will cease. That is, money supply will not be growing as a consequence of purposeful Fed action by buying bonds and mortgages. This action does not decrease the money supply or increase interest rates, it only stops the purposeful growth of the money supply by Fed action in the marketplace.

While this perception can create a self-fulfilling prophecy and cause a temporary rise in interest rates, financial realities will again take hold and bring interest rates down within a short time. If my analysis is correct, it is a great time to pick up some good preferred stocks to juice up the returns in one's portfolio. However the perception of increasing rates is probably going to grow over the summer and fall. So the prices of preferred stocks and other interest rate sensitive stocks will likely go down further over the next several months. Below is a table listing some preferred issues with suggestions for a buying price and also a suggested price to sell if they rise to a certain level. There is no guarantee that the preferred stocks listed below will ever reach the suggested selling price. For that reason, one must be willing to consider holding these income issues for the long haul as long as the company is viable.

Symbol

Type Preferred

Common Symbol

Common Name

Current Price

Current Return

Moody Rating

SBP

SBP Return

Suggest Sell Price

PSA-W

Cum 5.20%

PSA

Public Storage

$21.48

6.0%

A3

$20.00

6.5%

$22.50

CTY

6.125% Notes

CTL

CenturyLink

$23.13

6.6%

Baa3

$23.00

6.6%

$25.00

DLR-G

Cum 5.875%

DLR

Digital Realty

$21.92

6.7%

Baa3

$22.00

6.7%

$24.00

IPL-D *

Cum 5.10%

LNT

Alliant Energy

$23.70

5.4%

Baa2

$22.00

5.8%

$24.00

KRC-H

Cum 6.375%

KRC

Kilroy Realty

$24.00

6.6%

Ba1

$23.00

6.9%

$24.50

PSB-V

Cum 5.70%

PSB

PS Bus. Parks

$22.68

6.3%

Baa2

$22.00

6.5%

$23.50

BXP-B

Cum 5.25%

BXP

Boston Prop.

$22.00

6.0%

Baa3

$20.50

6.4%

$22.50

  • SBP = Suggest Buy Price
  • Current Prices are as of 6/11/2014
  • *indicates dividend is eligible for lower tax rate.
  • Cum = Cumulative preferred stock

I think it makes sense to hold preferred stocks currently to replace what one would normally hold in bonds. For example, if one would normally keep 20% of one's portfolio in bonds, one might consider these preferred issues as a substitute. While preferred issues carry more risk than government and/or municipal bonds, they offer higher returns. With bond rates so low and businesses doing reasonably well, this exchange appears to be a reasonable trade-off between risk and return at the present time. Furthermore, these issues can be purchased in much smaller dollar amounts than bonds and carry a much lower trading cost when purchased through a discount broker. These factors also make it easy to diversify one's holdings to spread the risk among many issues.

Since preferred stocks do not participate in the growth of corporate sales and income, one should not put a great portion of one's portfolio into preferred stocks. These preferred issues generally offer higher dividend rates than dividend growth stocks and are especially useful for retirees that derive their monthly income from investment accounts. By having a portion of one's account in these issues, one can raise the total dividend return in one's account by 1 to 2%. But it is wise for a greater portion of one's portfolio to be invested in dividend growth stocks to participate in the economy and to keep pace with inflation and economic growth.

Conclusion:

Analysts and investors are overreacting to the reduction and termination of QEIII. Hence it is creating a buying opportunity in preferred stocks over the next few months. Several preferred issues were suggested in the table above with concurrent ratings from Moody's. Preferred issues can increase one's dividend returns when used as a substitute for the bond portion of one's portfolio.

Source: The Fed And Preferred Stocks: Perceptions Vs. Reality

Additional disclosure: The author has positions in each of the preferred stocks covered in the article