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I reside in Houston, and it can be a great place to live. Houston hosts the second-highest number of Fortune 500 companies in the U.S. after New York City. Our unemployment rate is consistently lower than the national average, and salary increases outpace the national average. We have some of the nation's lowest housing costs, and no state income tax to boot.

But there are downsides. Summers, which last well into October, are as hot as blazes. The city school system leaves a lot to be desired. Don't get me started on the extreme humidity and the blood-sucking mosquitoes.

Then there are the hurricanes.

One of the first pieces of advice a new Houstonian is given: prepare for a hurricane. Stockpile water and canned goods; keep flashlights, batteries and a battery-powered radio on hand. If possible, buy a generator and camping gear such as a Coleman stove for cooking.

Yet I never cease to be amazed - and more than a bit baffled - at Houstonians' reaction to an impending hurricane. All-out panic sets in. The grocery stores and gas stations become madhouses. People rush to stock up on water, canned goods, batteries and gasoline for their vehicles, all of which inevitably sell out within hours of a hurricane warning.

Panic-mode worsens as the storm begins to hit. Motor vehicles jam up freeways because evacuees ignore city officials evacuation orders. Worst of all, foolish persons in high-risk areas refuse to evacuate, only to suffer a sad inevitable fate. It's as if some Houstonians are actually surprised or in disbelief that a hurricane would actually come here.

I want to scream…you knew this when you moved here. Why aren't you better prepared?

Fixed Income, Inflation and Rising Interest Rates

For those of you that hold fixed income - are you prepared? It seems a silly question, given current circumstances. Inflation currently is within the average rates of about 3% and is actually predicted to decrease in 2012. The FOMC announced January 25th that there will be no consideration of an interest rate hike through the end of 2014.

At the same time, what kind of investor do you want to be? Prepared and have taken action long before a change hits? Or like oblivious Houstonians in hurricane-panic mode: trying to shop for alternative investments only after the worst case has made itself known?

Wouldn't it be better to prepare far in advance? Wouldn't you prefer to "shop and stockpile" at your leisure? When inflation and interest rate hikes hit, you can be the investor with your "stockpile" in place, not the one that is finds him- or herself on the wrong end of the trade.

Seeing the Storm From Afar - Inflation and Interest Rate Correlation

I am no economist, so if you want to get in the weeds on the relationship of inflation to interest rates read this expose by Nouriel Roubini. Instead we'll take the bird's eye view:

Inflation: There is monetary inflation, which is caused by an increase of money supply and is influenced by Federal Reserve policy. Then there is price inflation, which is influenced by not only by monetary inflation, but also consumer preferences, production output and interest rate hikes. This article primarily addresses how to deal with price inflation, which relates to the rising price of goods and services pertaining to our everyday lives. Price inflation is measured by the Consumer Price Index, or CPI, which is published by the U.S. Department of Labor, Bureau of Labor Statistics.

Interest Rates: The federal funds rate, or fed interest rate, is set by the Federal Reserve and is the interest rate at which depository institutions actively trade balances held at the Federal Reserve. The prime rate is the interest rate banks charge to their most credit-worthy customers. While the Federal Reserve interest rate is virtually 0%, the prime rate is currently 3.25%. The prime rate is usually adjusted according to the fed funds rate.

How are inflation and interest rates related? The simplest explanation is that adjusting interest rates are a means by which the Federal Reserve attempts to adjust inflation or deflation. When the economy is slowing, the Federal Reserve lowers interest rates in order to spur on consumers to spend. If the economy is growing too fast, the risk of inflation increases dramatically. The Federal Reserve may then raise the fed funds rate, which should have the effect of slowing the inflow of cash into the economy, with the goal of keeping inflation in check.

The Effect of Rising Interest Rates on Fixed Income

The best explanation I have found for the effect of interest rate hikes on fixed income is found at Fidelity's Learning Center page called "Bond Prices, Rates and Yields:"

The price investors are willing to pay for a bond can be significantly affected by prevailing interest rates. If prevailing interest rates are higher than when the existing bonds were issued, the prices on those existing bonds will generally fall. That's because new bonds are likely to be issued with higher coupon rates as interest rates increase, making the old or outstanding bonds generally less attractive unless they can be purchased at a lower price. So, higher interest rates mean lower prices for existing bonds.

The primer goes on to explain the relationship between inflation and interest rates:

Inflationary conditions generally lead to a higher interest rate environment. Therefore, inflation has the same effect as interest rates. When the inflation rate rises, the price of a bond tends to drop, because the bond may not be paying enough interest to stay ahead of inflation. Remember that a fixed-rate bond's coupon rate is generally unchanged for the life of the bond.

Here is my big concern: I see a lot of investors jumping on the bond and preferred bandwagon in the last couple of years. If you buy under the call price, and are buying single issues, you have less concern than those who are buying funds, and any issue above call price.

However, if you bought over call or are invested mostly in bond funds, you may be in for several potential surprises when interest rates are raised:

  • A drop in market price for all funds and single issues
  • Premature calls on single issues (read your holding's prospectus; most issuers reserve the right to call the issue at any time)
  • Capital investment loss on single issues bought over call
  • Inability to recoup capital investment on funds, due to perpetual maturity of funds (you do not get a call and/or maturity "pay day" on investment like a single issue)
  • Rising interest rates = more inflation, and more inflation = less purchasing power on your fixed interest payments
  • The only way to increase purchasing power of fixed interest payments is to reinvest your interest payments, which is not possible if you use them for living expenses


In other words, your fixed income may experience a double-whammy: the market price of your bonds and preferreds will depreciate, while the effects of inflation will erode away the purchasing power of your interest payments.

Fixed Income that Can Adjust to Inflation

This multi-part series was written for the express purpose of helping you beat the beast that's been asleep since 2008, but will one day rear its ugly head again: inflation. Fixed income has been highly in favor, and indeed an overall excellent investment, since interest rates were lowered. The favorable environment won't last forever.

The answer is not to sell whole hog all your fixed income just yet. I'm not, and neither should you. Instead, now is the time to research, shop and begin to take positions in other types of investments. Remember that no bargains are had when shoppers are panicked to buy; bargains only exist when fewer folks are thinking about buying.

What should you be looking for when considering an income generating vehicle that meets or beats inflation? There are four types of investments to consider:

1) TIPS bonds

2) I-bonds

3) Dividend growth stocks

I am not addressing the first two investments in this article. You can learn about, and purchase, the first two at TreasuryDirect.gov. Indeed, these two are worthy of an entirely separate article that addressed their benefits.

Dividend growth stocks (choice #3) have the best chance long-term of creating a stream of income that not only meets but also beats the rate of inflation. I provided plenty of choices in Part 3 of this series for dividend growth stocks that can meet or beat inflation rates of 3% - 6% or more.

Instead, I will present to you a 4th class of investment that is not widely discussed on Seeking Alpha, and that is:

4) Floating-Rate Preferred Shares

Floating-Rate Preferred Shares: Adjusting to Inflation-Induced Interest Rate Hikes

Floating-rate preferred shares, also known as Adjustable-Rate Preferred Shares (ARPS), are preferred shares with interest payments that adjust to benchmarks that mark inflation; usually the LIBOR, but also the T-bill rate and the CPI.

The reason I went into such great lengths previously to explain the relationship between inflation and interest rates is this:

There are few floating-rate preferreds that directly correlate to the CPI, which is the most direct benchmark correlation to price inflation.

In most cases, when you buy a floating-rate share, you are not buying a benchmark that directly correlate to the rate of inflation. Instead you are buying adjustable interest according to the LIBOR or T-bill CMT. In this sense you are buying into the "lagging indicator", as interest rates adjustments are reactions to inflation.

Bird's Eye View of Benchmarks

Floating-rate preferred shares use several benchmarks to calculate the fluctuation in interest payments:

Consumer Price Index: The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. This benchmark is used for only a few floating-rate preferreds, but it does provide the most direct correlation to consumer inflation. For more information on the CPI, click here.

London Interbank Offered Rate: LIBOR is the most commonly used benchmark for floating-rate preferreds. The LIBOR is the average interest rate that leading banks in London charge to lend to one another. Banks borrow money for various time-frames, and the LIBOR tracks the average interest rates for 1-month, 3-month, 6-month and 1-year loans. For floating-rate preferreds, the LIBOR most used is the 3-month LIBOR. For more information on the LIBOR, see BankRate.com.

Constant Maturity Treasury Rate: CMT is commonly known as the "T-Bill" rate. The yield curve relates the yield on a security to its time to maturity, is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market. The U.S. Department of Treasury publishes the CMT yield curve rates here. There are only a few floating-rate preferreds that are benchmarked to the CMT, the most helpful being the 10-year and the 30-year. The 30-year CMT is currently about 3%.

Floating-Rate Preferred Shares: Choices

There are a surprising number of choices available to investors for floating-rate preferred shares, some of them priced under call: a rarity for investors these days.

While many fixed coupon preferreds offer interest payments of 5% or more, floating rate works differently. Some shares only offer a pure floating rate payment; these tend to yield less than issues that provide an interest payment floor. An interest payment floor is the minimum interest rate that is paid. If the calculation of benchmark is under the floor for any interest payment period, you will be paid the floor interest rate. If the interest rate calculation is above the floor, you would get the greater interest payment. Issues with either an interest floor or generous interest calculations are what we're looking for

To provide a full list, we need to lower Five Plus Investor's minimum coupon of 5%. There are plenty of choices with an interest payment floor that starts at 4% or more.

Using the excellent resource QuantumOnline.com, I searched for the following preferreds:

  • Minimum interest payment floor of 4%; or
  • Calculation of interest payment allows for better than 4% coupon; or
  • Current market price allows for better than 4% coupon
  • Floating rate set to one of the following benchmarks: T-Bill, CPI, LIBOR

Click Here to access the Floating Rate Spreadsheet (sorted alphabetically by issuer).

I then lined up the choices in an attempt to create an ideal wish list that ranks issues "first in line" according to the following criteria:

  • Maturity Date: maturity preferred over perpetuals (no maturity)
  • Maturity: shorter maturities preferred over long
  • Call date in future, if it is perpetual maturity.
  • Benchmark: CPI is preferred over other benchmarks
  • Coupon Floor is preferred
  • Higher additional yield over benchmark is preferred
  • Rating: S&P / Moody's investment grade preferred; however, see this article by Ploutos regarding the returns of BB-rated bonds
  • Tax Rate: 15% is preferred


Click Here to access the Floating Rate Spreadsheet - FPI Sort.

This sort shows that no ideal floating rate preferred exists.
We want a future call and maturity; investment grade rating; a coupon floor; and tax favorability. Since "ideal" doesn't exist it is up to the individual investor to choose issues that best serve their investment goals and risk tolerance.

In spite of not finding the "chupacabra" in our sort, there are a few interesting issues to consider:

Prudential Financial, Inflation-Linked Retail Medium-Term Notes (NYSE:PFK) - This issue is the closest "pure play" floating rate in existence. It is only one of three issues - along with (OSM) and (ISM) - that correlate directly with the CPI only. It has a very reasonable maturity (6 years) and is investment grade. It is also richly priced right now at approximately 8% over call.

JPMorgan Chase Capital XXVIII, 7.20% Fixed-to-Float Capital Securities, B Shares (JPM-B) - This is an investment-grade issue with a generous coupon (4.46% over 3-month LIBOR) which also has a call date in two years, but a long maturity.

Southern California Edison, Variable Rate Series A (OTC:SCEDN) - This one is interesting if only for the calculation! The yield calculation chooses the highest of three benchmarks (3 month LIBOR, 10-year Treasury CMT and 30-year Treasury CMT) and adds 1.45%. Even in this low-rate environment with the issue close to call price it is currently yielding over 5%. However, it is also past call with no maturity so proceed with caution on this one.

Santander Finance Preferred, Float Rate Series 6 Preferred Stock (STD-B) - This is an investment grade issue taxable at the 15% rate. It has a generous coupon floor of 4%, and although it has no maturity it is callable in 2017. It is also priced way under call around $16.00. So what's the problem? Well, Europe (Santander is based in Spain) and speculations about Santander's financial condition. Still, this issue maintains a better credit rating than the higher priced MET-A (from MetLife) and is priced more than $8.00 less. If you don't believe Europe will pull through its crisis, it's to be avoided. If you do, this speculative play may appreciate greatly towards the call date, when momentum players try to cash in on a call.

Conclusion

Writing this piece has been like peeling an onion: the more I think we're at the core, the more I find to discover. It was my intention to make part four the last installment, but I'm already anticipating two questions you might have:

  • What do I do with the fixed income I already own?
  • How can I put together a diversified, inflation-busting, high yield portfolio?


So we'll peel away the onion some more with more installments; hopefully with no tears and feeling prepared no matter what 2014 and beyond holds.

Source: Dividend Growth Vs. Fixed Income Challenge, Part 4: Floating-Rate Preferred Shares