In this issue, we're talking REITs, preferred stocks, bonds and other income instruments with veteran Seeking Alpha contributor Rubicon Associates. He has 20 years of investment industry experience, primarily focused on fixed income and preferred portfolios. He walks us through the risk-off trade in debt, the Fed's fund rate estimates and what they mean for the markets, and key metrics to consider when analyzing preferreds. There are some solid ideas here, along with a number of valuable takeaways, so let's dive right in.
Seeking Alpha: You cover preferred stocks quite a bit, especially for banks and the REIT sector. However, we know that not all preferreds are created equal, and they can be complex to analyze. As such, it seems investors sometimes get the metrics wrong when comparing multiple preferred stocks. What metrics do you consider when looking at preferreds, and how can investors do a better job of looking out for the "right" ones?
Rubicon Associates: Preferred stocks aren't as difficult to analyze as you might think. Honestly, security selection becomes a function of an investor's outlook. What is the outlook for rates, sectors, regulatory changes etc.? The outlook defines which risks you are willing to buy and sell. For example, if an investor believes that rates are going up, she would most likely be willing to sell call protection and pay up for a higher dividend rate. She might trade out of a preferred with a longer call protection into one with shorter call protection because the likelihood of a company using their optional redemption (CALL) provision decreases. Similarly, the investor might pay a higher price for a higher "coupon" to reduce the duration of the preferred and sustain smaller losses due to higher rates. When I was actively trading these for a sizable preferred stock mandate, these are the types of trades we would do.
I tend to write more about the $25 par market, as it is applicable to individual investors than the $1000 par market. The caveat with the $25 par market is that some securities have low trading volumes, and if you are trying to get into or out of a larger position, it can take a while. Trading between the $25 par and $1000 par markets is also a way to add value to the portfolio.
One of the things I have noticed when talking to many investors on SA and elsewhere is the desire to avoid securities trading above par. At, above or below par is just another form of risk assumption or avoidance. Personally, I am par agnostic, and I use the yield-to-call to determine whether the rate if the security is called is acceptable. This allows investors to select the rate (coupon) level, the call protection and the duration they are willing to own that is consistent with their view and their risk tolerance.
You ask the question about comparing preferreds and the metrics that can be used. This is often one of the shortcomings I see when investors are discussing preferreds. Comparing two (or more) preferreds that might have different payment dates using the current yield can be misleading. Investors should focus on stripped yield, or the yield that is determined after stripping out the accrued dividend. It is important to remember that preferred stocks trade with accrued, unlike bonds. If an investor is comparing one preferred that will go ex-dividend in two weeks with a preferred that just paid the dividend, the comparison is flawed, as one is "loaded" with dividend and the other is not. Strip out the dividend and then compare. I was looking at some mREIT preferreds today and noticed that in a more extreme example, the difference amounted to over 30bps between current yield and stripped yield, the average being closer to 10-15bps. These are not insignificant amounts when every little bit helps performance.
SA: You mentioned to me that you've been following the risk-off trade in debt, notably in the investment grade, high yield and commercial mortgage-backed securities spaces. I think a discussion around that would be valuable for our readers. What are you seeing here, and where are the opportunities?
RA: Over the last six months or so, we have been seeing spreads widen in the credit markets, whether it is the investment grade, high yield, levered loan or emerging markets. The same can be said within the CMBS market, especially notable in the non-AAA tranches. The market has a definite risk-averse feel to it. Credit spreads, using the CDX indices (due to their relative liquidity), have widened appreciably over the last six months without a real shift in the fundamentals of credit (ex energy and metals/mining), making the current market relatively attractive. When viewed as a risk premium, the widening of spreads across the credit/securitized market looks somewhat overdone relative to the actual risk.
The problem for many investors is that the absolute level (RATE) is still low versus many alternatives. The widening is more compelling for those running fixed-income portfolios with a more focused mandate. It's hard to get excited about 10-year IG paper trading at 4% when you can choose from more than just fixed-income. If you go further out on the risk spectrum, however, things can get a bit more interesting.
As an example, a mining machinery/services company like Joy Global (NYSE:JOY) currently trades as if it were a single B credit, when its metrics (current and forecasted) look more like a strong BB credit. There are going to be many opportunities in credit for those willing to dig in and do their homework. That said, I never really recommend that individual investors get involved in distressed credits such as Peabody Energy (BTU), Energy XXI (Bermuda) Limited (EXXI) or other distressed credits unless they have the resources to really dig in and withstand a significant amount of pain.
CMBS presents an opportunity directly for institutional managers (QIBs) as spreads have widened and metrics are still (somewhat) decent. That said, we have seen a degradation in some of the underwritten metrics, support/enhancement percentages and loan quality. Again, digging through the deal to the underwriting will be what separates success and pain. The refinancing/balloon/CMBS wall is also upon us, where a significant amount of deals/properties will have to be refinanced.
Finally, for investment grade buyers, I recommend they look at REIT debt, as it is some of the only investment grade paper that contains financial covenants. In addition to this, it is widely held by insurance companies that are super-focused on quality/credit analysis and will toe the line with issuers. The insurers used to be known as the REIT mafia, the way they would enforce the covenants upon the issuers.
SA: There has been a lot of attention paid to REIT valuations of late on Seeking Alpha and elsewhere. What's happening there, and why are valuations in the spotlight right now? In your opinion, what should investors be aware of, or perhaps wary of, as they evaluate these investments?
RA: I think that it is a function of investors finally having more choices for income. When there was nowhere else to turn to get a decent yield, everyone seemed to become a REIT investor, and valuations got somewhat stretched for the outlook.
I look at the great debate surrounding the valuation of a REIT stalwart like Realty Income (NYSE:O), where at current multiples and the dividend yield, it is hard to say it's compelling. I can see both sides to this argument; yes, the multiples are stretched and the yield is somewhat low (for Realty Income), but many investors are willing to pay up for a name they won't have to worry about. As we enter a period of uncertainty regarding growth and inflation (a driver of rental rate increases or escalators) and volatility in the equity markets, proven management and a strong business profile trade at a premium. This is what investors have to focus on - how much risk are they willing to take, in what form are they willing to take it and what is the expectation/cost of the risk or avoidance of it.
At the end of the day, I like the REIT space, and there will always be opportunities to trade among the various sectors or pick a solid REIT and just stick with it (assuming there is diversification). Looking at returns across time, REITs outperform the broader markets, due in part to the dividends being paid. This cannot be taken lightly.
SA: There's also been a lot of discussion around the Fed's estimates for the funds rate and how that impacts the markets, and what the potential implications are going forward. Could you offer some thoughts on that? Do you see this being an issue for the markets for most of 2016? What should investors be thinking about in relation to what's happening with the Fed right now? How can they position their portfolios to help mitigate some of the volatility that is sure to plague the markets if the uncertainty continues?
RA: It's interesting. If you look at the FOMC "dot plots" - the members' expectations for anticipated/expected rates - there should be another three rate increases during the course of calendar 2016. Then look at the futures market - Fed funds or eurodollar - and the expectation is for no further rate increases until 2017. Recently, I read that Bank of America (NYSE:BAC) revised its outlook for Fed funds increases to two more this calendar year. Add to this that the FOMC minutes released today show a conflicted Fed with an uncertain outlook, and what you have is one big grey area. No one really knows the path rates will take during the course of the next 12 months, and the Fed saying it is data-dependent while mentioning foreign economies (China) as well as commodities and fiscal policy makes nothing any clearer.
Under "normal" circumstances, an increase in the Fed funds rate would also be accompanied by an increase in longer-term rates due to inflation expectations. Honestly, I am not seeing it. Market-implied inflation rates still don't hit the Fed's 2% mark. If you look at five-year inflation expectations five years forward (calculated similarly to regular forward rates by extrapolating the real rate or TIPs market), expectations are somewhere around 1.5%. To me, this means longer rates could stay lower, and what we get is a curve flattening. I have been positioning rate-sensitive assets (mREITs, banks) accordingly.
Ultimately, an investor has to have a view. We all get paid according to our view - if it is right, we position right and outperform; if it is wrong, we position wrong and underperform. The key is to have a view and then ask, "What if I am wrong?" Is the downside significant, and if so, how can you hedge your position without sacrificing returns? The first step is diversification - this is the easiest and most obvious risk management step an investor can take. Options can be a great way to manage the risk within a portfolio - sell some of the upside to buy protection for the downside. Stop loss orders are a wonder, especially if they are rolling stops, where the stop increases with the increases in the price of a security.
SA: The great debate in Seeking Alpha's DI community has been, and probably forever will be: "Capital losses don't matter as long as I'm collecting those dividends" versus "It's all about total return!" What are your thoughts on this, and which "side" are you on, if any?
RA: Honestly, I don't get the DGI folks. I understand wanting to position companies that are growing their dividend (theory states it is because they are comfortable and confident with the expected performance of the company), but to do so at the cost of capital appreciation just doesn't do it for me. Here's the thing, saying "I don't care about price movements because I will just end up buying more at lower prices and increase my yield-on-cost" means you haven't had one of those "life events" where you might be called on to liquidate positions. Dividends are nice, and a 5% increase in dividends is great, but if I have to sell at a 25% capital loss, I am certainly not feeling the love.
I am more total return-focused, with a bias towards income. In other words, I typically like income investments where I believe that I will have capital gains or a lower likelihood of capital losses. An example is NorthStar Realty (NRF) - crazy dividend and significant upside. I actually hope they cut the dividend to juice my upside - have my cake and eat it too. I bought Glencore (OTCPK:GLNCY) after it whacked the dividend and, thus far, have been rewarded. It's all a balance. Buy some income and buy growth, tilt the portfolio towards your bias, but don't give up one approach singularly for another.
I once did a comparison between a triple net REIT that has grown dividends forever and a preferred stock of the same company. The preferred started with a higher yield than the common, and it would take the common nearly a decade of growing dividends at 5% per annum to catch up.
SA: Any other thoughts you want to share?
RA: Ultimately, everything is about tailoring your portfolio to your risk profile. Buying REITs at 25x FFO, preferreds above par, IG, HY or EM bonds are all expressions of risk preferences. If you choose EM sovereign over HY credit, you are taking one risk instead of another. A portfolio is no more than a bundle of risk designed to achieve a desired return. My style isn't going to be the same as yours, which won't be the same as another investor's.
Now it's your turn to weigh in. Do I even need to ask...? I am sure the "total return" versus DGI debate will rage on in the comments!
One more thing… I promise I'll bring back the list of the week's top D&I articles, probably next issue, but I have two announcements, and I didn't want to chance y'all missing out on them.
You may not know it, but we are building a thriving podcast platform for the Dividends & Income community here on Seeking Alpha. It's just another way we're providing you with fresh content on building solid dividend strategies and generating income for the future, whether that be achieving a short-term goal, attaining financial independence, taking an early retirement, or living a secure, comfortable lifestyle in your post-career years.
I'm excited to announce the debut of the Dividend Health Checkup podcast, with your hosts Seeking Alpha contributors Doctor Dividend and DGI Guy. Episodes 1-5 will be live on the site this week, and each one is chock-full of great dividend investing wisdom and ideas. Plus, these guys are super-entertaining to listen to. But that's not all - the idea is to get YOU involved. So if you want to be featured on a future podcast, or if you have questions or comments on what you hear, be sure to give these guys a shout at firstname.lastname@example.org.
Check out episode #1 here.
You can find all of the episodes under Doctor Dividend's author profile here.
And Chris DeMuth Jr. and Andrew Walker at Rangeley Capital have their latest podcast on Seeking Alpha here about the First Trust Dividend and Income closed-end fund (NYSE:FAV). It's a great idea, and it's on sale at about a 9% discount with a potential upcoming catalyst.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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