6 Ways To Minimize The Stress Of Interest Rate Risk

| About: Wells Fargo (WFC)

Summary

Interest rate risk affects every investor in preferred stocks.

We cannot predict what will happen, but we can prepare for certain outcomes.

Discussion on how to manage the risk effectively.

Whenever an investment is made we must always ask, 'what are the risks?' We can usually identify these in our specific stock or sector, but there is one universal danger that I mention in nearly every article I write: interest rate risk.

The effect of rising rates

When rates rise there will be a parallel shift in the yield curve of the treasury notes. Preferred stocks are widely compared to the 10-year treasury yield as the lowest risk alternative. So if the 10-year starts paying a higher yield, investors will want a proportional amount more from their preferreds. This of course can't happen in existing issues as the coupon is fixed. Therefore, price has to compensate. Most stocks have a $25 par value and the more rates rise the less attractive the coupon, the further under par it will trade. Newer issues will have increased coupons, and lower yielding preferred stocks will be sold as investors chase this yield.

Will rates rise enough to hurt preferred stocks?

One could argue the tapering and eventual end to QE3 were the first steps in a tightening/rising cycle. Since the initial reaction in 2013, 10yr yields have made higher lows. Was this the turn in bonds? Bill Gross certainly thought so and boldly claimed it was the end of the three-decade bull run.

The cycles seem to say it is due:

Rates gradually rose for 35 years to the 1981 peaks, and have now fallen 34 years to the 2015 lows. A closer look shows just how symmetrical this rise and fall have been.

source: www.economagic.com/

Of course it won't look so symmetrical if rates continue to bobble around zero (or even go negative) over the next ten years. I just think it is an interesting chart given the context.

I am not as bold and knowledgeable as Bill Gross, and have learned the hard way not to make predictions; they generally hinder, instead of helping my trades. I do, however, need to identify risk and prepare for varying scenarios. One of those scenarios is simply rates trend up and preferred stocks are affected. Whatever your opinion, surely you have to accept this as a possibility.

How to manage the risk

Everyone will have a different approach to investing and tolerance for risk. The ideas presented here are not an exhaustive list of techniques, and I invite a further discussion in the comments section below. With some constructive comments, this article could provide a valuable resource for Seeking Alpha readers.

Make comparisons and always switch to the best preferred in the family. Prepare a reaction.

This is the first and most efficient way to manage any kind of risk in preferred stocks. Here is an example from my previous article. SSW-E was fundamentally undervalued compared to SSW-D at the time of writing by more than a dollar. This gives an investor the opportunity to hedge in any event. You can hold SSW-E with no concerns as you have a plan B ready by shorting the overvalued stock. When there is fundamental shift in the yield curve, you will eventually see the so called "smart money" narrow the arbitrages and you have $1 room to lock the hedge. If SSW-E starts falling first then short SSW-D. If SSW-D starts falling first, then just sell SSW-E. The arbitrage protects you.

Short some spikes that present a fundamental arbitrage in high volume preferreds

There is no law that forbids the income investor to short. Let's say you have $100000 allocated to preferred stocks and you are invested in the best preferreds from all the companies you hold. I will use the SSW preferreds as an example even though they are not high volume. Let's say you managed to buy 1000 shares SSW-E at $23 when SSW-D was trading at $24.20. You did a nice trade, but here is an idea: try to short SSW-D at $25.20. If you get lucky, you can "catch" a spike. This short trade will have a very nice risk-reward ratio and will make your portfolio a little closer to delta neutral. This way you are using your investment as a hedge for trading some short-term inefficiencies on the short side. The benefit is that you are increasing your ROI while reducing your risk, because by implementing this strategy you will not be $100000 naked long, but for example $70000. It is up to you to determine what is the maximum amount you want to hedge, and up to the market to give you the fundamental arbitrages.

Floating rate preferreds

I wrote an article about GS-D which explains some benefits of this type of preferred stock. I also received some interesting comments and the one I liked the most, from Lawrence J. Kramer, stated this, "I look at floating rate preferreds with floors as two securities: (NYSE:I) a fixed rate bond (of credit quality equal to the preferred) that pays the floor rate, and (ii) an option on a floating rate bond that pays LIBOR + Spread - Floor. When rates rise, the bond falls in value, and the option gains in value. How these movements offset strikes me as a bit of math that can be done, but not by me." This is the best explanation I heard. Floating rate preferreds protect you as much as the described option (in the comment) offsets the capital loss made by the shift in the yield curve.

Buying High Nominal Yielders that are currently priced to be redeemed

This idea is not very popular, but here it is. There are stocks like WFC-J that have nominal yield more than 2% higher than some of the WFC preferreds. This stock has a 99.99% chance of being redeemed on its call date. If you can lock a yield to call greater than a treasury with the same maturity that is reasonable for you as an investor for the specified short term, you will most likely end up with the tiny yield to call of 1.73%. But if the yields raise so much by the call date that this security does not make sense to get redeemed, this would mean that all Wells Fargo (NYSE:WFC) preferred shares will have yield to worst equal to their current yield. And here is where WFC-J will significantly outperform the preferred stocks from its family, because the current yield spread will narrow to a point where all WFC preferred shares have similar current yields. Let's look at an example: WFC-J is trading at 27.87 with a current yield of 7.20%, while WFC-N is trading at 25.57 with a current yield of 5.10%. For those two current yields to become equal, WFC-N will have to fall to $18. This really illustrates how WFC-J can be used as an interest rate protection, in a sharp rate raising environment. WFC-J is just an example to propose the idea and every investor should look for a better analogue, because WFC-J will most likely be redeemed and an investor will end up earning 1.73% yield to call.

Flipping Short

As a trader, I cannot hide that this is the option I like the most. There are so many preferred stocks that offer very limited upside risk on a shift in the yield curve, that a scenario of raising yields is the trader's dream. In the last few years there hasn't been a single day that I have not been prepared with my "best shorts" list. Changing direction from long to short is really unthinkable for many of the income investors, but shorting is the best way to manage interest rate risk.

Holding on

Many investors in preferred stocks have a very long-term outlook. Although no one likes a loss of capital, rising rates needn't hurt you at all if you just hold on. This isn't exactly active management of risk, but if you are happy with your yield, then this will not change. If you don't need the money, you can sit on your investment as long as it takes to get back to break even or it is called at par. Granted, this may take a very long time; so long that it is your grandkids, not you, who finally collects the redemption. Preferred stocks issued in the low interest rate environment of 1945-1965 are still in issue. These generally have yields from 4-5%, so it hasn't made financial sense for the issuers to redeem them, as they can't IPO a new stock with a lower yield. Currently many of them trade about 10% below par and this is about as high as they have traded for a long, long time. But somehow I doubt someone holding for the last 70 years is too concerned with a few percent here and there.

Conclusions

No one knows what the future holds, but almost every risk we know can be measured and prevented as long as one is willing to do some extra work or to sacrifice some yield. The big problem with trying to take care of all the risks is that, there is always something in the future that cannot be anticipated today, and it is this that will hurt the most. But what is better - to leave our positions and let them manage themselves, or to try our best to manage them? If it is the latter, hopefully this article helps. If it is the former, then good luck; we'll need it.

Disclosure: I/we 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.