Past Performance is Unlikely to Repeat Itself
Everything with a safe yield has rallied this year as the ten year treasury rate has dropped from over 2.0% to under 1.6%. Every investor with interest rate risk exposure has been left with gains they want to protect. An ideal investment would have a high yield without risking capital loss if interest rates increase. Investors are turning towards Powershares Variable Rate Preferred Portfolio (NYSEARCA:VRP). The concept sounds perfect in theory. It has a 5.0% yield with low volatility and the yield will increase if interest rates increase. An investment like that would make a fine addition to any portfolio.
Below is an illustration of how the recent run up in prices has pulled future returns forward. The blue line below shows the expected return with volatility removed of Citi Preferred Series K (C-K) if purchased at face value during the IPO in 2013. The expected return was equal to the coupon value with the assumption that the issue would be called on its call date in 2023. The red line is what actually happened with volatility removed. In the last three years, C-K has had a CAGR of 12.9%. The end point of the investment remains the same; however, the future return is a much smaller 4.28%. The outstanding past performance was stolen from future returns. By analyzing one holding in isolation, it gives you an idea of what is happening inside the entire fund.
Below is a table of the top 10 VRP holdings that haven't been called and trade on the NYSE. Data is compiled from QuantumOnline, DividendYieldHunter, and Invesco. The holdings analyzed are Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), PNC Financial (NYSE:PNC), Goldman Sachs (NYSE:GS), Bank of America (NYSE:BAC), and US Bancorp (NYSE:USB).
In reality, the theory doesn't prove true. When it is too good to be true there must be a catch. The most common holding of VRP is a fixed-to-floating structure. The preferred share starts at a fixed rate, often at a reasonably high rate and then at a predetermined date switches to a floating rate tied to the 3 Month LIBOR. The floating rate ranges from LIBOR plus 0.67% with a 4% minimum to LIBOR plus 6.375%. A few of those interest rates would be great investments. The catch is twofold.
Premium to Issue Price
First, nearly all of the holdings of VRP are trading at a premium. To calculate the current yield, you need to divide the coupon by current share price. Five of the top ten holdings have a greater premium greater than 18%. Even with an adjusted coupon the yields are no longer high.
Yield to Worst
The second catch is the yield-to-worst. Issuing companies strategically pick a call date on or before the coupon adjusts to the floating rate. If the company is in good financial health and the floating rate is above market rate, the company will pay you face value for your investment. If you paid more than face value, the premium is lost. The yield to worst is 3.28%. I would not use the yield to worst to predict future performance. Included in that average are issues past their call date and Goldman Sachs Series D (GS-D), which is unlikely to get called. I included an expected return column defined as the lower of YTW and Current Yield. The trusts past their call dates use current yield. Though trusts have been called recently, I did not include a negative YTW to show that even with the high current yield of the trusts, the expected return of VRP is lower than the current yield. I expect VRP to return 4.24% before expenses.
Current Yield vs. Expected Return
The current yield of the top 10 holdings is 5.53%, while the yield of VPR is 5.00%. The difference is approximately the 0.5% expense ratio. An investor that has not analyzed the holdings of VRP would expect to get a 5.00% return. Based on my analysis, I expect a return of 4.24% less the 0.5% expense ratio or 3.74%. A return of 3.74% does not compensate an investor for the credit risk and lack of diversification of VRP. In a low interest rate environment, an investor cannot afford to pay a 0.5% expense ratio on an investment with an expected return of 4.24%. That's 11.8% of your expected return. The chart below from Invesco shows the lack of diversification that you are paying a 0.5% expense ratio for.
Lack of European Banks
I do like that within the financial holdings of VRP, there are no European Banks. I recently wrote an article examining the holdings of US Preferred stock ETF (NYSEARCA:PFF) and found that despite its name four of the top ten holdings were European banks with current yields above 7%. The additional risk is increasing PFF's current yield. The YTW of PFF is 3.67% compared to the expected return of 4.24% of VRP. I prefer VRP to PFF for this reason, though I wouldn't buy either.
If you would like to add a variable rate preferred, I would recommend you directly buy either GS-D or one of the fixed to floating with a call date in the mid 2020s. GS-D is trading at a discount to call price and is unlikely to ever get called making it a perpetual issue. The only scenario leading to a call is if interest rates drop so low that Goldman Sachs can issue a new series with a coupon below 4.0%. It has the highest expected return because it has the most interest rate risk. If 3 month LIBOR were to increase to 3% and the 10 year treasury to 5%, the GS coupon would still yield only 4% leading to a capital loss. With a current yield of 4.51%, no one would choose GS-D over a 5.0% ten year treasury.
I wrote an article about why I recommend C-K with a 4.26% expected return. The adjustment to a floating interest rate will pressure the company to call the issue. This reduces your interest rate risk because you will get your $25 face value regardless of the direction of interest rates. If LIBOR were 3%, C-K would yield 7.13%, significantly more than GS-D. In that scenario, C-K would likely get called away. Both investments are appropriate for different investors depending on whether your portfolio needs more yield or less interest rate risk.
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Disclosure: I am/we are long C-K.
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.