I have always been fascinated by how deeply intertwined the political and economic systems are. Sometimes political decisions could completely transform the economic landscape of a country much in the way South Korea was transformed in the second half of the twentieth century. In other occasions, economic reality puts its mark on the political system and a good example for that is Germany in the years of the Great Depression which led to the ascent of the ultra-right and ultimately to the Second World War.
Recently, too much has been happening on the political arena for any prudent trader to easily ignore. With Brexit over the summer and with the election of Trump as the next US president in early November, all market participants have been scrambling to understand what those events mean for the economic system going forward.
Most of you who read my articles regularly probably know that my focus is mostly on the fixed income space, and for me, the election of Trump as president has had serious implications. With the fiscal policy that Trump is likely to start putting into place after his inauguration, we might finally see the end of the ultra-low-interest-rate era.
The Treasury yield curve has already started moving up to reflect the rising expectations of market participants with the 10-year rate increasing more than 50bp since the beginning of November. It is no surprise that after the announcement of the election results, fixed income products have sold off and investors have moved into other assets to seek higher returns.
Does that mean we should start completely ignoring the fixed income asset class? Of course not. There are always opportunities there that are worth considering. The financial market is a big and diverse place and there are people with a wide variety of risk appetites and financial targets that could be satisfied by the selection of the right fixed income product. Today I want to talk to you about one such product.
The product in question is a note issued by OM Asset Management (NYSE:OMAM) with a maturity in 2031 and a nominal yield of 5.125% (NYSE: OMAA). OMAA is currently yielding 5.77% and you can find more relevant information regarding it in the table below.
Source: Author's spreadsheet
Perhaps the best way to analyze OMAA, however, is in context, so I want to briefly compare it to another instrument from my tradable universe - PSA-D (Public Storage (NYSE:PSA) Series D Cumulative Preferred Stock). You can find more details about PSA-D in the table below.
Source: Author's spreadsheet
I know some of you might say that I am comparing apples to oranges here, but hear me out, please. Both instruments have similar current yields and current income for both is treated the same for tax purposes as Public Storage, the issuer of PSA-D, is a REIT company and thus the dividend on its preferred stocks is not qualified to be taxed at a lower tax rate. In that respect, cash flows from both instruments are perfect substitutes from the perspective of the end investor.
Of course, credit quality plays a role in the comparison as PSA-D has a two-notch advantage compared to OMAA. Also, OMAA theoretically has a higher seniority when compared to PSA-D, although that is less of an issue here as Public Storage uses exclusively preferred stocks as a source of outside financing.
With that being said, let's see how sensitive those two securities are when it comes to interest rate risk, which has increased its relevance after the election of Donald Trump as president. First of all, OMAA has a higher nominal yield than PSA-D, which makes it less susceptible to interest rate increases, but, more importantly, OMAA has a defined maturity date in 2031. PSA-D, on the other hand, is a perpetual preferred stock.
It is true that the security is callable after 2021, but the likelihood of it being called is quite low in a rising interest rate environment. That might happen if Public Storage is able to get a better rating for a potential new issue, but basing an investment decision on such an uncertain event, I think, is unreasonable. Let's also not forget that OMAA has an embedded call option, which becomes exercisable in 2019.
So if you believe that by 2021 the interest rate environment could make it reasonable for Public Storage to call PSA-D, then it would be reasonable to expect that OM Asset Management could also consider refinancing its OMAA notes. Then the maturity date of both instruments would be virtually the same, and again, OMAA would be the one with less exposure to interest rate risk due to its higher nominal yield.
If you believe that we are entering into times when interest rates are likely to be moving higher, then it might be a good idea to start looking for fixed income products with lower duration. Preferred stocks become less and less appealing as an investment option, especially if they were issued in recent years when interest rates were extremely low. Even if these preferred stocks have a call option, the probability of that call option being exercised is low. That makes preferred stocks instruments with a long duration that could be exposed to more capital losses if interest rates start to crawl up.
If you are a long-term investor who plans to hold fixed income products until their maturity, it is a good idea to consider OMAA as an investment. If you are a trader looking for a pair trade to take advantage of rising interest rates, you can also consider OMAA as the long leg of that trade.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in OMAA over 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.