Investors have been taught that markets are efficient places and assets are priced efficiently. This may be true when markets are permitted to function properly. However, the efficiency of markets is diminished when technical factors, such as wars, natural disasters or monetary policies enter the equation. Fed policy is driving much capital out of its usual places in the capital markets and is pushing it into more risky areas, such as the long end of the curve, into lower-rated bonds, or both. Investors have convinced themselves, or have been convinced by wholesalers and marketers that this is the "new normal" and junk bonds do not have the same risk they had in the past. If this does not sound like a bubble, we do not know what does.
Last week, we had an impromptu conversation with a friend who happens to be an institutional high yield bond trader with more than 25 years of trading experience. He told us that investors are loaded with cash and money keeps pouring in. When we expressed our concern that a bubble may be forming in the high yield bond market, he responded that high yield is going to have a rout when interest rates normalize.
It will probably be a few more years until rates normalize and when they do, they will probably remain fairly low from an historical perspective. However, when that happens, it is going to get ugly for high yield.
We have received some polite criticism over our view that long-term rates may not rise very high, historically speaking. Some readers believe that rates will spike much higher in a few years. Ironically, many of those who are concerned that rates will be much higher, tend to be buyers of high yield debt. If you are buying high yield debt with maturities much longer than five years, you had better pray that our views are proved correct.
Think Before You Ask
The same people, who fear rising rates, are the ones actively looking for preferreds trading at a discount. Folks, if the 10-year note broaches 3.00%, some of these preferreds trading at or near par today could be trading at $20 in a few years. As for the probabilities that newly-issued preferreds are called in five years, we wish we had the capital to take the other side of that bet on a grand scale. We will probably have grandchildren trading or investing in preferreds which have been issued during 2012.
Preferreds are long-dated (or perpetual) callable securities. Because they are callable, they are what we call negatively-convexed. This means that they have a greater potential for price decreases when rates rise than they have potential for price increases when rates fall. This is due to their call features. The par call limits how far prices can rise. If they rise too much, the result could be a negative yield to call. As the call date draws closer, the price required to generate a negative return drops. However, when rates rise, the call falls out of the money and prices of preferreds can fall precipitously. They can fall and fall and fall.
Let's use the newly-issued Stanley Black and Decker TRUPS 5.75% with a final maturity of 7/25/52 (symbol: SWJ):
The closing price of SWJ on Friday 8/3/12 was 25.74. This results in the following yields:
- Current Yield (Annual Dividend 1.4375 ) 5.585
- Strip Yield (Strip Price = 25.708056) 5.592
- Yield to Next Call 7/25/2017 @REDM 25. 5.119
- Yield to Worst Call 7/25/2017 @REDM 25. 5.119
- Yield to Custom 7/25/2017 @REDM 25.000 5.119
The market is pricing SWJ as if it will probably be called in 2017. However, if the 10-year is at 3.00% and 30-year is at 4.00%, Stanley will probably not call in SWJ. Why, because in that environment, there is a good chance that Stanley would have to pay around 6.50% (+250 bps to 10s and +350 bps to 30s) for similar financing. Just as you would not refinance a 5.75% loan at 6.50%, neither will Stanley.
When we run a 6.50% yield for a settlement date of 7/25/17, we get a price of 22.115. If rates are higher, the price only gets worse. Pricing could be helped by credit spread narrowing. However, if investors can obtain desired yield in investment grade bonds (which are far senior to Trups), credit spreads could widen. If it looks as though rates will continue rising, credit spreads will probably widen as investors wish to be compensated for taking on more duration risk.
If we run the scenario to reflect 300 basis points over a 4.00% 10-year Treasury note, five years from now, and the price works out to be, 20.536. Investors often say that they only care about the income. They usually forget that when new preferreds are being issued at 7.00% and their preferreds are trading at $20.00