Two 7%+ Yields That Will Rise With Rates

Includes: C, MS
by: Kraken

It's unclear what the Fed's exact strategy is going forward. The markets were expecting a rise in rates when Bernanke mentioned tapering could be right around the corner. However, it seems like that is no longer the direction they are going least not for awhile. This reversal from their initial plan means that rates are going to stay low for awhile.

As a fixed-income investor, it was good to see the initial tapering announcement happen. Before tapering was announced, preferreds and other fixed-income instruments were trading well above their par value. The market became too aggressive by chasing yield. The announcement set reality into the market, which is why several of these securities fell.

Even though rates are not likely to rise for awhile, they will eventually have to rise. I believe there are some great investments out there that will allow you to grab a strong yield, while hedging against a future rise in rates.

While banks may concern investors due to regulatory concerns and pending lawsuits, they are still strong cash flow producing companies. I found two new bank preferreds, which I believe to be good investments for income investors.

Last month, Morgan Stanley (NYSE:MS) and Citigroup (NYSE:C) each issued a 7.125% preferred. Both have an attractive yield and the added plus is that after 2023, the yields become floating over LIBOR. While 2023 is very far out, we need to understand that it has become clear that the Fed does not plan on raising rates soon. However, I do believe a rise in rates coming well before 2023. So there is likely to be an extended period of time where the preferreds could fall until they switch to floating.

The floating spreads for both preferreds are over three-month LIBOR. MS has a spread of 432 bps and C is 404 bps. So when three-month LIBOR eventually rises, the long-term holders of these securities will eventually see the yield rise without a fall in the principal value.

That is why it is important to point out that these investments are for longer-term and if your goal is to grab income for the short-term, these securities may not be right for you.

Investors should also look at these bank's ability to pay the preferred dividends each quarter. Morgan Stanley's Series E preferred will have a total dividend payment of $53.43 million each year. Considering that the bank had a total FCF of more than $23 billion in 2012, it's safe to say it can easily cover this obligation.

Citigroup's series J will have to pay investors $64.1 million each year. In 2012, the company had more than $18 billion in FCF. So coverage is pretty good here as well.

Remember that while bank stocks can be volatile, this doesn't affect the value of the preferreds. The value of preferreds will only fall if the market believes there is payment risk by these institutions. Given that both companies produce strong cash flow, I just don't see this happening.

Now there are a couple points I would like to address regarding these preferreds. One is that both are trading around 2% above par value. I am never a fan of buying above par due to call risks. However, given that the call date isn't until 2023 for both preferreds, the risk is very minimal.

The other risk is that both are non-cumulative preferreds. What does this mean?

It means that Citigroup and Morgan Stanley could stop payment on both preferreds and have no obligation to pay back investors. Now this might seem pretty bad, but keep in mind that if this were to happen, it would destroy the credibility of both companies. The financial industry is very fragile and is based on reputation. The only way a bank would ever considering stopping payments on its preferreds would be in another financial crisis, where multiple large financial institutions would fail. As I mentioned earlier, both companies are producing a strong amount of cash flow, so this is not likely to happen.

These two preferreds are great for long-term income investors. It allows you to grab a 7%+ yield, while hedging against a future rise in rates.

Note: Brokers list each securities differently. Some examples are MS-E, MS-PE, MS PRE, CS-J, CS-PJ, CS PRJ, etc. Please check with your broker regarding this.

Disclosure: I 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.

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