A 6.9% Yield That Rises With Rates

| About: Morgan Stanley (MS)
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The new trend for preferred securities has been regarding floating rate extensions. This basically means that if companies do not call their preferreds, the interest rate changes from fixed to floating. Usually the floating is based on a spread over three-month LIBOR.

This has been happening as there is a serious concern over when rates are going to rise, especially considering a new change in management at the Fed. Regardless of where rates go next year, investors should take caution. The market recognizes this risk and therefore companies have to make their offerings more appealing. If fixed rates were offered at a low rate, there is a good chance the demand for such a security wouldn't be that high. However, when throwing in a floating rate option, this makes it more desirable as it protects risk.

Now the issue, as I mentioned before, is regarding the timeframe for floating options. In many cases, you have to wait nearly a decade or more until the call date. This means if rates rise next year, investors are still on the fixed rate. So investors need to be comfortable with the existing fixed rate until the call.

Recently, Morgan Stanley (NYSE:MS) issued its series F preferred, which has a yield on par of 6.875%. The yield at the current price is 6.9%. Morgan Stanley issued nearly $850 million worth of preferreds with a call date of 1/15/2024. So the call is nearly a decade out. If rates rise, investors will have to be happy at a 6.9% yield until the call date. If you are not the person that can buy and hold for such a long period, this might not be the right investment for you.

So what happens if Morgan Stanley decides not to call this preferred in 2024?

Well at that point it switches to a floating rate. The rate will be floating at 3-month LIBOR + 394 bps. So if we assume LIBOR rises to 5% in 2024, the total yield would be 8.94%.

Another point I would like to make is that Morgan Stanley is one of the largest financial institutions in the world. In each of the last three quarters, the company reported a net income greater than $900 million. S&P has rated this security at BB+, which makes it just one notch below investment grade.

I believe Morgan Stanley's series F preferred is a good investment for those that have some liquidity to spare. The other nice part about this is that it's trading slightly under par. There is a possibility it could jump back over in the coming weeks if investor demand picks up.

The dividends from this preferred are qualified and fall under preferential tax treatment. So the tax rate is between 15%-20% on the distributions. Investors should speak with a tax professional if you need more information regarding this.

Remember, that rates are likely to rise before the call date. So investors may have to endure a decline in principal until the rate starts to float. This investment is really only for those that are willing to be patient.

Note: The preferred has various different names depending on brokers. Some examples are MS-F, MS-PF, MS PRF, etc. Please check with your brokers 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.

Additional disclosure: I plan to take a position in MS series F preferred.