Being very conservative investors we are always on the hunt for investments that give us the best shot at getting a full return of our capital while also paying us a reasonably fair return for the risk we are taking. As all income investors know getting an income that is worthwhile, while interest rates continue to tumble, can be one heck of a challenge.
We all know there are over 200 REITs to choose from as well as more than 100 Master Limited Partnerships that pay very tasty dividends (or distributions if it is a MLP). We also know that you are taking a sizable risk with your capital by owning these particular income instruments (as holders of upstream MLPs can attest to). Yes, we know, over the long term whether it be common stocks, REITs or MLPs all will likely eventually work out. The problem with a 'long term' point of view is that if I am 65 or 70 years old the desire to have a safe income while preserving capital is exceedingly strong. So where can one turn to find the golden ticket?
Just this week I wrote an article about 'baby bonds' which presents one potential way of minimizing volatility while preserving capital. In this article we are taking a look at 'Term' preferred stocks (also known as mandatory redeemable preferreds), which are another potential way to reduce risk and volatility while still being 'paid' a tolerable income. Anyone who has read our articles over the years, whether it be on Seeking Alpha or on our Yield Hunter website, knows that we hold these income issues in high regard for reasons we will touch on below.
The number of issues that fit the 'Term Preferred' category is fairly limited-totaling just 12 issues (and of the 12 we personally own shares in 6 of these issues). While this isn't a huge number of available issues it is adequate enough for the conservative income investor to choose a few that meet their needs within a larger diversified portfolio.
|Security Description||Ticker||Issue /Call Price||Current Price||Current Yield||Earliest Redemption Date||Mandatory Redemption Date|
|Gladstone Capital Corp 6.75%||GLADO||$25||$25.36||6.65%||6/30/2017||6/30/2021|
|Gladstone Commercial Corp 7.125%||GOODN||$25||$25.67||6.94%||1/31/2016||1/31/2017|
|Gladstone Investment Corp 7.125%||GAINP||$25||$25.72||6.93%||2/28/2016||2/28/2017|
|Gladstone Investment Corp 6.75%||GAINO||$25||$25.40||6.64%||12/31/2017||12/31/2021|
|Kayne Anderson MLP 4.25%||KYN-E||$25||$25.40||4.18%||Anytime||4/1/2019|
|Kayne Anderson MLP 4.60%||KYN-G||$25||$25.56||4.50%||Anytime||10/1/2021|
|Kayne Anderson MLP 3.50%||KYN-F||$25||$25.36||3.45%||Anytime||4/15/2020|
|Oxford Lane Capital Corp 8.5%||OXLCP||$25||$25.73||8.26%||12/31/2014||12/31/2017|
|Oxford Lane Capital Corp 7.5%||OXLCO||$25||$24.87||7.54%||6/30/2016||6/30/2023|
|Oxford Lane Capital Corp 8.125%||OXLCN||$25||$25.05||8.11%||6/30/2017||6/30/2024|
|Tortoise Energy Infrastructure 4.37%||TYG-B||$10||$10.04||4.35%||Anytime||12/31/2027|
|Tortoise Energy Capital 3.95%||TYG-C||$10||$10.09||3.91%||Anytime||5/1/2018|
The shares above from Tortoise and Kayne Anderson are rated 'AA' by Fitch (they are not S&P or Moody's rated). The debt of these 2 closed end fund companies is rated 'AAA'. The Tortoise and Kayne Anderson shares are truly high investment grade. The shares issued by the various Gladstone companies as well as Oxford Lane are not rated by any of the rating companies.
11 of the 12 issues above have a number of items in common.
- Like almost all preferreds they have an early optional redemption period
- Dividends are cumulative
- Each of these issues pays a monthly dividend
- Each of these issues is redeemable within the next 12 years
- Each of these issues is issued by a CEF
- Each issue is restricted in borrowing and preferred stock issuance by the Investment Company Act of 1940--they must maintain asset coverage of 200%
The 1 issue that is not an issue of a closed end fund is Gladstone Commercial, which is a REIT. This means that they are not covered by the leverage rule--beyond that the issue is near identical.
Each of these attributes are items that are desired by income investors. Cumulative dividends are desired in the remote chance that dividends are suspended. Monthly dividends are always nice--they smooth income flows and in our mind 'a bird in hand is worth 2 in the bush', but actually increase your yield slightly when compared to a quarterly paying issue. And to reduce volatility a relatively short duration is much preferred to a perpetual preferred.
Additionally, and we have written about this many times, all preferreds of CEFs are covered by a rule that mandates they must have a 200% asset coverage ratio. This is an added level of safety and is discussed at length in a previous article we wrote on Seeking Alpha. Additionally, in this previous article, we outlined the steps that the Gabelli Funds had to take during the financial crisis to alleviate a potential '1940 Act' violation.
By studying the chart above one can see that a number of these issues are redeemable 'anytime'. While this introduces a little uncertainty into the buy decision, Tortoise Energy Infrastructure (NYSE:TYG), Tortoise Energy Capital and Kayne Anderson MLP (NYSE:KYN) all offer a premium of 1/2 to 1% over par (plus accrued dividends) upon early redemption. This premium phases out 2 years after issuance. This also means that one shouldn't pay more than Par plus accrued dividends if purchasing shares.
Digging further into the above 12 issues a potential buyer should be aware of other special provisions that these 'term' issues have outlined in their offering documents for these shares.
The Tortoise shares as well as the Kayne Anderson shares carry a penalty rate that is to be applied if at anytime their credit rating falls below a full 'A'. That rate ranges from .75% to 4% depending upon the level of the credit rating. Additionally, for the 11 issues that are bound to the leverage rules of the Investment Act of 1940, if they fall below the asset coverage ratio for 5 days they have 30 days to cure the defect or the preferred shares will have to be redeemed. As a practical matter this is unlikely to occur as closed end funds move to raise funds with equity offerings if they are anywhere near an asset coverage ratio fault. Additionally each issue carries the more typical 'change of control' provisions.
As you can see from the disclosures we own 6 of the 12 available issues and as such have watched these issues closely for many years. During the time we have watched these issues they have for the most part been extremely stable, but like all interest rate sensitive investments interest rate movements can (and will) drive prices lower or higher. After the 'taper tantrum' in 2013 shares in Tortoise Energy Infrastructure 4.37% term preferreds (ticker:TYG-B) plunged giving income investors a great point in which to pick up shares 'on sale'. We wrote an article on Seeking Alpha at that time pointing out the exceptional yield available on a AA rated issue. That article is here. Additionally we pounded the table so to speak on our Yield Hunter website on this issue (it was trading at $8.32/share at that time). The shares now trade right around $10.
Now we don't want to convey to income investors that these are the perfect investment for everyone, but if you understand the various parts and pieces you will know what to expect. Like all preferred stocks an investor must pay attention to the start of the optional redemption period and when near redemption you should not pay more than par plus accrued dividends. You must accept that interest rate movements higher will hurt the share price by an amount that will be determined by the distance from the mandatory redemption date. Conversely, you must accept that if interest rates dive lower and lower (how low will they go?) that share prices will not rise by much, if any, in particular if they are near redemption. Lastly, a potential buyer must be patient. These shares, like the 'baby bonds' we wrote about last week, do not have huge amounts of liquidity. It may take 2-3 days to execute the trade you want. On the other hand for any issue that you are going to salt away for a number of years we think that it is 'penny wise and pound foolish' to quibble over 5 or 10 cents when placing an order. If it is not worth an extra dime it must not be worth owning.
A word about the companies issuing these preferred shares is in order. Tortoise Capital Advisors was founded in 2002 and operates 5 closed end funds (CEFs) as well as 3 mutual funds. This company is top notch in every way and we have no qualms about owning their preferred shares. Kayne Anderson Capital was founded in 1984 and they operate 4 closed end funds as well as many other private equity businesses. Like Tortoise we sleep very well at night with Kayne Anderson preferreds. Gladstone Management operates 2 closed end funds (as BDCs) and 2 REITs. We have no problem owning preferred shares of the BDC companies as they are covered by the leverage rules, but certainly none of the Gladstone companies approaches the quality of the Tortoise and Kayne Anderson companies. Oxford Lane Capital is a closed end fund and specialty finance company. Oxford makes loans to below investment rated companies. While Oxford's financials have been ok the last 5 years we would not own the preferreds of this company if we thought we were heading into a recession. Even though we currently own 1 issue and it is covered by the leverage rules we would sell if economic data started to weaken significantly.
In summary a conservative investor can construct a portfolio which includes 'term preferreds' which pay a reasonable return. Additionally they can likely reduce volatility and have a date certain for return of capital.
Disclosure: The author is long TYG-B, TYG-C, GAINO, KYN-E, KYN-G, OXLCN. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.