Term-Preferred Stocks To Save You From Interest Rate Risk

| About: Gladstone Investment (GAIN)
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Summary

With rising rates, priorities shift from yield to duration.

Term preferred stocks are an instrument worthy of your time.

Better be in preferred stocks like GAINO, not like GAINN.

It is always good to have a maturity date.

Last couple of years were unprecedented in human history with the ultra low interest rates that were dominating the markets. We even lived to see some rates move into negative territory - something many economists thought to be impossible. And in that environment, people went crazy hunting for yield. Even this year we saw a huge influx of capital into emerging market debt which soared in the second half of the year.

We started to get complacent, however, we started thinking too much about yield and not worry about interest rate risk, thinking that the latter belongs to the past. But things are about to change. With the shift away from monetary policy and towards fiscal policy, inflation is back in the picture, at least in the United States. And markets were quick to react with Treasuries' yields jumping significantly in the second half of November. Suddenly people start to worry about duration again and also about steepening of the yield curve. Money are moving away from fixed income and emerging markets and are rushing into equities. Does this mean that we should abandon fixed income as a class altogether? Maybe some people think so, but there are always smart money looking for opportunities. And we want to be on the side of smart money.

Term Preferred Stocks

Since a lot of people are becoming more and more worried about duration and some have voiced their concerns over the traditionally long duration of preferred stocks, I thought it might be beneficial to spend some time talking about a subsection of the preferred stocks universe. I am talking about term preferred stocks. Unlike their plain vanilla brethren, the term preferreds have a predetermined maturity date. In other respects they are pretty much like other preferred securities. The presence of a maturity date actually makes these preferred stocks more akin to bonds. Below you can find a curated list of term preferred stocks that mature before 2030.

Source: Author's spreadsheet

If you are looking for opportunities in fixed income and are worried about interest rates, it is worth considering some of the names in the list above. Some of the issues offer a nice combination of high nominal yields and a shorter maturity, which is nice to have if you are worried about rising interest rates. As interest rate start to get more often on the news, we are also likely to see a pick-up in volatility, especially at the short end of the curve where it has traditionally been higher. The overall effect of volatility, however, could be mitigated to some extent if you are planning to hold to maturity.

Another feature almost all of the term preferred securities in the list above share is the embedded call option. As the interest rate volatility increases, the value of the call options also increases. The higher value for the option makes these securities more likely to be called, which lowers their effective duration. Which is one more point in favor of the bunch, if you look for less exposure to interest risk.

Many of you probably think why go into term preferred stocks and not in bonds? After all these instruments are quite similar. First, the call option - you are much more likely to find preferred stocks with call options than bonds with the same option (the call option is actually very common among baby bonds, which I will cover in detail in another article). And the call option can actually play in your favor, as I mentioned before. Second - higher yields. Since preferred stocks rank lower than bonds in the capital structure, they usually bear higher nominal interest rates to compensate for the higher credit risk. The higher interest rate, however, has the effect of lowering their duration, which makes them a better instrument in a rising interest rate environment, if credit risk is somewhat subdued of course.

What to trade?

I myself prefer to look at shorter maturities and higher coupons when I am looking for opportunities to trade. I also look for relative value, which makes me more grounded when deciding what to buy and what to sell.

Just a couple of months back I heard this news about a conditional exchange offer when I was doing my morning read and I have been tracking Gladstone Investment Corp. (NYSE: GAIN) ever since. The company issued a new series of term preferred securities (GAINM 6.25% Series D Cumulative Preferred Stock) in order to refinance its existing debt part of which in the form of 7.125% Series A Cumulative Preferred Stock (NASDAQ: GAINP). The company has two other securities, 6.75% Series B Cumulative Preferred Stock (NASDAQ: GAINO) and 6.50% Series C Cumulative Preferred Stock (NASDAQ: GAINN), which I find quite interesting when compared to one another. You can find some metrics about the two in the table below:

Source: Author's spreadsheet

GAINO is callable, while GAINN is not. Given that the fresh new issue GAINM bears an yield of 6.50% over the 7-year part of the curve, it is almost certain that the cost of debt of GAIN over the 5-year part, where GAINO currently is, is lower. That makes GAINO a good candidate to be called at its call date in 2017. So, I am making the case that the relevant yield for the issue is the yield to call of 5.31%.

Now let's assume that you consider either buying GAINO, which is likely to be called in 2017 with you realizing a yield to call of 5.31% or buying GAINN and holding it to maturity, realizing an yield to maturity of 6.15%. Do you think that a spread of 0.84% compensates you for holding GAINN for 5 more years? I don't think so. Just look at the Treasury curve - the difference between the 1-year and 6-year rates in close to 1.2%. And that does not reflect the fact that probability of default for GAIN increases over a longer period of time. Moreover, if any of the positions has to be unwound prior to maturity, the long position in GAINN will suffer more losses in a rising interest rate environment, especially if the yield curve steepens as well. Overall, I see GAINO as the better alternative in this case.

Articles to come: A closer look at ECC and GAIN income securities, A look at baby bonds in general.

Author's note: While you are hedging interest rate risk, do not forget that credit risk also exists.

Conclusion:

Term preferred stocks are worth considering as an instrument if you are looking for fixed income securities with lower duration. There are opportunities for relative value plays that are worth your time and money, you just have to be selective in your positioning.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in GAINO 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.