Specific features of preferred stocks that work well in periods of steady interest rates, such as a fixed dividend and a fixed redemption price, do not work as well in periods of increasing interest rates and rate of inflation.
Trump has stated that he wants to increase defense spending and investment in infrastructure while at the same time cutting taxes. Theoretically this will be offset by an increase in the GNP and productivity, decreased regulations and increased employment participation. At the same time he wants to impose tariffs on imports, which are essentially taxes on consumption. There are both macro and micro economic reasons why this won't work as stated and the rate of inflation will increase. The Fed rate will either lead or lag the increase in inflation, but the Fed rate will increase.
The Fed increased the interest rate once in each of the last two years for a total increase of 0.50%. At the December 2016 meeting, it stated its goal of increasing the rate three times in each of the next three years for an increase of 2.25%, which is pretty dramatic compared with the last five years.
Changes in the Fed rate lead to changes in other interest rates including T-bills, CDs, and savings accounts. This leads some investors to move funds into perceived safer investments as the interest rate spread decreases. This will lead to a decrease in the price of the stock as the demand for a specific stock decreases.
Traditional preferred stocks have non-binding call dates. If a company can arrange for cheaper financing, then it is likely that a preferred stock will be called. If cheaper financing cannot be found and the preferred stock funds are still necessary for the operation of the business, then the preferred stock will not be called and can exist and be on the books forever (perpetual).
So the market price of a preferred stock decreases as the inflation rate and interest rate rise. Neither the rate of the drop nor the increase in inflation and interest rate is known, but these increases will occur, and the price of a preferred stock will drop.
There are numerous authors on SA whom I respect that have written on this and have offered different approaches to preferred stock investing in the changing economic environment. These approaches include:
- Don't invest in traditional preferred stocks
- Invest in only those preferred stocks that have mandatory redemption dates or failure to redeem clauses
- Invest in floating rate preferred stocks
- Invest in baby bonds
This creates a dilemma for me. Currently about 25% of my portfolio is in preferreds, but they generate about 33% of my annual dividend income. And while I do hold some of the more exotic preferreds and baby bonds, there is a pretty small, undiversified universe to choose from.
So I spent a portion of the holidays analyzing the risk associated with my portfolio, and I came up with this matrix. I typically buy preferred stocks in blocks of 200 ($5000 +/-), so the numbers in a cell represent the number of blocks of stock ( 2 = 400 shares, 6 = 1200 shares, etc.) that I hold.
In theory the riskier investments would be those in the upper right hand corner: low interest rate but longer callable time. And Mr. Market tends to agree. In general, those stocks in the upper right hand corner have lower share prices than those in the left half, but quality issues do impact the price; some of the lowest prices are in the left half, and the highest current price is the one stock that is not callable until 2024, which is (NASDAQ:CHSCM), but this series always has high prices except when issued.
I didn't pay that much attention to the initial call date because the Fed rate has been so low for so long. To be honest, I have been mostly interested in the coupon rate, my entry price, and the quality of the underlying firm. However, what worked from 2009 to 2016 will not work going forward. Call dates will assume a new importance.
As I stated above, just because a preferred stock has a call date does not mean it will be called. I have one preferred stock that has a 2012 call date but is still paying a 8.45% dividend, but I also have a stock that was paying 6.7% and was called in December 2016. So the questions that I asked myself included how many preferred stocks are there with call dates prior to 2017 that have not been called, and how many of my stocks should I anticipate being called in 2017? The answer to these questions was surprisingly easy to find. The Dividend Yield Hunter website has a listing of preferred stocks arranged by call date and whether or not they have been called.
Note that this table only updates the current price when the market is open - at least that has been my experience. I can't say that I have completely sorted through this table. However, I can see that I have some preferreds in the upper right of my holdings table that I should sell and might want to replace them with other preferreds that have a 2017/2018 initial call date or maybe even that are currently callable. Honestly, I have a lot of questions about this table and how the data contained here can help to make informed decisions as we move into an era of an increasing Fed Rate.
However, I do know that my matrix of preferred stocks is not optimum, and it should probably look more like the following table.
Constraints that I would place in developing this proposed matrix include:
- Maintain or increase the total annual dividend
- Maintain or decrease the total number of preferred shares
- Give more consideration to baby bonds and non-traditional preferred stocks
- Rarely pay more than par value for shares
- Have a basic understanding of the underlying business and its business model
- Pay attention to the ratio of the common share dividend to the preferred dividend
- Maintain diversification relative to types of preferred stocks,call dates, and underlying business
- See what other SA contributors think of a specific stock
Disclosure: I am/we are long AMH-D, COF-D, BANC-E, CHSCM, DLR-F,-I, DFT-C, PSA-Y, SSW-G,-E,-D, NGLS-A, NS-A, TNP-D, FRC-A, PEB-C, O-F, HCH-J, TOO-A, WFC-T, AHT-D, ARI-A, CORR-A, CIO-A.
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.