Misconceptions And The Preferred Investor: Preferred Safety Turned Upside Down In Today's Market

by: Norman Roberts

Summary

The preferred market might soon be turned upside down.

I attribute this to the impending interest rates that are poised to continue.

How it will affect your existing and future preferred portfolio is worthy of discussion.

Unlike past articles concerning preferreds and risk, this article will be submitted more as a question than a firm statement of my belief that the circumstances surrounding and those directly concerning the preferred market at present might have turned what we consider safe and unsafe upside down.

Historically and at present, the preferreds of what are considered safer companies, those that are actually rated, are considered far safer than the preferreds I usually invest in. Consequently, those considered a safer company usually are able to offer their preferreds at coupon rates (the interest they will pay the shareholders) of, say, 6% or less (I chose this number arbitrarily because for some it might be considered a high rate of interest; for others like myself, it's considered low.)

Consequently, preferreds considered riskier usually offer coupon rates above 8%, and the really risky companies, due to their small market cap, D/E ratio, business model or a host of other parameters, are required to issue their preferreds at coupon rates greater than 9%. Like the mortgage you hope to finance your house with, the worse your credit rating, the higher the interest you will be charged for your loan.

Although the above still holds true, there's another wrinkle that's worth considering: today's expanding economy and the possibility of additional Fed Fund rate increases, both long and short term. To me, this means higher interest rates that will result in the yields you receive on your current preferred holdings being squeezed in direct proportion to the interest rate increases. Therefore, it is my belief that the safer preferreds that were initially offered at low coupon rates will be squeezed much harder percentage-wise than those riskier preferreds that had to be issued at higher coupon rates.

For example, a preferred with a coupon rate of 5% will suffer a far greater relative hit by a 2% interest rate rise than a preferred whose initial coupon rate was issued at 8%. Yes, both will lose 2% in value, but the loss as a percentage of the return will be far greater and impactful for the 5% preferred than for the 8% preferred.

Furthermore, this will also eventually make it necessary for companies which issue new preferreds to have to issue them at correspondingly higher coupon rates as the interest rates continue to rise. This will further reduce the value of the existing preferreds of those companies you now hold. Hardest hit will be the existing company preferreds that were issued at the lower coupon rates - therefore, the now less attractive rates of interest.

Consequently, the preferred world might be turned upside down as a result. This I want to throw open for discussion to either talk me down or convince me that I just might be correct.

Disclosure: I/we 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.