Conventional wisdom and practically every analyst confirms that in a rising interest rate environment, it is dangerous to buy bonds/preferred stock. I get it. The fed funds rate remains near historical lows (1.5-1.75%) and the market is pricing in at least two additional 25 basis point jumps this year. That would take the fed funds rate to 2.25%. The contrarians are the ones who predict another 25 points on top of that, not those who expect rates to remain subdued.
For perspective, the predicted 2.25% rate would still be 3% less than the pre-recession rate of 5.25%.
Is it any wonder then why the market performed so remarkably since bottoming in 2009? The trifecta of fiscal stimulus along with quantitative easing and practically "free" paper allowed companies to rebound with a vengeance from the financial crisis pushing valuations far passed fair into overvalued territory.
And then, as the market stretched its legs and then roared after President Trump’s election, Congress passed the cherry on top with the Tax Cuts and Jobs Act of 2017 lowering taxes on both consumers and corporations, providing even more ammunition for a market that was fully loaded.
Bullish? Try again. This is as good as it gets folks. And it helps explain the parabolic chart where we find ourselves today.
Skeptics like me take one glance at that chart and gulp. Retail investors and institutions alike chasing this epic rally for FOMO may be in for a bit of pain looking ahead. The minor 10% correction sustained in February could serve as a prelude for what’s to come.
For income investors, that day of reckoning has already arrived, with perennial favorites like Altria (NYSE:MO), Procter & Gamble (NYSE:PG), Dominion Energy (NYSE:D), and AT&T (NYSE:T) all near bear market territory. Below is an income-oriented (equity) sector-by-sector depiction of what yield chasers have endured the past year:
REITs, Utilities, Telecom, Consumer Staples
Suffice to say, investors seeking yield have seen share prices retreat as borrowing costs move higher. Investors dump riskier securities in favor of safer alternatives, meaning yield-focused equities and fixed income have sold off considerably. Opportunity lies therein.
Preservation of Capital
In the backdrop of this dichotomous market - where indexes remain overvalued partially due to the weight of large companies like FANG, while entire sectors like those listed above continue to struggle to find their footing - I have read many anxious comments fretting over the preservation of capital.
And boy, is that warranted.
Whether you were one of the unlucky few to purchase Realty Income (NYSE:O) in the $70s or you take a glance at general market valuations today with a healthy dose of apprehension as I do, none of us want to encounter unrealized losses if we can avoid it.
This is why, ironically, fixed income is becoming more and more compelling as interest rates rise.
When yields rise, bond prices go down. It’s a pretty simple formula. Fortunately for those of us who have not been chasing this raging bull, we have cash on hand to take advantage of this selloff. And it is my belief that even though you will not get the upside of dividend growth like you would with common stock, you will gain a layer of protection by purchasing a higher yield under par.
Let me provide an example of a preferred stock issuance I own from Summit Hotel Properties (NYSE:INN) with a coupon of 6.25% to demonstrate my point.
As you can see, there are some unrealized losses for those who purchased above or near par as the E-series has fallen to nearly $23.00, pushing the yield to 6.7%. But does that mean that the company is in danger of not being able to pay its preferred dividend?
Well, no, it doesn’t. This preferred stock is getting dumped because it was issued at a time of lower interest rates. Investors are trying to secure a higher coupon to swap their shares of this for something higher. Let’s take a look at some of the facts about this issuance:
You can see the coupon rate along with its annual dividend in the second column. The liquidation or call price is in the third column and the call and maturity date in the fourth. It is currently unrated, so investors must do their own due diligence to determine if this is investable.
The way that I do that is by reviewing the financials within company presentations. Many of the pertinent details are found on slide 20 in the latest investor presentation:
The interest coverage ratio is robust and the payout ratio for the common dividend is only 50%. Remember, the preferred must be paid before the common, so ensuring a safe common dividend is important to me. Next, I look at the cost of capital and average interest rate to ensure it is not unusually elevated. Below 4% as depicted above is cheap money in this particular instance.
Next, I look to see if the yield on the common stock looks unusually high. A company like CBL & Associates (NYSE:CBL) has a yield of nearly 21% on the common. This is a red flag to me, and I would not purchase either the common or preferred because it is just too risky for my taste. The yield on the common of Summit Properties is below 5%, which immediately tells me that the market is not pricing the common at any risk of a cut. If the common is very secure, it’s a safe bet that you can sleep well at night with the preferred.
Why Not Just Buy the Common?
Why shouldn’t investors just buy the common stock and be done with it? Well, for one, the yield is nearly 2% lower. Second, you have a bit more protection of your capital than you do as the preferred is ranked higher in the capital structure in times of duress. Third, investors may like the fact that although they could see unrealized losses, if purchased below par their shares cannot be called at anything less than par ($25). Shares bought at $23, therefore, have nearly 9% upside in event of a call. And you get to collect nearly 7% each year until then. This issuance is also cumulative, which means in the event of elimination of the common and preferred stock, preferred stockholders will receive missed payments upon the restoration of the common dividend.
Dividend growth investors would likely prefer the common stock, but for those who want an additional layer of capital protection and the immediate juice of yield, the preferred is a great option.
Another feature I enjoy about investing in preferreds is this: As common stock share prices decline, the chances for consolidation via mergers and acquisitions heighten. We have already seen this in the hotel space as Pebblebrook Hotel acquired LaSalle Hotel. For common stock investors this can be bad news if the share price declined for years; they may find themselves underwater in the event of a buyout (even after the buyout premium).
That is not typically the case for preferred investors. If purchased under par (a prerequisite for me), the purchasing company may have the option to call the issuance early based on the prospectus, but they can only do so at par value. Therefore, there is a built-in-layer of protection of capital for preferred investors that common shareholders do not have. And from what I’m reading, that is refreshing news for many retirees.
As interest rates rise and bonds and preferred stocks selloff, that is the time to find buying opportunities. I am refuting the consensus opinion. It’s the old: Be greedy when others are fearful adage. I am not prescient enough to know how high and how fast rates will rise but the Fed has reiterated the importance of telegraphing their plan which really helps us anticipate what may occur in the next couple of years.
I also know that inflation is being kept in check due to the Amazon effect and the fact that consumer staples producers are having a very difficult time raising prices. And while demand for oil remains strong and price per barrel rise, the United States is pumping more than ever and has an administration keen on continuing down that path which will hopefully keep prices contained.
Runaway inflation is always a threat, but even if that manifests (with corporate and governmental debt as high as it is that would be unlikely in my estimation), that is the time to buy, not the time to sell. With equity markets still overvalued there is even a chance for an inverse relationship where equity prices fall and preferred stock and bonds rise as investors seek safety. Although recently that has not been the case as they have traded in tandem.
I am pacing myself judiciously as the Fed attempts to normalize interest rates, but I am unafraid to lock in 7% yields long-term. I also feel less exposed as I would purchasing common stocks by ensuring greater capital protection. It is never wise to rush in and buy on the first dip, but bond and preferred investors should keep their eyes peeled for further discounts.
Disclosure: I am/we are long O, D, MO, INN, T.
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.