3 Safe Income Picks Yielding 8%+ With Improving Fundamentals

Summary

• I present three fixed income securities that have declined in the past year despite improving fundamentals.
• These securities offer well covered yields between 8-9.3% and potential upside in price, with options for both 1099 and K-1 tax treatment.
• With Fed Chairman Powell now seeing current interest rate levels "just below" neutral, a major headwind for all fixed income might be ending in 2019.

1. Hersha Hospitality Trust

6.50% Cumulative Preferred Shares Series E (NYSE:HT.PE)

Current Price: 20.12

Current Yield: 8.07%

Callable: 11/7/2021

Tax Treatment: 1099

Hersha Hospitality Trust (NYSE:HT) is a real estate investment trust which owns and operates high quality upscale hotels in urban gateway markets and coastal destinations. The Company's 49 hotels totaling 7,730 rooms are located in New York, Washington, DC, Boston, Philadelphia, South Florida and select markets on the West Coast.

In 2018, Hersha had a transformative year, spending $80 million in CapEx to renovate and upgrade two hurricane damaged properties, the Cadillac Hotel & Beach Club in Miami and the Parrot Key Hotel & Villas in Key West, as well as renovate several others. These two properties are forecast to contribute $20-25 million of EBITDA and account for 10% of total portfolio EBITDA by 2020 according to the latest Hersha investor presentation.

Hersha already has one of the lowest dividend payout ratios in the sector at a 50% payout target. 2019 CapEx is planned at $30-35 million, with the excess cash flow slated to pay down debt.

From Hersha's President and COO Neil Shah on the latest earnings call:

We have been planning to use our free cash flow, our excess free cash flow in 2018 and the coming years to primarily to kind of pay down leverage and to pay down debt, while we had our EBITDA increase as well on the other side.

Here is a visualization of a bearish case for Hersha in 2019, where EBITDA stays flat at $172 million despite two major properties reopening, CapEx coming in at the high side of guidance, ignoring that some of the CapEx is for growth, and interest expense increasing slightly despite promises of paying down debt

Even in a bearish scenario, the preferred payout is very well covered, and in a more neutral scenario, increasing EBITDA and targeting excess cash to pay debt and reduce leverage are all positive catalysts for the preferred shares.

Despite this, the preferred shares have fallen this year and especially lately, which is especially strange as they have significantly diverged from common shares, which have advanced slightly.

I believe this is a serious mispricing and in addition to the 8% yield, there is a strong chance that the price of the preferred shares recovers next year, adding to the return. If the preferred shares continue to trade at these levels, Hersha could choose to repurchase these on the open market, since they yield significantly more than their bonds which have an average interest rate of 4.3%.

2. Energy Transfer

Energy Transfer 7.375% Cumulative Redeemable Preferred Shares Series

(ETP.PC)

Current Price: 22.50

Current Yield: 8.2%

Callable: Yes

Tax Treatment: K-1

Energy Transfer (NYSE:ET) began in 1995 as a small intrastate natural gas pipeline operator and is now one of the largest and most diversified investment grade master limited partnerships in the United States. Energy Transfer operates more than 83,000 miles of natural gas, natural gas liquids, refined products, and crude oil pipelines today.

Earlier this year, Energy Transfer ownership was split between General Partner units and Limited Partner units. The Limited Partner units had a higher yield and owned most of the assets, but also held most of the debt and owed incentive distribution rights, or IDRs, that gave the general partner an increased share of a limited partner's incremental distributable cash flow.

This October, the General Partner and Limited Partner merged, with each limited partner share being converted into 1.28 shares of the general partner, eliminating the incentive distribution rights while reducing payments to the former limited partners. These reduced payments to the limited partners saves Energy Transfer $800 million per year, significantly strengthening the preferred distribution coverage.

Energy Transfer has a relatively small amount of preferred units outstanding in comparison to their bonds. As a preferred shareholder, seeing less cash being paid on the common units, a renewed commitment to higher coverage and reduced leverage, as well as growing EBITDA on top of already significant coverage are major positives. Despite this, the preferred shares have traded down significantly in the past month.

Looking at Energy Transfer's bonds show no obvious signs of stress, with the 2027 bonds trading just 2.5% over a similar maturity treasury.

Considering the small amount of outstanding preferred units and the fact they are cumulative, I believe these represent an extremely safe yield above 8%. I'm bullish on Energy Transfer and expect these preferred issues to trade back to $25-26 range early next year.

3. Nustar

NuStar Logistics 7.625% Fixed to Floating Rate Subordinated Notes (NSS)

Current Price: 25.02

Current Yield: 9.31% (3 month LIBOR plus 6.734%)

Callable: Yes, now

Tax Treatment: 1099

NuStar Energy (NYSE:NS) is another master limited partnership and one of the largest independent liquids terminal and pipeline operators in the nation. NuStar has more than 9,700 miles of pipeline and 75 terminal and storage facilities that store and distribute crude oil, refined products and specialty liquids. They have a large presence in the Permian basin and are focusing their expansion there, while selling certain non-core assets in Europe to help fund that growth and reduce leverage.

Similar to Energy Transfer, NuStar maintained a general partner / limited partner structure before it was merged earlier this year, eliminating IDR payments and reducing payments to common unit holders. NuStar had a strong Q3, with EBITDA rising 10% YoY to $172 million.

As we can see from the above, NuStar's distribution coverage on its common units is on the lighter side at 1.2-1.3x and is projected to stay in this range in 2019 as it continues to grow. These metrics should improve in 2020, per NuStar's CFO Tom Shoaf on the latest conference call. NuStar also recently announced the sale of non-core assets at a 8.9x multiple, which will improve its projected year-end 2018 debt leverage metric, which is great news for debt holders.

NuStar has several series of preferred shares (NS.PA) (NS.PB) (NS.PC) that are all trading below par and yielding 9.5-9.8%. NuStar's bonds, shown below, yield between 4.9-6.1%, depending on the maturity.

Occupying the spot in the middle between senior notes and the preferred shares are the Subordinated notes, currently trading at par and yielding 9.3%. These notes are traded on the NYSE under the ticker NSS and are significantly more liquid than most bond issues. They are indexed to the LIBOR, similar to their preferred units, offering protection against rising rates. Worth noting that these are junior debt and the company has the option to suspend payments for 5 years without causing a default, as described in the prospectus. This is one of the reasons I believe they trade close to the preferred shares.

In addition to NuStar's growth prospects, another reason these subordinated notes are a safe play is because I believe NuStar would be an attractive acquisition target for a stronger player, especially in a distressed scenario. In fact, Energy Transfer made an unsolicited bid for NuStar in March of this year. NuStar has great assets but a high cost of capital, so if acquired by a stronger company that could refinance its debt at lower rates, it could dramatically improve its cash flow.

Conclusion

I believe all of the securities presented offer a safe high yield in an environment where rate increases are slowing. They all have seen fundamental improvements in their coverage over the past year yet have had their prices decline. The energy names are being dragged down by a combination of sentiment and falling energy prices, despite their businesses being somewhat insulated from commodity prices by fixed, long term contracts. The Hersha preferreds are a mystery, with perhaps tax loss selling on a thinly traded security being the only reason I can think of to explain the recent drop. I'm bullish on all 3 of these companies heading into 2019 and consider these securities to offer an excellent risk/reward balance.

Disclosure: I am/we are long HT, ET, NS. 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.