Bought 100 VRP at $24.89 (see Disclaimer): This is a very low expectation purchase.
Snapshot of Trade:
Security Description: PowerShares Variable Rate Preferred Portfolio Fund (NYSE:VRP) is a new ETF that owns variable rate "preferred" stocks and bonds.
Sponsor's Website: Invesco - Product Detail
Semi-Annual Report 4/30/14 (starts at page 70; as of 4/30/14, the allocation was 44.1% in bonds and 55.1% in equity preferred stocks)
Given the low status of preferred stocks in the capital structure, and this fund's concentration in preferred stocks and junior bonds issued by financial institutions, there will be a significant weighting in junk rated issues:
The weighting is in BBB/BB (S & P) and Baa and Ba (Moody's). The BB and Ba ratings are high end junk ratings.
This fund is currently paying monthly dividends of $.10 per share. At that rate, the dividend yield is about 4.82% at a total cost of $24.89 per share.
The sponsor lists the effective duration as 4.08 years.
The expense ratio is high at .5%.
As of the date of my purchase, the fund owned 88 securities.
Looking at the portfolio, the fund owns both trust preferred (or subordinated debentures) and traditional preferred stocks. Holdings
A trust preferred is technically a "preferred" stock, but is in reality a bond. Stocks, Bonds & Politics: Trust Preferred Securities: Links in One Post; Stocks, Bonds & Politics: Regular Preferred and Trust Preferred (1/1/2009 Post) That type of hybrid security has a superior claim than traditional preferred stock which is superior only to common stock in the capital structure.
Some examples of trust preferred securities owed by this fund are as follows:
Trust preferred securities pay interest.
Some examples of equity preferred stocks owned by this fund are as follows:
The preceding equity preferred stocks pay qualified dividends.
A number of the bonds owned by the fund are traded in the bond market and have $1,000 par values:
So the dividends paid by this ETF will have both qualified and non-qualified components.
I have bought and sold the GSPRJ, and will simply drag and drop my discussion about the advantages and disadvantages of this type of security. Item # 4 Bought: 50 GSPRJ AT $22.78 (11/12/13 Post)
Description of a Fixed-To-Floating Rate Equity Preferred Stock:
A fundamental problem with this type of security is that the investor has to accept a somewhat lower coupon than a pure fixed rate preferred stock, while possibly never receiving the benefit of the Libor float provision. These fixed to floating rate securities give the issuer the right to redeem at anytime after the fixed rate coupon period expires.
To illustrate the issues, I will simply discuss one security in detail.
The Goldman Sachs Group Inc. Fixed-to-Floating Preferred Rate Stock (symbol-GS.PJ) is a fixed to floating rate equity preferred stock issued by Goldman Sachs.
GSPRJ will pay quarterly non-cumulative dividends at the rate of 5.5% per annum on a $25 par value. The 5.5% fixed coupon rate will be applicable from the issue date to, but excluding 5/10/23.
On or after 5/10/23, GS has the option to redeem this security at par value plus any accrued dividends. If the security is not redeemed, the coupon transitions to a floating rate on 5/10/23. The floating rate would be a 3.64% spread to the three month Libor. PROSPECTUS SUPPLEMENT DATED APRIL 18, 2013
The coupon rates on GS fixed coupon preferred stocks are higher, though the actual current yield will depend on the total cost paid for the stock. Goldman Sachs Group Inc. 6.2% Series B Non-Cumulative Preferred Stock (NYSE:GS.PB); Goldman Sachs Group 5.95% Non-Cumulative Preferred Series I (GS.PI)
This security has a typical stopper clause, summarized at page S-3 of the prospectus, that prevents GS from paying a cash common dividend after eliminating the non-cumulative preferred dividend. In order to legally eliminate the dividends on its non-cumulative preferred stocks, GS must first eliminate the common stock dividend.
As with other equity preferred stocks issued by Goldman Sachs, GSPRJ is currently rated junk by both S & P and Moody's. S & P has it at BB+. Moody's rates it at Ba2.
This security will pay qualified dividends.
Initiation of the Floating Rate May Result in A Redemption:
If the Libor rates are high enough in 2023 or anytime thereafter, GS may elect to redeem this security.
Investors do not want a redemption when the comparable alternative securities produces less income. GS would not redeem a 5.5% fixed coupon perpetual preferred stock in order to replace it with a 7.5% coupon preferred stock. It might refinance a preferred when it has to pay 7.5% due to the Libor float activation. GS will do whatever it perceives to be in its best interests when this security makes the transition from a fixed to floating rate or at any time thereafter.
If GS chooses to pay the 3 month Libor + 3.64%, it will be because it views that rate as favorable to it. To result in an increase to the 5.5% fixed coupon rate in existence before the activation of the floating rate, the 3 month Libor would have to be over 1.51% during the relevant computation period.
A fixed to floating rate preferred stock will have a theoretical duration less than a fixed coupon preferred stock (see page 8: cohenandsteers.com When Interest Rates Rise.pdf) I would not personally use the bond concept of duration in connection with perpetual preferred stocks unless it was likely that the issuer would exercise its right to redeem the security.
In practice, if short term and long term rates remained abnormally low after the GSPRJ option right comes into existence, the duration would remain perpetual for GSPRJ until such time as short term rates rose to a level where it would make sense for GS to redeem it.
Equity preferred stocks issued by heavily indebted financial institutions would become worthless in a BK. Their lowly status in the capital structure, superior only to common stock, creates volatility in the share price in times of economic stress. The non-cumulative feature will on occasion provide fuel for that volatility. A rise in interest rates will cause declines as more senior securities become more competitive.
A company like GS and other highly leveraged financial institutions have all kinds of inherent risks. (see discussion of risk factors starting at page 24 in the GS 2013 Form 10-K. Risk factors relating to GSPRJ are discussed in the prospectus starting at page S-8)
Equity Preferred Non-Cumulative Floating Rate Stocks with Minimum Coupons:
This fund also owns several equity preferred floating rate securities that pay the greater of a minimum rate or a spread to the three month Libor rate. Those types of securities are discussed in my post titled Advantages and Disadvantages of Equity Preferred Floating Rate Securities
Some examples of non-cumulative equity preferred stocks that pay the greater of a fixed coupon or a float over the 3 month Libor rate on a $25 par value include the following:
Bank of America Obligations (BML suffix originally issued by Merrill Lynch):
BMLPRG 3% or .75% over 3 month LIBOR Prospectus Supplement
BMLPRJ 4% or .75% over 3 month LIBOR Final Prospectus Supplement
BMLPRH 3% or .65% over 3 month LIBOR Final Prospectus Supplement
BMLPRL 4% or .50% over 3 month LIBOR Term Sheet
BACPRE 4% or .35% over 3 month LIBOR Prospectus
Goldman Sachs Obligations:
GSPRA 3.75% or .75% over 3 month LIBOR Prospectus
GSPRC 4% or .75% over 3 month LIBOR Prospectus
GSPRD 4% or .67% over 3 month LIBOR Prospectus
HSBC USA Obligations:
HUSIPRF 3.5% or .75% over 3 month LIBOR Prospectus
HUSIPRD 4.5% (with a 10 1/2% cap) or .81% of the highest of T Bill, 10 Year Constant Maturity Treasury Rate or 30 Year Constant Treasury Rate Prospectus
HUSIPRG 4% or .75% over 3 month LIBOR Prospectus
MSPRA 4% or .7% over 3 month LIBOR Prospectus
USBPRH 3.5% or .6% over 3 month LIBOR Prospectus
STIPRA 4% or .53% over 3 month LIBOR Final Prospectus Supplement
SANPRB 4% or .52% over 3 month LIBOR Prospectus
I currently have positions in GSPRC, GSPRD, HUSIPRG, MSPRA AND SANPRB.
Looking at the semi-annual report, this fund owns all of the foregoing except for one out of 5 BAC floaters.
My more recent discussions of that kind of security can be found in this SeekingAlpha Instablog post: Equity Preferred Floating Rate Stocks: Added To MSPRA At $19.87 - South Gent | Seeking Alpha and in my blog at Item # 6 Bought 50 GSPRD at $20.2 (6/7/14 Post)
The trust preferred and subordinated debentures ("junior bonds') will generally grant the issuer the right to defer interest payments, but any deferred amount accrues interest generally at the coupon rate. The deferral right will generally be conditioned on a stopper clause that would require the issuer to cease paying cash dividends on junior securities before exercising the deferral right (e.g. page S-14 of Chubb prospectus). For junior bonds, both common and equity preferred stocks are junior securities.
I am talking generally here. I have not read the prospectuses for all of the securities owned by this fund. I am most familiar with the equity preferred floaters that pay the greater of a minimum coupon (usually 4%) or a spead over the 3 month Libor rate on a $25 par value. Those have been trading vehicles for me for several years, as shown by the snapshots at the end of the Gateway Post on that niche product. I have traded small lots and have realized gains to date of +$11,752.05. (profit snapshots at Advantages and Disadvantages of Equity Preferred Floating Rate Securities; see also Stocks, Bonds & Politics: Floaters: Links in One Post)
Rationale and Risks: This is simply a trade and is viewed as a source of income generation superior to a money market fund. It is not hard to find a security paying more than .01%. Hopefully, I will be able to exit the position at a profit after harvesting several dividends.
In a BK, a "preferred" security or junior bond issued by a bank holding company or other leveraged financial institution will likely become worthless; and that would include both junior bonds in addition to the equity preferred stock. Depending on the circumstances, there could be exceptions to that general rule.
Given their issuance by leveraged financial institutions, and their lowly status in the capital structure, they will also tend to be volatile in price, with a strong downside bias, in times of financial distress.
As mentioned above, the investor in the fixed to floating rate securities is accepting a lower current fixed coupon rate in exchange for the "insurance" protection afforded by the Libor float without any guarantee that any benefit will actually be received from the floating rate when it would be beneficial to the investor.
However, if there is not much difference in the starting yield, which is the case now for GSPRI (6.12% at $24.32) and GSPRJ (5.67% at $24.24), I would probably go with the fixed-to-floating rate security since it is less likely to remain a perpetual security compared to the fixed coupon 5.95% GSPRI. If interest rates are high when the float provision comes into effect, GS might elect to redeem GSPRJ at the $25 par value plus the accrued dividend, thus giving the investor an out. The owner of GSPRI would need to recognize that rates were trending up in a non-temporary manner and hopefully sell before the security lost too much in value. The market may also anticipate a rise in rates and start to reflect that eventuality in the fixed coupon preferred stock price before rates actually rise meaningfully.
The junior bonds have optional redemption dates and generally long term maturity dates assuming no exercise of the optional redemption right.
A number of the securities owned by this fund are trading above their par values. An issuer redemption at par value plus accrued dividends would result in a reduction in the net asset value per share and possibly a loss for the fund depending on its average cost per share. There is also more room to the downside in price than upside.
Disclosure: The author is long VRP.
Additional disclosure: SA does not recognize preferred symbols. I am also currently long MSPRA, SANPRB, GSPRC, GSPRD, and HUSIPRG mentioned in this post. Disclaimer: I am not a financial advisor but simply an individual investor who has been managing my own money since I was a teenager. In this post, I am acting solely as a financial journalist focusing on my own investments. The information contained in this post is not intended to be a complete description or summary of all available data relevant to making an investment decision. Instead, I am merely expressing some of the reasons underlying the purchase or sell of securities. Nothing in this post is intended to constitute investment or legal advice or a recommendation to buy or to sell. All investors need to perform their own due diligence before making any financial decision which requires at a minimum reading original source material available at the SEC and elsewhere. Each investor needs to assess a potential investment taking into account their personal risk tolerances, goals and situational risks. I can only make that kind of assessment for myself and family members.