Interesting.
But they are yielding so much more than any debt known.
The only market that I know of that yields that much is the mini-bonds market in Germany (not directly comparable since general interest rates levels are very different), where issues go bust on a weekly/monthly basis.
I feel like having a look in that utility security that you posted, because I am very curious.
you have to remember that a lot of the yield on prefs comes from interest rate risk. for a rough estimation, on a straight pref, duration = 1 / yield, so a 5% yielding straight preferred has a duration of roughly 20. so you’re basically comparing it to a 25-30 year bond. most of the spread above the 25-30 year bond is your additional credit risk on the pref over the bond. that said, we know that duration is not linear and the excess credit spread related yield that prefs offer today will likely soften the blow when interest rates risk. i’d hazard to guess that the duration of a 5% straight pref is actually closer to 12-15 when the thinning of the credit spread is factored in during a period of rising interest rates.
so not only are you taking on tons of interest rate risk, you’re taking on tons of credit risk (in some cases) when buying something like PFF. in Canada, the profligation of fixed-reset preferreds limits the interest rate risk a bit and are mostly issued by banks and utilities so the credit risk is typically quite low. i’m not 100% sure on how the pref market makeup is in the U.S. or how it has evolved over time.
one other thing that likely adds some spread on prefs is liquidity risk. anything Pfd-2L or lower, will experience air pockets during times of interest rate uncertainty or heightened credit risk. it is important to own a certain level of quality in the pref market and to never go below the line in the sand you have drawn.
Yeah, what Matt said is soild. Drinking coffee and analyzing fixed income, damn this is fun. Unlike equities which are basically “crystal ball” type shit, these portfolios can be reasoned thru rationally, modeled, and movements mostly explained. Never thought I’d be doing it in my own portfolio though. So yesterday I spent some time looking more closely at interest rate risk, and building up my model… The interesting thing is that fixed-rate investment-grade (BBB) preferreds had an avg spread to 10yr treasuries of 225bps pre-crisis (1997 to 2007). They widened massively during the credit crisis of course, but never fully came down. They now trade at a 320bps spread, despite the fact that credit risk is lower post-crisis. We can call this “mispricing” or whatever we want (treasuries might be the ones mispriced), but the fact is they kick ass over other fixed income right now. My main task now is quantifying interest rate risk for 2015. I modeled some interest rate shocks, but ran into the problem of estimating mod duration on preferreds. I do not think 1/yield is appropriate. If we look at 2013 when the 10yr treasury increased around 120bps, the PFF ETF declined around -8% for each 100bps increase. The BoA Lynch Fixed Rate Preferred Securities Index with a modified duration of 8 was hit for -10% for the entire year. Those two data points agree with each other, so for modeling purposes I’m calling it a duration of around 8 for diversified portfolios of fixed coupon perpetuals. It’s probably this low because 1) the massive 320bps spread compresses when the 10yr treasury rises (in 2 of 3 last Fed tightening cycles), 2) PFF holds some floating rate, 3) any foreign securites don’t track Fed movements. Also because the dividends are so high, the total return was only -3.7 in 2013 (not too bad for a large rise in rates, given these are perpetual securites, but it does need to be taken seriously). But floating rate preferreds really kicked ass during this shock. They have a lower yield, but in 2013 the BoA Lynch Floating Rate Index only decreased 1%, and had a total return of 5%! So in a potentially rising rate environment it makes sense to have some of the portfolio in floating. VRP ETF is 5.3% yield. So if beta vs the equity markets is almost zero, and interested rate risk is essentially eliminated on those floating holdings, that only leaves credit risk which I am not super concerned about right now. LOL, time to lever up on 5% floating preferreds and put a credit hedge (WYDE) in place! A blended 50/50 fixed/floating rate portfolio would have outperformed all fixed income in 2013, except for HY bonds which didn’t suffer any price decrease at all. 2013 Rate Shock, Total Returns High Yield Bonds 7.4% Floating Preferred 4.9% Floating/Fixed Mix 0.6% Corporate (1.5)% Fixed Preferred (3.7)% Treasury 10yr (7.8)%
Purealpha, I deal a fair amount in this kind of work in terms of the interest rate risk. I don’t have the time to go through your write up in detail, but I’m now interested and will.
In terms of IRR, a similiar occurance has been witnessed in the revenue bond index. The spread between the revenue municpal bonds and 10 year is at an all time high. Some believe this will mitigate some of the interest rate risk associated with investing, due to a larger spread than is necessary. This only applies to already outstanding revenue bonds, all new issuances have very low yields.
Revenue bonds were the only asset class I was aware this had occured. But it sounds as if preferred may be another area, which interests me a great deal.
Levered fixed income looks like my 2015 strategy, probably going to start buying lots next month as opportunities present themselves (focus on short duration and/or floating rate, and BBB/BB). Been running worst case scenarios on the model portfolio and even at 2.5X a 600bps rate shock wouldn’t result in a margin call. Base/low/high scenarios are all around 10% total return, given the way it’s hedged. Starting to research names now, here’s a juicy one at first glance – GMAC Capital Trust I (ALLY A). This bad boy has a chunky 7.7% yield. The chumps are owned by the USG and Cerberus, it was “too big to fail” before, why now? Besides it looks like it got upgraded this year to B- “positive”. Bummer that it’s callable 2016, eyeballing it looks around 4% yield to worst, but will they have billions in cash to do so? Need to look at their financials. Regardless that’s 7-14% yield levered 2X. Will post back on this thread if I blow myself up next year… 
Posting back, preferred stocks are turning out to be an ace move so far this year (in the end went with 25% of my portfolio, and decided against leverage). The stuff I acquired in Nov/Dec appreciated 4-8% by the end of Jan, in addition to the 6% yield. Tickers: GS I, DLR G, STI E, PSA U, CNTHP.
Must be the mad dash for yield, seems like it has really accelerated in the last few weeks. Not sure if it overseas investors snatching these up or what? Or expectations there will be no rate cut anytime soon so people piling into these? The key now is getting out before the rate cut, easy money for Q1 and perhaps Q2.
Are you just looking for some high yield debentures and the like? How far down the risk curve do you want to get?
Well with the majority of the world cutting rates and a new announcement daily it feels like, I could see demand for them increasing. Nice play
Problem is if you’re American, investing in any of these countries cutting rates means big currency losses. Sure you will probably have some upside if you bought a Canadian 5 year, but you’d have been crushed on FX.
Oh yea, I wouldn’t do it as an American. But most of you guys who post in this section aren’t from USA
15% bonds, 85% cash