Don’t Be Afraid to Own Preferreds When They are Call Eligible

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As all experienced preferred stock owners know most preferred’s (and baby bonds) become eligible to be called after 5 years, although there are some fixed to floating rate issues that don’t become call eligible for 10 years.  The call (or redemption) is at the option of the issuer. This feature doesn’t generally work in the investors favor as it gives the issuer the ability to “refinance” the issue if interest rates are falling taking a juicy coupon away from investors.  On the other hand when interest rates are rising the investors is stuck with a substandard coupon-potentially forever as they watch their net asset value sink.

As interest rates fall and then rise the motivation of companies to refinance issues changes and investors with only a modest amount of experience get concerned when their holdings reach the  “call eligible” date.  We get notes both from this site as well as on Seeking Alpha wanting to know why we hold so many issues that are “call eligible”.  This is really not a difficult question to answer.

Owning a particular security, for the most part, for us is a matter of the income stream we are receiving.  It is not about capital gains or capital losses, although we are mindful of buying shares at too high of prices.  We attempt to not buy new shares that are dramatically above $25/share, although if they don’t become call eligible for 5 years we are less concerned with buying right at par.  Additionally we are more than happy to buy a decent issue at a large discount to par when those “bargains” pop up from time to time, but generally with our 7% return target we are most concerned with a reasonable income stream.

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It is the norm that as a preferred or baby bond issue approaches the call eligible period it will sink in price toward the $25 call price.  While logically this should happen in a gradually sloping manner many times it doesn’t start the descent until 6 month or a year before the call period. Because of this we try to sell issues that are way above par a year before the call eligible date.

The shares we hold that are “call eligible” are simply a risk/reward play. We try not to hold any issues that are more than 25 cents or so above the $25 call price plus the accrued dividend.  A 7% issue will gain about 1/2 cent per day of accrued dividends or interest.  Additionally it would be the norm to receive a 30 day “notice of redemption” from the issuer during which time dividends/interest continue to accrue.  Thus a 7% issue which is redeemed 60 days into a quarter would have about 30 cents of dividends/interest accrued so the issue is redeemable at $25.30.  In a perfect world an investor would not own issues that are trading above this price–but the fact of the matter is that most issues would probably trade 25 or 30 cents higher ($25.55 to $25.60).  This premium would be equal to about 1% and this is the risk we are taking by holding an issue at that time.

So why take any risk at all by holding call eligible issues?  It is simple.  As rates fell in the last number of years the issues available that we were willing to hold became more and more limited.  While we hold some lower yielding issues (as low as a 3.50% coupon) we have to have a mix of higher coupon issues–coupons in the 7-8% range and there have been virtually no newer issues available in this range that we have been willing to hold long term.  Remember that we have limited our possible holdings because we have shied away from perpetual preferreds as we believe we are in a rising rate environment and the net asset value losses will outweigh the dividends over the next year.  If investors have less sensitivity to net asset value changes there is a larger selection of available higher yielding issues.

So the bottom line is we are willing to risk a 1% loss in order to own particular issues–we believe this is a very reasonable risk to hold the portfolio we are most comfortable with and which will hit our 7% target return.

To get more information on preferred stocks and exchange traded debt (baby bonds), screen them, set up your own portfolio and receive email alerts, go to www.preferred-stock.com now.

 

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Tim McPartland

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Tim McPartland
Tim McPartland is a private investor with over 45 years of investing experience. His analysis, research and writing is devoted to the hunt for income producing securities of all types, but in particular specializing in preferred stocks, exchange traded debt and Master Limited Partnerships.
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