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Yield Chasers Rush In

By Ari Charney on December 23, 2016

These are interesting times for fixed-income investors. Indeed, the end of the 30-year bond rally may finally be underway.

Of course, investors have thought we were at such a juncture a number of times in recent years. This time around, however, the situation may truly be different: We’ve got a growth-oriented government set to take control and an inflation-minded Federal Reserve.

But even as rates head higher, their normalization could still unfold more slowly than the market currently anticipates. After all, there are any number of factors that could derail our customarily cautious Fed from its preferred course of action.

Nevertheless, there’s no question that monetary conditions are tightening.

Energy prices are rebounding from their lows, the U.S. Dollar Index is at its highest level since 2002, inflation though still low is trending higher, bond yields are rising, and the Fed just hiked short-term interest rates by another quarter-point.

Meanwhile, the promise of fiscal stimulus, whether it comes in the form of corporate tax cuts or a $1 trillion infrastructure bill could force the Fed to raise rates faster than previously expected.

Though fiscal stimulus would certainly be welcome, we don’t think the deficit hawks in Congress are just going to be giving money away, at least not entirely.

For instance, Republican policymakers are reportedly considering offsetting corporate tax cuts by eliminating the deduction for interest payments. That means the net effect of the most sweeping form of stimulus may not be nearly as dramatic as the market is hoping.

For its part, the Fed is still taking a wait-and-see approach.  

At its latest policy meeting, the central bank only made modest adjustments to its forecasts. The number of rate hikes predicted for 2017 increased by one, to three, while the long-term projection for its benchmark federal funds rate climbed a tenth of a point, to 3.0%. Overall, that’s still a pathetic outlook.

Opportunity Drops

Even so, the market wasted no time in dumping rate-sensitive securities in the days following the election.

For yield-hungry investors who’ve lamented having to pay a premium for income, the resulting selloff has created some intriguing opportunities.

For instance, some recently issued utility preferreds have dropped 12% to 16% below par, pushing their yields up to around 6%.

By contrast, the three utility preferreds in Utility Forecaster’s Income Portfolio all still trade at premiums to their par or call prices. Two still yield 6% to 6.7% at current prices, while one trades at such a premium that its yield has compressed to 4.9%.  

Some of the preferreds hit by the inflation trade are backed by well-capitalized utilities such as Virginia-based Dominion Resources Inc. (NYSE: D), Michigan-based DTE Energy Co. (NYSE: DTE), Florida-based NextEra Energy Inc. (NYSE: NEE), and Louisiana-based Entergy Corp. (NYSE: ETR).

All seven of the preferreds that came up on our screen have investment-grade ratings, which could give us an opportunity to swap out one of our preferreds that’s firmly in the “junk” category.

And while our other two preferreds are investment grade, some of the preferreds issued by Entergy’s fully regulated operating subsidiaries have “A” credit ratings.

As risk-averse investors, we certainly relish any opportunity to improve credit quality, if a security’s other characteristics are at least as appealing as the ones we already own.

But we’re still kicking the tires on these preferreds. For instance, only two that came up on our screen are cumulative, which means that if they choose to defer payment of their dividends, they eventually have to make up all the missed payments.

Others may have covenants that are too permissive. In an era of historically low interest rates, there has been a proliferation of so-called covenant-lite issues.

One preferred that we’ll be looking at more closely is the Dominion Resources 5.25% Preferred (CUSIP: 25746U844), which is due 7/30/76. The preferred is cumulative and callable anytime after 7/30/21 at par.

Although it’s up from its post-election low, the preferred still trades about 12% below par, for a current yield of nearly 6%.

It also has an investment-grade credit rating, though it’s at the bottom rung of that category. Preferreds typically have a lower rating than the issuer’s corporate debt to reflect the risk of their lower position in the capital structure.

Speaking of risk, the Dominion preferred is also an unsecured, junior subordinated security, which means it’s not backed by any hard assets.

In addition to the particulars of these securities, we also have to weigh the risk-reward of the current interest-rate environment.

There also changes in tax policies being discussed that could greatly boost preferred issuance. A marked increase in issuance could also weigh on the prices of existing preferreds.

If we like what we see despite the various risk factors, then we’ll report on what we’ve found in the next issue of Utility Forecaster.


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