The 10-year Treasury yield stopped just short of 3% last week and the recent Commitment of Trader’s data is showing massive short exposure to the 10-year futures contract by non-commercial traders. These are speculative positions betting that the 10-year yield will continue to rise (bond prices will continue to fall). The market has a funny way of moving against the masses when everyone is betting one way so I wouldn’t be surprised to see a short-squeeze here that pushes yields lower for a while.
10-year Treasury Yield – 1 year
Whether or not the 10 year trades above 3%, I think these are good levels to be buying some of the higher yielding assets for income. I’ve been selectively buying on the weakness since September and will continue to do so for as long as the long end of the Treasury curve pushes higher.
One area I like right now are shares of bank preferred stocks. Preferred stock is a hybrid stock/bond asset class. It technically is considered stock but the return profile is more like a bond. You’ll often see banks and utility companies issue preferred stock as a way of raising money that doesn’t count as debt on the balance sheet (since it’s considered equity) but it also doesn’t dilute the common stock. In the event of bankruptcy, it falls below bonds but above stock in the capital structure. This means they tend to have higher yields than the bonds that a company will issue.
I view the higher quality bank preferred shares as relatively low risk since the regulations slapped on the banking industry after the financial crisis have forced them to be a lot more conservative. All of the banks also need to pass stress tests with the Fed if they want to be able to pay dividends on their common stock (which just about all are at this point) and the preferred dividend must be paid before dividends on the common stock. This means there’s a VERY low chance of the company skipping the preferred dividend.
One negative is that the dividend rate on most preferred shares is fixed (like a bond) which is why I view these as bond alternatives. However, there are some classes that have a variable component which can be attractive if you think yields will continue to rise. It’s usually listed as the greater of a fixed rate or LIBOR plus some additional spread. One of the big positives is that the dividends are taxed as qualified dividends at long-term capital gains rates making them much more attractive to own in taxable accounts than bonds. And one last item to mention is that preferred stock can have a call date so it’s important to look at the yield-to-call when analyzing any potential investments, not just the current yield. There are a handful of decent preferred shares out there with call dates in 2021 that are still yielding above 4% – not too bad for a 3 year “bond.” And if the shares aren’t called, the current yield is even higher.
I wrote a post about a year ago highlighting one preferred stock in particular that we own from Wells Fargo (WFC). Bank of America (BAC) has a similar share class that I’ve also purchased. These are very unique and I’ve been looking to add to both. I view these basically as 30-year Treasury equivalents but with double the yield and a more favorable tax rate. I say “equivalent” because they essentially have the backing of the US government since these institutions are “too big to fail” and the precedent has been set following 2008. JP Morgan (JPM) and US Bank (USB) also have some preferred shares that I have my eye on and will be buying if they dip a little.
I’ve been looking to add some of these to replace Terra Nitrogen LP (TNH) – one of our larger “income” stocks. Unfortunately TNH is being taken out by CF Industries, which owns of the General Partner. We were limited partners and there was a clause in the partnership agreement that stated that CF could acquire all of the limited partnership units without shareholder approval. I’m not happy about this because this is exactly the type of asset you want to own in this macro environment – a high yielding company with no debt backed by real assets. While we’re losing TNH, we’re also large shareholders of CF and this should only strengthen their long-term financial outlook so I’ll likely buy some more if we get a good sized pullback.
Thanks for following!
-Nick