Interest Rate Pop Brings Some Red to Income Issues

The last 60 days has brought the 10 year treasury from a low of around 1.45% back in late August to a recent level of about 1.84%.

I know readers have been watching this climb from some of the comments made on the site–and certainly these climbing rates have made everyone kind of leery of purchasing much in the way of recent new issues that came to market at really low coupons–i.e. 4.875% to 5% and it looks to me like folks should use a bit a caution right here.

The perpetual preferred issued by 4.875% PS Business Parks (PSB) last week, which continues to trade on the OTC Grey market under ticker PSPBZ, came out of the chute pretty hot trading up to $25.20 on day one–but now is struggling to get back above $25.00 closing today at $24.96.

The new junk rated 5% preferred from Citizens Financial Group (CFG) has traded as high as $25.20, but closed today at $24.99 on the 1st day of trading on the NYSE.

Personally we have noted some of our investment grade holdings have dropped some today. The Allianzgi Convertible and Income Fund II (NCZ-A) 5.50% preferred was off 22 cents and the Allianzgi Convertible and Income Fund (NCV-A) 5.625% was off 11 cents. On the other hand these issues were kind of overheated a bit anyway and a bit of a sell off is not a surprise–even though I hate to see RED on the brokerage statement–this year has been a bit of a gravy train for gains so I guess we will have to work harder to make our 7% next year.

18 thoughts on “Interest Rate Pop Brings Some Red to Income Issues”

  1. Hello,
    I am new to preferreds and the bond/CEF funds preferreds have always been a learning are for me. So you mention preferreds like NCZ-A and it is rated as AAA, however, for the websites I have been looking so far they are often labeled as unrated (e.g. I searched on http://quantumonline.com/search.cfm). Where should I look to see the ratings for bond/CEF funds preferreds? Thank you very much.

    1. QO doesn’t generally update for rating changes. Go to the 3 original sources Tim mentioned. I always start with S&P.

  2. I don’t think the 22 cent decline in NCZ-A is related to rates and is just noise. It’s back to the range it was in for most of October and back to the price it was at last week. NCZ-A IPOed when the 10 year was at 2.9%, so rates at 1.85% shouldn’t pose any issues. Personally, NCZ-A is my single biggest position and about twice the size of my next largest position. Current yield of 5.35% with four years of call protection is a great deal for what I think is the strongest credit in the entire preferred marketplace. Not just my opinion, either. Fitch rates them AAA which is the highest rating of any preferred out there. It would take either fraud or WWIII to impair this preferred due to the asset coverage and mandatory redemption feature.

    1. Landlord, over the past 31 year ave of AAA rated credit, the default rate for that segment was 0.00%. Seems like you are going to be forced to have to worry about something else than a default. 🙂

    2. Ok, I haven’t invested in securities issued by mutual funds before, but your mention of AAA credit rating and a 5.35% yield got my attention, but looking at the parent, NCZ, I see it currently has negative earnings and pays a dividend over 10% (how sustainable is that?). The revenue has gone down every year for the past 5 years and the income has fluctuated between positive and negative. The chart of the share price looks like a downward staircase ($15 to $8 to $5). Morning Star gives the parent NCZ a 3 star, so can someone explain why does this preferred get a AAA?

      1. Under the 1940 Act, the Fund is not permitted to issue new preferred shares unless immediately after such issuance the value of the Fund’s total net assets (as defined below) is at least 200% of the liquidation value of the outstanding Preferred Shares and the newly issued preferred shares plus the aggregate amount of any senior securities of the Fund representing indebtedness (i.e., such liquidation value plus the aggregate amount of senior securities representing indebtedness may not exceed 50% of the Fund’s total net assets). In addition, the Fund is not permitted to declare any cash dividend or other distribution on its Common Shares unless, at the time of such declaration, the value of the Fund’s total net assets satisfies the above-referenced 200% coverage requirement.
        In other words, the fund would have to redeem preferreds to maintain the coverage ratios.

        1. Grid – Just to be clear, as you know, it’s not the 1940 Act 200% coverage requirement that is the deciding factor to the AAA rating. It’s probably a contributor, but it’s not the reason for it. For example, up until about a year ago when it was lowered to 150% by SBCAA, BDCs had the same 200% requirement and none of them came close to AAA quality. The 1940 Act’s mandatory coverage rate for mutual funds, CEFs and BDCs is a huge factor to their preferreds appeal to me, however, it’s not the raison d’être for NCZ’s rating..

      2. Derek—as Grid pointed out these closed end funds have to maintain at least a 200% asset coverage ratio on senior securities—senior securities are either preferreds or debt issues. Typically the CEF preferreds are some of the safest preferreds out there—this is not to say something couldn’t go very wrong, but that is true of all preferreds. I think it is good to look over their financials–in fact necessary–on the other hand the performance of the common shares should not be overemphasized. I wouldn’t own many of the Gabelli closed end funds–but they have a bunch of rock solid preferreds outstanding and I own many of them.

      3. Derek,

        NCZ is a bond fund, not a company, so you have to look at investment income, not earnings. I don’t know offhand exactly but NII is coming at least close to covering the distribution.

        However, it really doesn’t matter. As Tim points out, all CEFs are subject to a rule requiring 200% asset coverage on preferreds. If they don’t meet coverage, they can’t pay a distribution to common stock holders of the fund.

        What makes NCZ-A special is an additional feature requiring mandatory redemption of preferreds at par if coverage drops below 200%. I believe this feature is why NCZ-A is rated higher than other CEF preferreds. They have 90-180 days after failing to meet the asset coverage test to liquidate assets and redeem the preferreds at par. So the value of the bonds held in the fund would have to drop 50% within 90-180 days after failing the test before preferreds would be impaired. The fund owns fairly liquid, run of the mill high yield bonds (no illiquid Level 3 assets like loans or CLOs). A 50% drop in the high yield bond market in 90-180 days isn’t happening outside of a WWIII scenario.

        Another consideration is fraud. NCZ is managed by Allianz (parent of Pimco) which is one of the world’s largest and most respected asset managers. So no worries about fraud and there should be adequate controls in place to prevent a rogue trader.

  3. Higher rates mean higher coupons in the future. The tradeoff is lower resale prices on what you already own. Good tradeoff! Do people really want lower rates forever just so they can prop up existing prices? And remember, it’s not a loss unless you sell it. Hold it and you continue to get what you paid for.

    1. Martin, as we know, everyone has their own goals and purposes so that becomes an individual decision. But I have some issues I want to keep and are too hard to acquire. So if they drop, so be it. I reinvest dividends so at least lower prices equate to better yield going forward.
      But sadly I mark to market. So for it my spreadsheet will show a loss even if I dont sell. Its a loss, just an unrealized loss. 🙁

      1. IMHO, the issue is a problem of perception.
        1. Preferred investments for me is mainly about the dividends, and only minorly on capital gains. So if this year I had say 5% gains from distributions and 4% gains from appreciation, and now it dropped to only 3%, I am still very happy of making above the 5%.
        2. When I see such a drop in my spreadsheet I tell myself: “this is not a loss, but rather, this was a temporary overvaluation which I decided not to sell into it and now the valuation is coming back to normal, and its ok, I can buy more now if I want”. Of course the possible remorse is: why didn’t I sell when it was overvaluated. However, if it was not simply because of greed or laziness, then you probably had good reasons not to sell and you knew the overvaluation was temporary. So you should not care about a “virtual” loss nor an unrealized loss, it’s just an ok correction of an otherwise mistaken evaluation.
        …This blurp helps me about 80% of the time….

  4. I agree fully. If we look at some higher coupons that came out earlier this year like CFG-D at 6.35%, the 10-year TBILL was retreating. Seems like the preferred markets tend to lag the treasury markets. So now that the 10 year seems to be back recovering, the low coupons should not last long particularly if buyers don’t grab them up. So yes, it’s possible we will see higher coupon’s soon in the preferred marketplace.

    In Canada, my reset rates (which I limit to 10-11% of my net worth) have stabilized and begun to recover. Less concern about 0 interest rates.

    I am finally starting to like the interest rate curve which looks to be normalizing if the Fed does as expected tomorrow.

  5. Are you seeing a near 2% rate as a threat in taxable accounts or in general?
    Could you be more specific?
    thanks

  6. Tim, A couple of the Euro banks – Norway and Switzerland I think it was – are having second thoughts about absurdly low IR policy. Brexit ending, China story becoming normalized, record deficits and repo man – no predictions but plenty of upside catalysts.

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