The time for baby bonds and preferred stocks is approaching

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Introduction

I have been an active self-directed investor for over 40 years and have never seen our economy go from good to bad in such a short time. What a difference 18 months makes made. With the exception of our CEO, almost everyone understands that the current state of our economy and its current direction is going to be difficult for many families, in some cases very difficult. However, one of the truisms I have learned over the past 40 years is that investment opportunities can be found regardless of the state and direction of the economy. We will most likely have the unique opportunity to acquire fixed income securities at bargain prices over the next 6 months.

Interest rate

Just 18 months ago, the economy was buzzing with the lowest rates in about 50 years, falling civilian unemployment and inflation below the Federal Reserve’s 2% target rate. In contrast, today, companies are laying off workers or planning layoffs in the near future, inflation at 8.5% or higher (the highest in over 40 years) and rising interest rates currently far more than double the rates of 18 months ago.

Inflation rate

US Bureau of Labor

10-year treasury bill rate

FinancialTimes

The fixed income bull market is clearly over. That’s the bad news. You can, however, turn some of this into good news with a little patience and due diligence.

The Federal Reserve (Fed) is committed to fighting inflation with the two tools at its disposal. Raise short-term interest rates and stop buying securities to allow them to exit their books as they mature (Quantitative Tightening). Both of these Fed actions will put upward pressure on interest rates. The bottom line is that we are going to be in a rising rate environment for the foreseeable future. We will most likely see another 75 basis point hike in July and at least a 50 basis point hike in September. After September, it’s not so clear what additional actions the Fed will pursue. We are already seeing some impact due to rising interest rates. Single-family and multi-family building permits are down and residential mortgage applications are down by about a third. With another 125 basis point rise by mid-September, we should see a deeper slowdown in economic activity. We may see the Fed halt or slow the rate of short-term rate hikes after September.

I now have cash reserves on the sidelines which I hope to use in fixed income. At this point, I’m forecasting for September, but Fed actions may move that period earlier or later. To ease the uncertainty of timing, I prepare early with a list of baby bonds and preferred stocks.

List of baby obligations

Over the past two months, I’ve been putting together a list of baby bonds for possible investment. I say “possible” because it depends on how individual bond prices stabilize after another 125 basis point increase in short-term rates. The list contains about 60 issues and I plan to invest in about half of those 60 issues. To put some objectivity into the process of selecting which issues I will choose for investment, I have plotted yield against credit rating. This allows me to select securities that offer above-average yield for their credit rating category. The list is in the form of an EXCEL spreadsheet and the column headings should be self-explanatory.

List of baby bond issues

Author

I had to split the baby bond table in half, the other half is below.

List of Baby Bond issues

Author

Readers should note that because baby bonds are exchange-traded debt securities, the price fluctuates during the day. As a result, the prices shown will be different from those you will find on securities trading this coming week. Most issues trade below par ($25) with a handful still trading at par or above par. After a few more rounds of short-term interest rate hikes from the Fed, I expect all of the bonds in the above list to trade below par. As a general rule, I don’t invest in bonds selling above par unless there is a special circumstance that compensates for the price above par.

All baby links in the listings above are included in the table below. The graphic, as presented here, is simply an image pasted into the article. In my EXCEL spreadsheet, the points in the chart are linked to the corresponding title in the lists above. As mentioned above, I use the table below as an aid to selecting bonds that are yielding above average for their credit rating group. I may ultimately decide to invest in a stock that falls below the fitted power curve line, but at least I have enough information to make that decision.

Baby Bond Yield Chart

Author

One of the quibbles that readers might have is my choice to assign a value of 0.5 to the pseudo credit rating for unrated securities. This is somewhat arbitrary, and if I had assigned a value of 0 instead, the fitted power curve would have a slightly less negative slope near the vertical axis (between 0 and 2). This would effectively lower the curve for 1 (BBB-) rated securities a bit, placing some additional issues above the line rather than below.

Preferred shares

Although preferred stock issues are technically stocks, because they pay a fixed dividend and most don’t have a maturity date, preferred stocks behave much more like long-term bonds than like ordinary shares. I only have a few preferred stock issues listed because I find that preferred stock, for the most part, doesn’t offer much more risk protection than common stock. Yes, preferred shares are a notch higher in the capital stack, and issues that are cumulative must pay accrued dividends before common stock dividends are paid, but the board can cease dividends on preferred stock as easily as common stock dividends. Failure to make baby bond distributions usually results in a default on the issue and a major impact on a company’s credit rating. Baby bonds clearly have a lower risk of not repaying principal and an interruption to your income stream. That said, here’s a list of preferred stocks I’m considering.

List of preferred shares

Author

I should probably note here that the yellow highlights in the baby bond listing and the preferred stock listing are to remind me that these issues are either fixed in floating rate or reset rate securities. This is quite important for anyone considering investing in this type of security to understand. Similar to the baby bond list, I have a graph of current yield versus credit rating, although it’s rather sparse due to the few issues being considered.

Preferred Share Performance Chart

Author

It is also important to note that preferred stocks generally do not have issue-specific credit ratings, so the ratings in the list and table relate to the issuing company.

Conclusion

I plan to retire in the third quarter of this year. This will be the second time I’ve tried to retire; the first attempt (at age 55) was derailed by boredom. This time I think I will stay retired. So for me, the Fed’s plan to raise rates and reverse quantitative easing to fight inflation is a welcome change. I have money that I need to work and I already have a large stock portfolio. The ability to invest in fixed income securities at decent yields is a very welcome change from the historically low fixed income yields of just 18 months ago.

I hope this article was helpful for those of you in the same situation of looking for low risk fixed income opportunities.

Garland K. Long