Will Higher Interest Rates Huff and Puff Your House Down?

Sheaff Brock Investment Advisors | Indianapolis | Preferred Stock Performance | Asset Class

Will Higher Interest Rates Huff and Puff Your House Down?

Ever since (think back approximately a year-and-a-half) rates began their slow upward movement, income investors have experienced a certain degree of worry about the “big bad wolf” blowing down their carefully constructed investment “abodes.”

Thankfully, as Sheaff Brock senior portfolio manager JR Humphreys, CFA, CAIA explains, if you’ve “built” for the longer term (planning a longer holding period), there may be little reason for concern. In fact, Humphreys pointed out in an October interview with our SheaffBriefs editor, since December of 2015, preferred stock as an asset class is up 12%!*

On the flip-side, Humphreys is quick to admit, all fixed-income investments are damage-prone when there is a sudden jump in rates. Investors in coupon-bearing investments, including preferred stock, who needed to sell their holdings during the two months following the last presidential election would have sustained considerable “wind damage.” A year later, he feels, it has become obvious that preferreds’ higher yield (as compared with bonds) proved to be their longer-term saving feature once the short-term “storm” had passed. Humphreys believes today’s average preferred stock 5.5% coupon offers “weather-proofing” when compared with the 2.3% available on ten-year Treasuries.*

In pursuit of the goal to maximize income and minimize price fluctuation, Humphreys explains, the Sheaff Brock Preferred Income Portfolio uses floating-rate preferreds along with fixed-to-float securities (these shift after five years from fixed rates to floating rates).

The “weather forecast” for next year? With perhaps two interest-rate hikes on the radar, Humphreys does not anticipate any extreme rate increases. Kiplinger staff economist David Payne apparently agrees: “The Fed sees inflation running close enough to its 2 percent target to forge ahead with its rate and balance sheet normalization program. … Long-term interest rates should rise a little by year’s end, but inflation’s flatness combined with ongoing economic and fiscal-policy uncertainty should keep those rates from increasing much.”

Factors intrinsic to preferreds may help them withstand “huffing and puffing” damage. Hybrid securities, preferreds blend the traits of both stocks and bonds. Like common stock, preferreds represent ownership in a company, but without voting privileges; like bonds, preferreds are issued at a fixed par value and rated by independent credit-rating agencies.

Humpheys further “unpackages” some of the factors; his opinion includes:

  • In a gradually increasing interest rate climate, the net interest margin—a measure of the difference between interest income generated and interest expenses—for insurance companies and banks widens, therefore increasing their earnings (so their “spread,” and therefore their profits, would likely increase).
  • The U.S. has some of the highest interest rates in the world, and that has triggered a lot of foreign demand for our securities.

Will the “big bad wolf” of rising interest rates huff and puff your investment house down? Sheaff Brock believes that a carefully managed preferred stock portfolio and a reasonable holding period has the potential to keep him at bay.

*Source: Bloomberg Market Data S&P Preferred Stock Index returns from 12/18/2015 to 10/13/2017.

 

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