Market Commentary | July 17, 2024
A Glimpse at the Future?
Earlier this month, a report of a cooling jobs market, closely followed by a CPI report that consumer prices declined in June, provided more than enough fuel to reignite speculation the Fed would soon begin cutting interest rates. The fever pitch suggested cuts could begin as early as the July 30 Central Bank meeting but cooled when Chair Jerome Powell’s comments at an Economic Club of Washington luncheon indicated no change would happen before September. That gave us a little more time to assess markets and develop a new action plan.
Same Destination, Better Route
We have long relied on the preferred stock markets to source high, predictable dividend income. At present, we can choose from more than 5 dozen REIT preferreds that can be purchased to produce yields of 7.0% to 10% (250 to 600 basis points higher than 10 Y Treasuries), so the options are extensive.
If it passes credit underwriting, any given fixed income issue is fungible to the next on a yield comparison, but market price is the differentiating metric that identifies potential opportunity. Like bonds, preferred stocks have call provisions that enable the issuer to redeem them at par ($25/share for most preferred issues). Declining interest rates will cause fixed income securities’ market prices to rise, but the price will be tethered near par value if the shares are callable.
Fixed Income with Upside Potential
We can compare hypothetical securities ABC.pr.A to XYZ.pr.A, where each issue can be purchased to produce a 7.5% dividend yield, but the ABC issue is priced at $24.50 and the XYZ issue is priced at $20.50. If interest rates decline by 200 basis points, each issue’s share price could conceivably approach its $25 par value: ABC.pr.A rises $0.50 (+2.0%), XYZ.pr.A rises $4.50 (+21.95%). This is the differentiation potential we see in the preferred stock markets today.
In anticipation of rates imminently declining, we will be actively repositioning our portfolios. We already own the 7.5% yields; we want to own the more discounted issues that have double-digit appreciation potential.
Notes and Disclosure
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