Market Commentary | July 15, 2023
Segueing to Higher Dividend Income and a Return to Par
The Labor Department on Wednesday reported that its index of consumer prices rose just 0.2% in June from a month earlier. Market watchers breathed a sigh of relief, but the Fed quickly warned that its battle with inflation is not yet done and at least three Fed Governors indicated we would see two more 25 basis point rate hikes this year. As this information evolved, we felt the need to review one of our investment themes in this inflationary environment.
A little more than a year ago we described that we had identified several $ Billion of discounted REIT preferred issues that carried a particularly attractive feature of dividend coupon rates that would convert from fixed to floating interest rates at specified dates in the near future. Upon conversion to floating rate, they would then pay dividends at 3-month London Interbank Offer Rate (LIBOR) plus 350 to 600 basis points. At the time, the Fed had just started its rate hiking campaign and LIBOR stood at about 1.60%; on June 30th, LIBOR had hit 5.53%. Two additional rate hikes this year, and we will be looking at LIBOR (or its new equivalent SOFR) indexing our floating rate preferreds at 6% +350 to 650 basis points.
Segueing to Higher Dividend Income and a Return to Par
Prior to the start of rising interest rates, these preferreds traded around or slightly above their $25 par value. When interest rates rise, bond prices fall and that is exactly what happened with these preferreds, with many of them seeing their market prices fall as much as 25%. Upon conversion to floating rate, however, the three issues that have thus far converted almost immediately resumed trading around par. Surprisingly, the issues that have not yet converted, but soon will, are still available at steep discounts.
The accelerated opportunity we see here is that the passage of time has moved more issues closer to conversion while rates have risen much higher than anyone anticipated they would. At present, we have ten issues currently trading at 10 to 20% discounts to par that will convert from interest coupons of 6.50% to 8.0% to floating rate coupons of 10.5% to 12.5% over the next 12months. In buying at discounted prices now, we stand to lock in high, rising dividends and a short wait to capture capital gains as prices return to par. If we are watchful and quick, we might be able to accomplish the result in succession.
Over the coming periods we will shuffle portfolio positions to free up capital to take advantage of this situation. If you are enthusiastic about this prospect, send more money; the opportunity exceeds our current capital.
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