Following correspondence with some readers regarding the value of LIBOR-based floating rate preferreds in this environment, I decided to truly delve into them to uncover, if I could, their advantages at this time. I was surprised that they are not as bad as I had thought (or as they had been). Most of them are trading at prices which would permit investors to purchase enough shares to equal the cashflow generated by purchasing the same dollar amount of preferreds offering twice the coupon. When one considers that once LIBOR rises high enough to push the floating-rate coupons above their floors (where the reside currently), there may be some value here indeed, but it is not all roses.
Pushing LIBOR high enough to get these adjustable rate preferreds above their minimum coupons may take some doing. The typical floating-rate preferred spreads its coupon between 75 and 100 basis points over three-month LIBOR (BACprE only spreads 35 basis points over three-month LIBOR). With three month LIBOR sitting at 1.35%, a sharp increase in short-term rates in necessary to get these coupons off of there floors. To make matters worse, LIBOR rates are falling. This is by design.
Typically, three-month LIBOR trades at approximately 15 basis points above Fed Funds or between 20 and 30 basis points above three-month T-Bills. The government's liquidity programs are designed to narrow the gap. One may take the view that it doesn't matter when three-month LIBOR rates rise because one is not disadvantaged in terms of cashflow on capital invested while one waits. Although this is true, a floating rate preferred which is not experiencing rising coupons may actually trade more poorly, especially if falling LIBOR rates make it push floating benchmarks further below the floor coupon.
From a trading aspect, if long-term rates rise from inflation (caused by growth or, more likely, the printing of dollars), but short-term rates do not rise or rise appreciably, prices of these floaters may suffer along with those of high-coupon fixed-rate preferreds. Any price improvements from credit spread tightening will benefit fixed and floating-rate preferreds similarly, to a point. If the Fed chooses to keep Fed Funds relatively low and the financial sector improves to where LIBOR spreads are near their "normal" levels, it is possible that their coupons will stay near or at their floors even though long-term rates and inflation is rising. This makes them imperfect inflation hedges at best, sorry Barron's. Also, since LIBOR must rise hundreds of basis points to get the floaters' coupons off their floors, we could be well into, if not through an economic cycle without ever experiencing a coupon increase.
As call dates approach, depending where new issue preferreds can be issued (if they can be issued), the high-coupon fixed-rate preferreds will have calls coming "into the money" This would cause their prices to accrete to par ($25.00). However, the floaters stuck at low coupons (they could remain low even of they rise somewhat from their floors) would have calls out of the money and may experience little in the way of price increases.
As I have said before, use these preferreds as ways to play a flatter yield curve and as a speculation the short-term rates will rise sharply. At least now, one will probably not suffer too severely if they bet incorrectly, just remember, it is not a sure bet.
One quick note, as expected BAC has decided to explicitly guarantee MER preferred stocks, However, unexpectedly BAC has left MER as a subsidiary and is not explicitly guaranteeing MER bonds or trust preferreds. The street consensus is that BAC wants to keep Merrill's large amount of debt separate from its own capital structure. S&P upgraded MER debt stating that it believes that BAC understands the importance of Merrill paying its obligations. Nothing is every easy.
Hang on for Non-farm Payrolls.
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