The article was first published to members of my service on September 26, 2022.
In all our future articles we will have a small intro presenting the returns of the different asset classes so that the reader can get an idea what is normal in the current environment. This includes the Treasury Yield Curve, Mortgage Rates, Corporate Bonds, Fixed Rate Preferred Shares and a number of instruments that we find interesting and representative at this time. We call this “the big picture”. After the overview, we present our income idea in the shortest way possible, hopefully without any fluff.
The big picture
As we all know over the past few weeks, US Treasury yields have reached decade highs and the curve is now inverted:
Federal funds rate
On September 21 last week, the Federal Reserve raised rates by 0.75% and lowered the benchmark to 3.25%. Fed officials have signaled their intention to continue raising interest rates as much as necessary to fight inflation. Market expectations can be viewed below:
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to each other in the international interbank market for short-term loans. The current 3-month LIBOR rate is 3.60%, whereas at the start of the year it was around 0.2-0.3%. It is highly likely that LIBOR will continue to outperform Fed Funds, as it makes sense
The average interest rate on a 30-year fixed mortgage is 6.7%, down from 3.3% at the start of the year. The average rate for a 15-year loan is 6% at the time of writing
To draw the yield curve, we’ll use Back of America as a benchmark because it’s supposed to be somewhat of a representative of an “A-” issuer in the corporate world.
Yields are in the range of 4.5% to 6% and this is the typical yield curve for a company with such a rating.
Fixed Rate Preferred Shares
We have over 100 fixed rate preferred stocks with investment grade credit ratings from S&P or Moody’s. Some of them qualify for lower tax rates, some don’t, but generally their returns range between 5.7% and 6.5% depending on the specifics of the business.
Preferred shares of CEF
From a credit perspective, they are the safest preferred shares on the stock exchange and their yields range between 5.38% and 6.5% depending on the issuer and certain tax differences.
idea of the day
The stock that caught our attention was Allstate Corp., 5.10% fixed to floating rate subordinated debentures due 2053 (NYSE:ALL.PB). We believe this is an appropriate fixed income investment from both a credit risk and an interest rate risk perspective. It is rated BBB by S&P and in early 2023 will be floating, which is supposed to combat interest rate risk
Description of ALL-B
ALL-B is a fixed to floating rate subordinated debenture issued by Allstate Corporation (New York Stock Exchange: ALL). This exchange-traded debt security pays a fixed dividend of $1.28 per year until it becomes a floating rate security on 01/15/2023 and matures on 01/15/2053. After the call date, ALL-B will either be redeemed at par or paid 3.165% above 3 month LIBOR. At the time of writing, the stock is trading at around $24.48. This security is rated BBB by S&P and Baa1 by Moody’s.
The first possible scenario for ALL-B is to be redeemed. We believe that the probability of redemption is quite high, given the LIBOR rate. Let’s see the numbers in the graph below.
ALL-B priced at $24.48 has a yield to call of 16.17%. That’s a huge return even in the current environment, so it’s the best possible scenario for an investor in ALL-B
The second scenario for ALL-B after its purchase date is not to be reimbursed. This means that ALL-B will become floating and its coupon rate will be 3.165% + 3 month LIBOR. The 3-month LIBOR is currently at 3.60%, and as the Fed continues to raise rates, it is expected to rise as well. We will take a rate of 4.15% for the 3-month LIBOR on the date of the call. So, the baseline expectation for ALL-B if not repaid is to have a floating rate of around 7.3% (4.15% + 3.165%). As long as the buy price of ALL-B is below par, a possible buyback will always be positive, which will increase the yield, so the lowest you can get at the moment is the free float of 7, 3%. Now we need to compare this to ALL’s yield curve and favorite stocks.
At the time of writing, ALL Perpetual Fixed Rate Preferred Shares are trading at a current yield of approximately 6%, which is well below the expected floating current yield of ALL-B:
ALL’s corporate bonds can be seen here:
These bonds are 2 notches higher than ALL-B and it is up to the reader to decide if the 2% yield spread is fair, bearing in mind that ALL-B is a floating instrument with a protection integrated against rising yields. For us the comparison is very simple and we believe that ALL-B is far superior to anything presented in the article.
What about common stock
At the time of writing, ALL’s dividend yield is 2.75% and the company’s forward P/E ratio is around 11. The company’s so-called earnings yield may sound tasty to many investors, but with the current market uncertainty common stocks lack the built-in interest rate risk protection of ALL-B and the bond is far superior from a market perspective. credit. We can use ALL’s price behavior as an early signal of deteriorating credit and, at the time of writing, the common is as strong as it gets in such a market downturn:
The liquidation of fixed income securities offers opportunities in the area of floating rates. Based on the logic presented above, we believe ALL-B has the potential to weather the storm and deliver abnormal returns somewhere between 7.3% and 16% annualized while acting as a hedge against the downside. increase in yields.