EnvisionCap.com: Forbes Article - Rate-Rise Protection

Rate-Rise Protection

Marilyn Cohen, Forbes Magazine, 10.04.04

There are bonds to protect you from inflation. But they don't shield you from rate hikes. Luckily, we have securities whose payouts are rate linked.

Investors are worried about higher interest rates, and they've spoken. They have withdrawn $22.6 billion from bond funds in the first six months of the year, according to the Investment Company Institute. No wonder. It's only rational to assume that higher rates and accelerating inflation will erode the value of their bond portfolios.

Sitting in cash and money markets isn't the answer. You can't buy a tank of gas on your earnings from a Treasury bill. Treasury Inflation Protected Securities and inflation-linked corporate bonds are not the answer. They protect against inflation, not against higher interest rates. These are not the same thing. In the mid-1990s we had high rates and low inflation. Investors are concerned this could happen again.

But there is an answer. Maybe not a perfect one, but a strategy that helps protect investors in this kind of impending storm. Invest in variable-rate securities whose payouts keep pace with rising interest rates. These are what I lovingly call my "hell in a handbasket" investments. If interest rates rise, they won't go to hell in a handbasket with the rest of your fixed-income portfolio. The coupons or dividends of variable-rate securities (which come in both bond and preferred forms) are not fixed.

The newest example is a $175 million SLM Corp. (also known as the student loan entity Sallie Mae) bond issued July 8 this year. This has a floor of 4%, which protects you from a rate slide. Should the ten-year Treasury rate go back to last year's historic lows of 3.11%, you'll still clock 4%. For the life of the bond, which matures July 25, 2014, the coupon is linked to 80% of the ten-year Treasury. This means whatever the ten-year rate is in the future, you will be protected. So two years from now, say the ten-year Treasury yields 7%, you will receive 5.6%. The calculation and payment is done monthly and thus truly keeps pace with rate gyrations. This bond is priced at par.

The ten-year Treasury, at 4.2%, now yields so little that you are bumping against the 4% floor. But that shortfall is likely a short-term phenomenon. You're really buying insurance for the next ten years. Odds are that rates will rise. You will be earning less this year than you could on a Treasury, but next year, and for the next eight, the floating rate will probably pay off--and your bond's price should hold up quite well.

What can go wrong? We can have an inverted yield curve and short-term rates may be higher than long-term, as we last did in 1989 (and in 2000 for just one- to ten-year bonds), according to Bianco Research. But inverted curves rarely last long.

Corporate preferreds also are part of this game, and they pay more because they can be called every 30 days--though none has been called yet, a hopeful sign. The yield is figured out against the highest yield among the current issue 3-month, 10-year or 30-year Treasurys, calculated quarterly. Finding these FRAPS (floating rate adjustable preferred securities) in the secondary market may take a few calls to brokerages. It's certainly worth the effort.

One dandy variable rate security to protect your portfolio in an interest rate storm is a perpetual preferred stock issued by J.P. Morgan Chase (50, JPMCP). The minimum dividend is 5.46%. And that's not too bad today. These have a maximum rate of 11.46%. Regardless of what happens to the yield curve, you are guaranteed to earn just 0.2 percentage points less than the highest-yielding new Treasury. That means that if the then-current 30-year Treasury bond goes to 10%, you will earn 9.8%.

This preferred has been with us since 1998, and Chase hasn't called it yet. To be on the safe side, though, be sure you never pay much more than the original price of $50 per share.

Another floating rate preferred, J.P. Morgan Chase (101, JPM L), outstanding since 1994 and not yet called, has a quarterly dividend that yields 84% of the highest Treasury. It has a 4.5% floor and 10.5% maximum dividend cap--all a bit less generous than the previous Chase preferred. The short call keeps these prices close to par.

Another veteran FRAPS is a perpetual preferred issued by Citibank (100, C A), with a minimum dividend of 6.34% and maximum of 12.34%. Its rate adjusts to 0.05 points above the highest Treasury. It has survived since its 2001 issue without being called. Don't pay much above the $100 par.

Any of these preferreds would suffer if the issuer's earnings fall apart, since dividends can be suspended if the company lacks the financial ability to pay. Nevertheless, these dividends are cumulative and are likely to be made current. Moody's rates the two Chase issues A2 and the Citibank preferreds Aa3.

You should put 20% of your fixed-income money in FRAPS or other adjustables. Worry some, but not a lot, about credit risk. Interest rate risk is the bigger hazard these days.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed-income money manager and author of The Bond Bible. Find past columns at www.forbes.com/cohen.