Your grandfather’s bonds were bought to provide safe, secure income with the added bonus of security of principal upon maturity. However, like black licorice made from licorice root, those days are long gone.
Today, we have an unstable fixed-income environment. The four-decade long bull market in bonds is over, driven by declining and unsustainably low interest rates. Interest rates are rising rapidly in virtually in every country, with projections of multiple rate hikes remaining in the current upward interest rate cycle.
Demographics and deglobalization are in the process of producing lower sustained global economic growth, which could be exacerbated by higher interest costs, crimping both personal and corporate spending. To curb inflation, the federal funds rate historically needs to match or exceed the “reported” rate of inflation.
While it can be debated what “reported” inflation should be, the reality is the U.S. Fed rate is far from being anywhere close to the inflation rate. According to the Atlanta Federal Reserve Bank’s Taylor Rule calculation, the Fed Fund rate should be closer to 5.9 per cent than its 2.5 per cent. The Taylor Rule is an alternative calculation for appropriate levels of Fed Funds rates based on employment, inflation, and several other inputs.
Under these circumstances, fixed- income investors should expect additional downward pressures on bond prices as yields adjust upwards. While widespread bond defaults are not yet expected, lower-quality companies offering higher-yielding bonds could begin to experience market pressures not seen in over a decade.
In late 2019, Guiding Mast Investments recommended reducing bond exposure and building a portfolio of utility preferreds with the proceeds. Utility preferreds were selected due to their higher yields and unique regulatory attributes that encouraged many preferred issues not to be called even years after their call dates. In addition, many utility subsidiaries with preferred stock outstanding pay their dividends prior to sending any monies up to the parent. For example, Alabama Power Co. pays its distribution before sending funds to its parent, Southern Company (NYSE—SO).
While some utility preferred stock prices have come down with a bump up in yields, the majority have been relatively more stable and still offer higher yields than bonds. I maintain the preference of individual utility preferred issues over most bonds, and especially traditional bond funds with no specific maturity dates.
Some utilities have issued equity unit preferred stock. These securities pay like preferreds and are convertible to common shares. The conversion rate is usually a sliding scale based on the price of the common at time of conversion.
Some utilities have issued equity unit preferred stock. These securities pay like preferreds and are convertible to common shares. The conversion rate is usually a sliding scale based on the price of the common at time of conversion.
Find examples of these utilities from Investor’s Digest of Canada at www.AdviceForInvestors.com.
George Fisher is the founder of Guiding Mast Investments.
This is an edited version of an article that was originally published for subscribers in the September 2, 2022, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.
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Investor's Digest of Canada •12/7/22 •