Term Preferreds: Two BDCs for Safe Income

03/29/2017 2:50 am EST

Focus: DIVIDEND

Michael Cintolo

Vice President of Investments and Chief Analyst, Cabot Heritage Corporation

Term preferreds are a largely unknown area of the market for most investors. From our view, they offer the best fixed-rate bonds for income investors looking for a safer alternative to dividend stocks, asserts Mike Cintolo in Wall Street's Best Daily.

Term preferred stocks have a par value of $25 per share. They trade on major exchanges and are bought just like stocks through your brokerage account. Nearly all preferreds trade relatively sparsely. Thus, when buying, you want to be sure to use limit orders.

Almost all term preferreds are callable two to five years after their initial issuance. What does that mean? The company has the right to “call” back the security, paying owners $25 per share in exchange. Because of this, you want to avoid buying issues that are priced well above $25, yet could be called in just a few months.

Every term preferred has a fixed coupon rate. Most pay interest quarterly, though some term preferreds pay out monthly. Because these payouts are higher up the food chain for a company — they have to pay your interest before any common dividends — the payments are much safer than a regular dividend.

Some of the most common issuers of term preferreds and fixed-rate baby bonds are closed-end funds and business development companies (BDCs). Here are two to consider; but a word to the wise — nothing is risk free. It’s always possible things could go amiss, so be sure to do your due diligence before buying.

Gladstone Investment Fixed-Rate Term Preferred Stock (GAINN)

Coupon: 6.50%

Interest Payable: Last Day of Every month

(Note: Ex-dividend dates are around the 17th of each month)

Callable as of: 5/31/2018

Maturity Date: 5/31/2022

Gladstone Investment is a BDC, but it’s a small outfit with “only” $486 million in assets; much of that (74%) is debt investments in smaller companies, though the rest is via equity investments in those same firms (either directly, or via warrants or preferred stock).

While it’s smaller, Gladstone Investment is diversified, with investments in 35 companies in 18 different industries; 19% of its assets are in home and office furnishings, its largest sector stake.

What’s impressive to us from a safety point of view is that this BDC came public more than 10 years ago and has paid 138 consecutive monthly common dividends, even through the Great Recession. 

Plus, as a BDC, they’re subject to asset coverage requirements — Gladstone Investment’s assets are about 2.57 times its total liabilities.

As for income, the firm’s total income is about 4.0 times the combination of its interest payments and dividends paid on its term preferred stock. And, for what it’s worth, the common dividend alone is nearly twice as large (dollar-wise) as the interest and term preferred payments. Plenty of cushion there!

Eagle Point Credit Term Preferred Stock (ECCB)

Coupon: 7.75%

Interest Payable: Last Day of Every month

(Note: Ex-dividend dates are usually two weeks before the pay dates)

Callable as of: 10/29/2021

Maturity Date: 10/30/2026

Eagle Point is a closed-end fund that invests in collateralized loan obligations (CLOs). Please note that these are not the collateralized debt obligations (CDOs) that nearly brought down many big banks during the financial crisis. Conversely, CLOs have a long history of volatile-yet-juicy returns.

CLOs own a collection of senior, secured, floating rate corporate bank loans, and with lots of leverage, too. Thus, Eagle Point itself is almost like a juiced up high-yield bond fund.
Indeed, when high-yield bonds were under duress during the long the energy price collapse, this fund’s net asset value fell from $19.63 per share in November 2014 to as low as $13.02 per share in March 2016, a 34% haircut. (It’s since recovered strongly to north of $17.50 per share.)

However, as investors in the fund’s term preferred stock, that action doesn’t mean much. What counts is the fund’s asset coverage ratio and the cash its investments are spinning off.

For closed-end funds, assets must be at least two times the total leverage (debt plus preferred stock) issued. Eagle Point is even more conservative; the funds’ assets total about $448 million at year-end, compared to just $150 million of total leverage (including $60 million of fixed-rate bonds, and $90 million of its preferred stock)—about three times as many assets as liabilities.

As for income, Eagle Point brought in about $56 million of income in 2016, compared to interest obligations on its debt and preferred stock of about $11 million—a ratio of 5-to-1. Of course, there’s nothing that says Eagle Point can’t increase its leverage going forward, but clearly there’s plenty of cushion here, which spells safety.

Even better, this series of preferred stock just came public last year, and while it has a slightly longer time until maturity (2026), it’s also not callable for a few years (2021), so you don’t have to worry about it getting called away after just a few quarters.

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