ARPs: Keeing up with Rising Rates

04/29/2005 12:00 am EST


Roger Conrad

Chief Analyst/Managing Partner, Capitalist Times

"The best defense against rising interest rates is a rising yield," says utility expert Roger Conrad. "One area we particularly like is adjustable rate preferred stocks, which boost their distributions quarterly—in some cases monthly—to keep pace with rate swings."

"When rates are falling, the payouts from adjustable rate preferreds (ARPS) can be reduced. However, after five years of dropping interest rates, yields have bottomed. And with rates starting to rise, ARPS payouts are following suit. ARPs are relatively scarce. Most were launched either in the 1980s or early 90s, when volatile interest rates created demand for them. Consequently, the float will be less than a typical stock, and a relatively minor amount of buying can move the price.

"Improving credit quality is extremely important, particularly for preferreds that have no fixed maturity date. We also want to see an investment grade credit rating of at least BB+ from S&P. Call prices and dates are critical, since companies may call them to save interest charges. And monthly dividend payments and adjustments are best, though quarterly is frequent enough to eliminate most rate risk. Here, we offer a basket of six ARPS that best meet these criteria:

Dominion Resources Floating Rate 5/15/2006
Entergy Gulf States Series B
HSBC USA Adjustable Rate (HBA-D  NYSE)
Lehman Brothers Holding PIE (GIZ NYSE)
Northern Indiana Public Services Adjustable Rate Series A (NI-A   NYSE)
UBS Preferred Funding Trust IV Variable Rate (UBS-D  NYSE)

"Two of these are already in our portfolio, Dominion Resources and NiSource. The rest are improving credits. Entergy is the country’s No. 2 nuclear energy producer and a strong power utility based in the Southeast. HSBC, Lehman, and UBS rank among the most solid global financial institutions. All are solidly rated credits, with improving stature. The specific provisions of each ARPS vary somewhat. Dominion’s floating rate security is actually a bond due May 15, 2006. As a result, it’s doubly protected from rising interest rates by an adjustable distribution and a limited maturity. The exact yield is pegged to the same LIBOR rate that sets many loans.

"The ARPS from Entergy, Lehman Brothers, and UBS are considerably longer-dated, with the first allowable call dates in 2008-09. All three trade slightly above the call price. But even in a worst case, they’ll continue to pay high dividends until that point, they offer little credit or interest rate risk. We recommend buying all six of these floating rate securities at the following prices: Dominion Floating (1010), Entergy Gulf States (53), HSBC (25.25), Lehman Brothers Holding (26), Northern Indiana Public Service A (50), and UBS Preferred (26)."

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