Locking in Income for When Rates Rise

09/01/2009 1:00 pm EST

Focus: FUNDS

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, editor of the Forbes/Lehmann Income Securities Investor, favors the floating-rate notes of the banks deemed too big to fail.

For several months now I have been advocating that investors allocate a portion of their portfolio to adjustable rate or floating rate securities. Having followed this advice for my clients, I realize that this is easier said than done. This is because there are a myriad of adjustment options that offer different degrees of protection. The purpose of such securities is to protect the principal by adjusting the yield sufficiently so that the security will always trade at or near its par value. The interest payout, or benchmark rate is usually monthly or quarterly and is calculated based on an index such as three-month LIBOR, the CPI or a composite treasuries rate. Added to these adjustments is a fixed minimum amount usually based on the credit rating of the issuer.

When such securities trade below par it is usually because the security is trading at its floor or minimum yield and the benchmark yield, where there is no floor, is significantly lower. The financial crisis has introduced a new element in the pricing of these securities, namely a concern as to credit quality. This is because the majority of these “floaters” are issued by financial institutions, all of which are just now coming out from under a cloud. Hence, their yields tend to mirror the inflated yield on the fixed-rate securities of the same issuers, meaning that the adjustment option comes to you for relatively lower cost than comparable issues of companies in other industries. This is particularly fortuitous since we don’t know today how soon an inflation spiral is likely to begin, so we are reticent to forgo too much current yield.

My focus has been on floating rate securities in the financial sector issued by institutions which are being propped up by the government or which don’t need any propping but still meet the ‘too big to fail’ criteria. My favorites here are Goldman Sachs (NYSE: GS A; GS B; GYB), Morgan Stanley (NYSE: MS A), JPMorgan Chase (NYSE: GJN), and US Bank (NYSE: USB H). While most of these securities are trading well below their floor rate, which means they offer no protection until rates rise to that floor rate, they still offer value in that they sell at significant discounts to par value.

When shopping for these types of securities, look out for the following negative factors:

  • No floor rate or a floor below 2%.
  • A ceiling rate below 7%.
  • A benchmark rate that is only calculated annually or even less frequently
  • A near-term call provision and trading near par.
  • An issue priced near par and trading at its floor rate
  • Newer issues which are due to reset downward in the near future
  • Issues that reset to specific fixed amounts and have call provisions

Those who want to short cut the selection process may want to consider buying the PIMCO Floating Rate Income Fund (NYSE: PFL) fund. This fund would be a good stabilizer for a medium- or low-risk portfolio. Buy at or below $9.50. [Shares closed at $10.64 Monday—Editor.]

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