February 22, 2014 The Difference

Risk/Reward Vol. 209

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

"It ain't that I'm too big to listen to the rumors
It's just that I'm too big to pay attention to 'em
That's the difference."---lyrics from "What's The Difference" sung by Dr. Dre

"I'll make a wish/Take a chance
Make a change/And breakaway."---lyrics from "Breakaway" sung by Kelly Clarkson

"I've been working on the railroad/All the live long day
I've been working on the railroad/Just to pass the time away."---lyrics from "I've Been Working On The Railroad" sung by Everybody

Comprehending yield spreads (discussed at Vol. 207 www.riskrewardblog.blogspot.com ) necessitates learning "the difference" between interest rate risk, which is a relative number, and credit risk which is an absolute (although not a constant) one. Last year when the the interest rate on the benchmark 10 Year Treasury Bond spiked from 1.6% to nearly 3%, the interest rates on securities priced or "spread" in relation thereto (such as preferred stock and real estate investment trusts) spiked similarly causing their prices to fall accordingly. (Remember, when interest rates increase, prices of the underlying securities decrease.) The risk of this occurring is called interest rate risk, and one must always "pay attention to it". On the other hand, credit risk is the risk that an obligor will default on an obligation---like back in 2009 when, if one had "listened to rumors," one reasonably could have concluded that the major banks would suspend dividend payments on their preferred stock. (Sixty percent of preferred stock is issued by banks.) After all, most major banks had suspended payment of common stock dividends. Fear of this occurring (and it did not occur) caused the price of preferred stocks to plummet, and their yields to spike. Those who bought preferreds in this trough have reaped bountiful rewards as major banks have rebounded (e.g. 400% price appreciation plus 25% annual dividends).

I believe preferred stocks are again ready for a "breakaway" to the upside. This belief is not "a wish." It is based upon my study of credit risk and is something upon which I have "taken a substantial chance." Allow me to explain. Prior to the 2008-2009 banking crisis, the difference between the yield on the benchmark 10 Year Treasury Bond and the yield on investment grade preferred stock hovered around 2.4%. This difference reflected the premium one received for shouldering what the market perceived as the risk of default on these preferreds. Thus, if the prevailing 10Year rate had been 2.7% back in 2007 (as it is today), the prevailing yield on an investment grade preferred stock would have been 5.1% (2.7% + 2.4%=5.1%). At the height of the banking crisis, the spread between the yield on the 10Year and the yield on an investment grade preferred stock spiked as high as 13% reflecting the above described fear that payment of dividends would be suspended. Since 2010 this spread has come to rest at around 4%. The recent issuance of JPMorgan's Series T preferred shares which pay a 6.7% dividend based an issue price of $25 exemplifies this spread (2.7% 10YearTreasury yield + 4% spread=6.7%). To me, continuing a 4% credit risk spread given the financial strength of investment grade banks is no longer warranted. In other words, the credit risk premium is overblown, and the market may be ready to "make a change" by migrating back toward the historic spread of 2.4%. This, of course, would mean a commensurate rise in prices. A quick glance at all of the green on the far right hand column of the preferred stock closing table indicates that my belief may be correct (http://online.wsj.com/mdc/public/page/2_3024-Preferreds.html ). I am using several preferred stock closed end funds (e.g. FFC, HPF and PDT) and some individual issues as vehicles for this play.

The resurgence of domestic oil production impacts our economy in a positive way "all the live long day". Look at what it has done for those who "have been working on the railroad." In 2008, only 9500 carloads of oil were transported by rail: last year over 400,000 carloads were transported. This equates to over 800,000 barrels of oil per day. Railroads and those that supply them no longer need to merely "pass the time away." Take Trinity Industries (TRN), a multi line manufacturer. One of its business units is the largest supplier of oil tank rail cars in the U.S. On Thursday TRN reported record sales of over $4billion dollars. More importantly, it reported a $5billion order back log in its rail car division alone. The stock spiked that day and is up 16.6% since I bought it on January 22, 2014.

In a four day week, the Dow Jones Industrial Average traded in a narrow range, ended down 51 points and remains 2.68% to the negative for the year. The yield on the 10Year likewise moved only slightly ending the week at 2.73%. This rate stability played into my fixed income strategy. Preferred stock, business development companies and real estate investment trusts all gained ground as investors are becoming progressively more comfortable with the prospect that the 10Year rate will stay below 3% (interest rate risk) and with the financial strength of the underlying institutions (credit risk). Like Kelly Clarkson, I've been waiting "For A Moment Like This." May it continue for a long time.