Stock Gumshoe

A big part of the advertising that comes out for Carla Pasternak’s High Income Investing is by way of their writeups on the “income security of the month” — I’ve looked at a few of these in the past, but it’s been a while, so now seems like as good a time as any to dig in again.

We’re told that she has for us a “Hybrid Security [that] Provides Stable, Legally-Bound Monthly Payments and a 10.1% Yield.”

Sounds pretty nice, no? 10% seems to be a magic number — that’s what Warren Buffett is getting for the preferred stock he bought from GE and Goldman Sachs in recent weeks, so why shouldn’t it be good enough for us mortals?

In this case it’s also a preferred stock, though a convertible one. A convertible preferred stock is a hybrid security, sometimes considered debt and sometimes considered equity, which has set preferred dividend payments and a stronger position than common equity (meaning that their dividends have to be paid first, and that they’re ahead of stockholders in the line for consideration in bankruptcy court, though they’re behind the bondholders). Usually preferred stock is held for income, though the convertible nature generally means that you also get some potential upside if the equity takes off.

So, assuming that you’re interested in a 10% yield and some level of safety (in her words, at least), what is the actual preferred stock Carla is hyping this month?

We get some clues:

It pays those dividends monthly (this is very unusual for preferred stock, almost all pay quarterly or semiannually).

It has beaten the S&P 500 by 34.5% over the past year. That’s certainly better than I’ve done.

The preferred shares are listed on the NYSE

And this:

“The parent company of our “Income Security of the Month” invests exclusively in the most secure investments on the planet — 99% of its portfolio is in securities with credit ratings of “AAA.” Thanks in large part to this strategy, the preferred shares have outperformed 90% of the stocks in the S&P 500 during the past twelve months.”

So … for some of that there are a few different companies that could fit the bill, but given that they pay monthly and have a 99% AAA portfolio this must be …

Capstead Mortgage Preferred Series B (CMO-B)

This is one that I’m fairly certain of, but I’m not quite 100% certain — Capstead does match the clues — NYSE traded convertible preferred, yield of about 10.1%, holds 99% AAA securities … but it’s feasible that there are other convertibles for mortgage REITs that are comparable that I didn’t find.

Here’s the description of this issue from QuantumOnline (which I always recommend for those in search of income securities):

“Capstead Mortgage Corp., $1.26 Cumulative Convertible Preferred Stock, Series B, liquidation preference $11.38 per share, redeemable at the issuer’s option on or after 12/17/1997 at $12.50 per share plus accrued and unpaid dividends, with no stated maturity, and with distributions of $1.26 per annum paid monthly on the last day of each month. The Series B preferred shares are convertible any time at the holder’s option into 0.5935 shares of common stock.”

These preferred shares currently trade at $12.20 and the company can choose to redeem them at $12.50 anytime they choose, so if Capstead decides to they can always raise debt or equity at less than 10% and buy out these preferreds, and show a profit for that. I have no idea what the likelihood of this is, but they do currently pay a much higher rate on the common stock (the common stock yields close to 20%) so redeeming them by issuing equity probably wouldn’t make much sense at the moment.

And they are technically convertible, but the price of the common stock would have to come close to doubling for that to be worth it — so these preferred shares are very likely trading primarily on the dividend and the potential redemption, which means I would be surprised to see the preferred shares move much above $12.50 unless the common stock goes up much more dramatically. If the current environment holds, it might just remain a nice, steady monthly 10% yield — not bad.

Capstead is a mortgage REIT, very similar to the better-known Annaly Mortgage — they borrow money at short rates and buy government-guaranteed mortgage bonds with slightly longer terms from Fannie Mae, Freddie Mac, and Ginnie Mae. All of those have the backing of the US government, so yes, Capstead’s portfolio is 99% AAA-rated, and they generally focus on buying adjustable rate mortgage bonds that give them some protection against rising short term interest rates on their borrowed money.

I would probably look at these preferreds before looking at the common stock, even though the common is cheap and has a high dividend — the credit markets are so wildly unpredictable right now that the perceived “safety” of the preferred might be worth the lower yield and reduced capital gains upside.

So what’s the downside on Capstead? Well, if you look at the common equity dividend history you’ll see a very bad year in 2006 — that’s because of the inverted yield curve. Though they try to match up their maturities to some degree, they do essentially borrow short and lend long, and they use very high levels of leverage, borrowing 8-10 times their equity. That means they need a decent gap between the rates they have to pay to borrow short term money, and the rates they can earn on longer term mortgage bonds. When the yield curve inverts and short money is more expensive than long money, they lose money.

That means there might be some concern in the current environment — I haven’t looked in detail at the way they structure their debt and their portfolio, though I did note that they have cut down on leverage a little bit, but with the money markets seized up it might be that they have to pay more than they expect for those 3-6 month loans that they rely on to leverage up their bond purchases. If it works as planned, they do get a nice return on equity of close to 20% thanks to the leverage they use, but, as with all leveraged companies, if it doesn’t work out as they planned it can turn fairly quickly and earnings can almost instantly disappear.

I’m no expert on mortgage bonds, and even an expert would probably throw up his hands at this environment and tell you to watch the House of Representatives and buy a crystal ball, but at least the preferred stock has a set dividend that doesn’t directly depend on current earnings. The common stock, which is a REIT, just pays out their 90%+ of income; the preferred pays out $1.26 a year.

So … feel like getting involved, even at arm’s length, with a mortgage trader?

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The author will always disclose any direct long or short equity, debt or option position in any stocks written about as of the day of publication, and will not trade in any stocks mentioned for three days (72 hours) after publication. Full disclaimer is at the bottom of the page.