Safety and a Government Guarantee? High Yield Investing

By Travis Johnson, Stock Gumshoe, October 2, 2008

A big part of the advertising that comes out for Carla Pasternak’s High-Yield 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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12 Comments on "Safety and a Government Guarantee? High Yield Investing"

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Buck
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Buck
October 2, 2008 3:32 pm
Hello Stock Gumshoe, I’ve been reading your posts for quite some time now and i’m wondering if any of these newsletter marketers have ever thretened your life? You know, like when Tucker invented a car that would last 1000 years and the other auto manufacturers had him removed from action. If i was one of these ‘gimiky’ marketers, I would be mighty mad that your are ruining my chances for anyone to subscribe to my little service, to find out what my little stock is that i’m promoting. Sincerely, Buck oh… p.s. stock gumshoe IS THE BEST GUY EVER!!!! Keep… Read more »
idbjls2
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idbjls2
October 2, 2008 5:58 pm

You have made all of us believers of free enterprise. You are the Moses of this industry, Gumshoe. Keep up all the good works! God bless.

Justin
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Justin
October 2, 2008 8:45 pm

I wonder why the newsletter isn’t touting the Preferred A shares as well. They are yielding just below 10%, so buyers are really wary of this company. As you mention to retain their REIT status, they must pay out greater than 90% of earnings, which could disappear at any time.
The Preferreds could also suspend dividend payments but holders would retain the right to collect the unpaid dividends prior to resumption.

However, investors are pricing this almost like a bankruptcy filing is in trhe cards somewhere in the future.
Being higher than the common in a bankruptcy proceeding isn’t exactly comforting either.

Questionit
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Questionit
October 2, 2008 9:29 pm

SGS: As always your articles are great! My question to you and your excellent supportive group who write in, and who all seem rather intelligent about investing/stocks. Do you or anyone else trade in stock options? Who is a good option source/trader/guru.

If you have time..
Thank you
Questionit

John Reynders
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John Reynders
October 3, 2008 7:45 am

Carla Pasternak’s October stock of the month is Hecules Technology Growth Capital HTGC.

Carla
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Carla
October 3, 2008 10:18 pm

You’re good, Stock Gumshoe!

Joseph L. Sexton
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Joseph L. Sexton
October 14, 2008 3:02 pm

So is this a good newsletter or not, I’m interested in dividends, any good newsletter recommendation would be welcome.

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October 2, 2008 4:00 pm

Nothing so sexy as a death threat, I’m afraid — the few I’ve spoken to have actually been quite nice and even, sometimes, supportive. So I must not be cutting into their income too much …

Thanks for the kind comments. Having great readers like you is what makes this all worthwhile, certainly much more fun than watching little red blinking numbers in my portfolio.

Gravity Switch
Admin
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October 2, 2008 8:57 pm
True, the two series are not all that different — though the A shares do yield slightly less and are above their call price already, and there are a lot more B shares out there so the volume is quite a bit higher. The A series do pay quarterly and the B pay monthly, but both have basically similar risk profiles as far as I can tell. And yes, I agree — when you’re levered up 8-to-1 or 12-to-1 the idea of being ahead of the common shares in bankruptcy is not all that comforting. It’s something, but it’s not… Read more »
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October 2, 2008 10:23 pm
Can’t speak for anyone else but I do sometimes speculate in options, or use options to hedge. I don’t use an options service and have never done so, so I don’t have much direct experience with them. I am generally more skeptical of options trading services than I am of stock newsletters — it is extremely hard for most options newsletter subscribers to come close to matching the “paper returns” of options services, due to the relatively large spreads and low volume in most options contracts. That’s true with some stock newsletters, too, and the bigger stock newsletter touts often… Read more »
Questionit
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Questionit
October 2, 2008 11:17 pm

Thanks sgs: as always I respect your input.

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October 3, 2008 8:32 am

Thanks John — that’s definitely not the “income security of the month” she was touting, but I’ll take you at your word that it’s the stock she’s currently recommending to her subscribers.

Hercules, for anyone who doesn’t know, also has a high yield but has a much different business — they mostly do private lending and equity investing, and venture capital, in small tech and biotech companies. Way, way, way far away from AAA, but whether it’s riskier than mortgages is maybe an open question in the current environment.

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