December’s “Income Security of the Month”

by Travis Johnson, Stock Gumshoe | December 10, 2008 11:13 am

A big part of the advertising that comes out for Carla Pasternak[1]’s High-Yield Investing[2] is by way of their writeups on the “income security of the month” — and, as she has done this month, she often recycles these ideas … it looks like today’s “Income Security of the Month” was also the income security of the Month for October.

Times are tough, everyone’s cutting back — so no need to hire another copywriter if you’ve got a perfectly good sales letter sitting around!

Some of the comments below first appeared in this space back then, which now seems a lifetime ago, but I’ve added some more info and done some updating.

“These special hybrid securities not only provide strong returns during market turmoil thanks to the ‘AAA’-rated portfolio of their parent company — they also provide unlimited upside potential since the shares are convertible at any time into stock of the underlying company.”

So we’re told that she has for us a “Hybrid Security [that] Provides Stable, Legally-Bound Monthly Payments and a 10.3% Yield.”

In this case, what she means by “hybrid” is a convertible preferred stock — a hybrid security that sometimes is considered debt and sometimes equity, which has set preferred dividend payments and a stronger position than common equity (meaning that their dividends[3] 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 44.2% over the past year. That’s certainly better than I’ve done. (It has also handily beaten the market over the last couple months, since she last teased us about this same investment — it’s up about 6%).

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 97% of the stocks in the S&P 500 during the past twelve months.”

(back in October, this had outperformed 90% of the market … that other 7% were apparently the final holdouts that collapsed late this year)

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 still be …

Capstead Mortgage Preferred Series B (CMO-B)

Capstead continues to match the clues — NYSE traded convertible preferred, yield of about 10%, holds 99% AAA securities … but it’s feasible that there are other convertibles for mortgage REITs[4] that are comparable that I didn’t find. The shares have had a nice run recently with the rest of the market, so the yield is now down to 9.7%, but still certainly quite nice.

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[5], 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 traded at $12.20 when I wrote about then in October, and are now up over that redemption price at about $12.75. They’ve also updated the conversion ratio — you can now convert your preferred shares to common shares at a rate of 0.6047, though that’s still far from profitable. Conversion seems very unlikely to make sense unless the common stock spikes up by 100%, and in that case the company could still redeem your preferred shares at $12.50 so you could have any potential upside pulled away from you.

Capstead can choose to redeem these preferred shares at $12.50 anytime (there are probably rules covering that conversion, read the prospectus if you’re worried about the details, or at least read the company’s summary here[6]), 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 about 20%) so redeeming them by issuing equity probably wouldn’t make much sense at the moment. And getting debt might be quite tough.

These preferred shares are very likely trading primarily on the dividend and the potential redemption, but it’s true that the company is built around that big portfolio of Fannie Mae and Freddie Mac[7] AAA mortgage bonds, so 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[8], 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 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 … this is one of the strongest performers in the market over the last year, though all that means is that the stock has held at just about unchanged for 12 months, which is all it takes to beat the S&P 500 by 44%. Interested?

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