Combat Inflation with Floating Rate Securities (Forbes)

Fixed-Income Watch
Inflation Protection For Free
Richard Lehmann, 09.12.11, 6:00 PM ET

I have been pounding the table warning about rising interest rates for some time now. Well, it hasn't happened yet, and the latest Fed pronouncement makes it clear that short- and long-term rates will likely stay low for the next two years. My fear of rising rates caused me to recommend adjustable-rate securities. I was wrong on inflation, but my floating-rate picks have done quite well.

Since 2009 the adjustable-rate securities have enjoyed a spectacular resurgence, because most of them were issued by banks and other financial institutions that suffered huge declines during the financial crisis. These "too big to fail" institutions needed capital, and they issued all kinds of paper to bolster their books.

While fixed-rate issues experienced a similar rise, they are hurt by their call provisions. Specifically, most of the issues with a 5% or higher coupon rate are likely to be refinanced. This means they're trading on a yield-to-call basis with measly returns measured in basis points rather than percentages (100 basis points equals one percentage point). Most are trading above the par value at which they will be redeemed. Those who bought fixed-rate capital note preferreds with high coupons, issued by the troubled banks in 2008, thought they would be safe from call until 2013. Not so.

Congress and the Dodd-Frank Act foiled this seemingly smart strategy. That act says these preferreds can no longer be considered part of a bank's tier-one capital. This triggers a "statutory change" loophole that now allows banks to call these fixed-rate preferreds early. Think of it as Chris Dodd's going away present to his banker buddies.

Adjustable-rate securities normally trade at lower yields than comparable fixed-rate securities. They pay interest monthly or quarterly based on a Treasury bond index, LIBOR or changes in the CPI. The floating rate means these notes are designed to trade at par. But this hasn't been happening. That is because these securities come with an interest rate floor, typically at about 4%. When these bonds were issued that was considered meager. Today a 4% yield is a king's ransom.

Despite the healthy yield floor, most of these adjustables are selling below par today because they are viewed as inflation hedges in a period when inflation fears are absent. Thus you can still buy these adjustable-rate securities below par value. That is like getting a dollar for 90 cents. Hence, inflation protection is free, and the call risk is a positive. Once inflation fears are rekindled and rates spike, you'll be all set with these floating-rate securities.

Here are some adjustables you should consider buying:

AEGON NV SERIES 1 (AEB, 17) PERPETUAL PREFERRED RATED BAA2/BBB/BBB. This Dutch multi-line insurance giant was hard-hit during the financial crisis and still suffers under the weight of European banking concerns. This preferred is adjustable quarterly based on three-month LIBOR plus 87.5 basis points. It has a 4% floor and no ceiling, so at its current price it yields 5.71%. Even better, it's eligible for the 15% qualified dividend income tax rate for those in the highest tax bracket.

Closer to home I like GOLDMAN SACHS SERIES A PERPETUAL PREFERRED (GS A, 19) RATED BAA2/BBB–/A–. It has a floor rate of 3.75% and no ceiling and is tied to three-month LIBOR plus 75 basis points. It yields 4.93%, and it also benefits from the preferable tax rate on dividend income.


If you are willing to accept more risk buy the SLM CORP. 0% OF 3/15/17 (OSM, 21) RATED BA1/BBB–, yielding 6.15%. SLM is better known as Sallie Mae, the student loan organization, which went private in 2004. This adjustable is different in that it pays monthly, based on the percentage change in the year-over-year Consumer Price Index, plus 200 basis points. It has no floor or ceiling rate and currently pays 5.164%. I like it because there is no delay in recognizing an uptick in inflation, but unfortunately it isn't eligible for lower tax treatment.

I thought rates would climb because the Fed would use inflation as its primary tool in curing our economic woes. Bernanke flooded our economy with dollars, but inflation failed to materialize. Our economy was much weaker than I thought. Dark clouds still hang over global markets. While inflation is not an immediate concern, it can and does crop up when it's least expected. Given the current international turmoil and clearly nervous markets, investments offering inflation protection at no cost are a gift I find hard to resist.