Floating Rate Notes to Cope with Rising Interest Rates (Wall St Journal)

Floating-Rate Notes Resurface As Economy Grows Again

By Katy Burne of DOW JONES NEWSWIRES

NEW YORK (Dow Jones)--Corporate borrowers are switching up the composition of their debt sales, throwing more floating-rate notes into the mix to entice investors who believe interest rates may be about to rise sooner and faster than expected.

Nearly $26 billion, or 23%, of the investment-grade bonds marketed in the U.S. so far this year have had floating rates, according to data provider Dealogic, making it the busiest January for so-called floaters since 2007. That compares with $57.4 billion, or 7% of the supply, for all of 2010.

Bankers expect to see more floaters this year for two reasons: Issuers are suddenly comfortable selling them; and investors are eager to buy them to position their portfolios for a potential rise in rates.

"People have had the view for the last year, or year and a half, that short-term rates aren't going higher any time soon, and that is not an environment where you think you can make money on floating-rate debt," said Jim Merli, head of debt origination and syndicate at Nomura Holding Americas Inc.

"Now that is starting to change," Merli added, "because there is stronger economic data, and other central banks outside the U.S. are making noises about raising short-term rates."

Data over the last few months have been supportive of a more bullish outlook on the economy, with more job creation, a rising stock market, and strong corporate earnings over the past two weeks.

"While there are certainly headwinds like unemployment and weak wage gains, the data is far more balanced and the growth camp seems to have the scales tipping in its favor," said David Ader, head of government bond strategy at broker-dealer CRT Capital Group.

To be sure, floating-rate deals account for only a fraction of the market share they had in the middle of the last decade, and the volume outstanding has fallen by 40% since end of 2007 to $428.9 billion now. But issuers are warming up to them again.

Financial institutions tend to be the biggest issuers of floating-rate debt, to bring their funding in line with assets such as floating-rate loans. Financial firms, including insurers as well as banks, have accounted for 63% of the U.S. high-grade issuance in dollar volume so far this year, the highest percentage for any January since at least 1995, when Dealogic started keeping records.

About 57% of that total was from banks, although units of non-financials like brewer Anheuser-Busch InBev SA/NV and energy giant Total SA have recently issued floaters, too.

AB In-Bev's strategy of pairing fixed- with floating-rate debt was "a function of the expected long-term recovery of the economy versus the short-term opportunity to benefit from historically low rates," said Scott Gray, director of global funding and financial markets at the company in New York.

Johnson Controls Inc. was in the market Tuesday with $350 million of three-year floating-rate notes as part of a $1.6 billion deal.

Heavy issuance by foreign banks has also contributed to the rise in these securities. They borrow in the U.S. because investor appetite is stronger here than in their domestic markets. January saw the largest volume of these so-called Yankee deals--dollar-denominated bonds sold by foreign firms in the U.S.--than any other month on record.

"Since the euro markets were less friendly to new issuance, floater deals that would normally have come as euro bonds were instead dollar issues," said Guy LeBas, chief fixed income strategist at Janney Capital Markets in Philadelphia.

Most of the floating-rate debt sold this year has been clustered around two- and three-year maturities, as was the case in 2009. Last year's issuance was more evenly spread between three-, five- and 10-year floaters, helping to stem the pace at which maturing debt exceeded new supply.

There is about $32 billion of floating-rate, Federal Deposit Insurance Corporation-insured bonds under the government's Temporary Liquidity Guarantee Program maturing this year, said LeBas, all of which needs to be refinanced--including $5 billion in the first quarter.

"Given that all the government-guaranteed debt from 2009 is maturing in 2011, banks will be able to issue short-term floaters beyond that maturity cliff," said Justin D'Ercole, head of Americas investment-grade syndicate at Barclays Capital. "As opposed to the last two years, when it would have had the effect of adding to their massive wall of maturities, it now fits into their debt-distribution profile."

LeBas said while there is marginally greater demand for floaters based on concerns about rising rates, investors are better off buying short-dated, fixed-rate debt. If rates rise and the income on the bond resets progressively higher, an investor would win out over time only if rates rise enough to offset the lower income in the early going.

"Rates would have to rise quite rapidly for it to make sense to accept such a low initial coupon," he said.

Last Thursday, ABN AMRO Bank N.V. sold $2 billion of fixed- and floating-rate bonds, with the $1 billion of floaters pricing at 1.77 percentage points over Libor, equivalent to a coupon of 2.07%, and the $1 billion of fixed-rate notes pricing with a coupon of 3%.

"Investors are using these floaters to shorten duration and express their view on the pace of future Fed tightening," said Michael Hyman, head of investment-grade credit at ING Investment Management, who participated in the ABN AMRO deal.

-By Katy Burne, Dow Jones Newswires; 212-416-3084; katy.burne@dowjones.com

Preferred Stock (Wall St Journal)

THE INTELLIGENT INVESTOR
FEBRUARY 5, 2011.
Preferred Stock: Are Those Juicy Yields Worth the Extra Risk?
By JASON ZWEIG..

As the Federal Reserve's low-interest-rate policy has turned the world of income investing into a howling wilderness, one oasis seems to remain: preferred stocks. With yields averaging nearly 7%, preferred shares seem to offer higher income at lower risk than either conventional stocks or the bonds that feel overpriced to many investors.

And the preferred oasis is one hot destination. The iShares S&P U.S. Preferred Stock Index Fund was the fourth-most-popular exchange-traded fund in 2010, returning 14% and doubling in size to more than $6 billion. Last month, it took in another $200 million. Fidelity Investments, Charles Schwab and TD Ameritrade all report rising interest in preferred stock among their brokerage clients.

It isn't hard to fathom why preferred shares might sound appealing. Ranking between common stock and bonds in a company's capital structure, preferred shares have the first claim on dividends. And those dividend yields may be "qualified," or taxable at lower rates than bond income.

But preferred stocks aren't low-risk. Unlike the interest on bonds, the dividends on preferred (as with common) stock can be shut off at will.

During the financial crisis, U.S. regulators suspended dividends on preferred shares issued by such giants as Fannie Mae and Freddie Mac. Many other banks stopped paying their preferred dividends. The Standard & Poor's U.S. preferred-stock index fell roughly 26% in September 2008, three times worse than "junk" bonds. Even in a bull market, preferred stocks are about 10% riskier than junk bonds, reckons economist Eddie O'Neal of Securities Litigation & Consulting Group in Fairfax, Va.

Preferred stock also can be "called away" if the issuer wants to retire it. That caught Stan Aten, a printing-company employee in Dallas, by surprise last year when some of his preferred shares of real-estate operator Public Storage, for which he had paid $25.74, were redeemed by the company at $24.50. Mr. Aten, who had bought a few months earlier, lost about $135. He still buys preferreds, but more carefully. "I should have read the prospectus and realized they had the right to do that," he says.

Also, "preferred stock" and "financial stock" are virtually synonymous. Fully 84% of the assets of the iShares preferred ETF are in financial firms, including Barclays, Bank of America and MetLife. Banks get special regulatory treatment on their preferred shares that other companies don't; outside of utilities, only 6% of nonfinancial firms have preferred stock, according to Standard & Poor's index analyst Howard Silverblatt.

"If you work in the financial sector you should definitely not buy a preferred fund," says Mariana Bush, a fund analyst at Wells Fargo Securities. With your career riding on the health of that financial industry, you shouldn't put even more money in the same place.

Finally, the income on preferred shares can be taxed either at the 15% rate that applies to dividends—or at your ordinary income rate, which can range up to 35%.

Generally, for the income to be taxable at the lower rate, a fund must own the preferred shares for at least 61 out of the 121 days on either side of the dividend date. That could get tricky for a fund whose asset base changes quickly, says independent tax expert Robert Willens. If a growing fund had to buy a lot of preferred shares quickly, or a shrinking fund had to sell them in haste, it wouldn't be able to keep them all for the minimum holding period. That, in turn, could subject investors to the higher tax rate on those dividends.

"Even if you are able to hold for the requisite period, you could be out of luck," Mr. Willens says. "That's because so much is dependent on the actions of other people over whom you have no control"—those who happen to be buying or selling the fund.

The iShares preferred fund has grown steadily and gradually over the past year, rather than in sudden bursts. Portfolio manager Greg Savage agrees that rapid inflows or outflows "can potentially affect the mix" of how the fund's income would be taxed. He adds that "flow impact has been negligible" so far. About 40% of the fund's dividend stream qualified for the lower tax rate in 2010, the same as the year before and the same as the underlying index.

These rules also apply to individuals buying preferred stock directly; sell too soon and you could double your tax rate on your latest dividends.

Preferred investors are pursuing long-term yield, says Rob Williams, director of income planning at the Schwab Center for Financial Research. "Unfortunately, a lot of investors also have short memories."

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Write to Jason Zweig at intelligentinvestor@wsj.com