By Carla Pasternak, DividendOpportunities.com
Companies are sitting on record amounts of cash. Default rates on corporate bonds — even for companies with questionable credit that pay high yields — are plummeting.
So why did I just tell my High-Yield Investing subscribers to watch out?
There’s a danger lurking in the market. A danger that only comes up when there’s a perfect mix of low interest rates, cash-rich companies, and yield-starved investors.
Let me explain…
Back in February 2009, I bought US Cellular 7.5% Senior Notes. At the time — the height of the downturn — they traded at just over $17 each, despite having a par value of $25. (Par value is the face value of the note, at which companies can buy them back from investors.)
While the market was scared, there was an opportunity. In the roughly two years I held the bonds, they paid $4.72 each and the price soared back above the $25 value.
High-Yield Investing subscribers who bought and sold with me ended up making more than 68%… on a bond… in a little over two years.
So what’s the problem?
Just a few weeks ago, these notes were called. Not only did we lose our solid income stream, but the notes were trading slightly above their par value. That means when they were called at $25, investors who bought above that mark were hit with a capital loss.
I’m seeing this happen more and more. Income investors are starved for safe income and have piled into bonds, pushing prices up.
At the same time, companies are sitting on massive cash deposits and seeing record-low interest rates. They are taking the opportunity to buy back outstanding debt and refinance at lower rates.
This all means investors buying bonds and other callable securities over their par value need to be careful. It’s getting more common for these securities to be called back, leading to a possible loss if you paid more than par.
But that’s not the entire story.
A little known amendment sponsored by Senator Susan Collins to the Dodd-Frank financial reform bill affects one popular type of preferred stock banks issue, called trust preferreds.
The Collins amendment says banks with more than $15 billion in assets soon won’t be able to use trust preferreds to contribute to their Tier 1. (Tier 1 capital is the cash reserves a bank must keep to safeguard against problem loans.)
Banks aren’t required to redeem their trust preferreds. However, they may wish to because the securities will no longer count as Tier 1 capital and also because they can issue new debt at much lower rates today.
And they don’t have to wait until the stated call date. Instead, the banks can claim a legislative change provision has been triggered in their prospectus, allowing the trust preferreds to be called anytime.
Bottom line: If you hold — or are looking to buy — any security that can be called and is trading above par value, make sure the income it pays is worth the risk of owning right now, even if the shares were called back tomorrow.
Good Investing!
Carla Pasternak’s Dividend Opportunities
P.S. — For more income advice, be sure to view the webcast my colleague Dan Moser recently put together about some of the market’s highest-yielding stocks. He calls it “Why Buy a Stock Yielding 2% When You Can Buy One Paying 26%?” Click here to watch.
