An Assiduous Reader writes in and says:
A question: How does a retail investor hedge out interest rate risk on perpetual preferreds?
Is there any simple, or reasonably efficient, way to do this?
Well … they can’t, really, which is one reason why I recommend that no more than 50% of a fixed income portfolio be in preferreds.
However, investors should be aware that the Modified Duration of a PerpetualDiscount is simply the inverse of its yield (see http://www.prefblog.com/?p=2582). With yields at about 7%, this means a MD of about 14 years. Many investors will blithely purchase 30-year strips while fussing about the interest rate sensitivity of perps.
I’ve written an essay on Perpetual Misperceptions (see http://www.prefblog.com/?p=1308) … there will be many more!
Perpetuals do have interest rate risk and – more importantly – inflation risk, but I suggest this be addressed in the rest of their portfolios; common stock in resource companies, for instance, or a shorter-than-otherwise-indicated duration in their bond portfolios. At one point – I haven’t done the calculation recently, it’s probably even better now – a taxable investor could swap his Universe iShares into perps and Short-Term iShares on a duration neutral basis and pick up a point in yield. (see http://www.prefblog.com/?p=2399)
Wouldn’t a simple investment in real return bonds be the best way to immunize perpetual preferred shares against inflation risk? With shares in resource companies you must take on the business risk of the operating company which could easily overshadow the price movements of the underlying commodities.
Wouldn’t a simple investment in real return bonds be the best way to immunize perpetual preferred shares against inflation risk?
RRBs won’t win against inflation, they’ll just stay even (like short-term bonds). Since perps will do very poorly in an inflationary environment, you need something that will actually win against inflation if you’re going to call it a hedge.
With shares in resource companies you must take on the business risk of the operating company which could easily overshadow the price movements of the underlying commodities.
True enough, but you could buy a resource ETF or mutual fund; even an ETF based on physical commodities would suit the purpose.