Thomas Grzymala, an Alexandria, Va.-based CFP licensee, says he would consider high-quality adjustable rate preferred stock if there is a strong interest rate trend. "I have not used them yet," he says, "but with rates changing, they are a desirable vehicle for an income portfolio. I would also diversify into REITs and GNMA bonds."
Others say institutional investors either are creating short-term bond ladders or investing based on the shape of the yield curve rather than parking cash in adjustable rate investments. "Adjustable rate preferred could be a small part of a portfolio," says Thomas Scharski, vice president of institutional sales with the Cambridge Group, East Lansing, Mich. "Their yields are too low based on the credit risk. Investors are concentrating on bonds. They are higher in the pecking order and there is less credit risk."
Jack Colombo, editor of incomesecurities.com, says the 2% yields on adjustable rate preferred stocks are not worth the price. "Interest rates would really have to jump for ARPS (adjustable rate preferred stock yields) to rise," he says. "Many have caps that limit how much they can pay."
Colombo recommends that advisors diversify bond portfolios by investing in high coupon preferred stock. The higher coupon issues will decline less in value as interest rates rise.
Colombo also recommends the closed-end Flaherty & Crumrine Preferred Income Opportunities Fund. The fund yields 7.8%, and 65% of assets are invested in adjustable rate preferred stock and fixed-rate preferred, some of which are hedged.
On the adjustable rate mortgage side, Morningstar's Berry says that investors should avoid investing in individual adjustable rate mortgage bonds. They are better off in a diversified mutual fund. The reason: ARM prices can decline if interest rates rise quickly, particularly on bonds with interest rate caps. In addition, there is some prepayment risk if homeowners refinance their mortgages.
"If rates rise quickly, there are adjustable rate mortgage bonds with rate caps that do not track with rates," he said. "Last summer the AMF and Evergreen funds declined in value when interest rates spiked."