Fixed Income Substitutes

Preferreds, including Contingent Convertibles (CoCo’s) bonds and other junior subordinated
Most preferred shares and their kin are issued by financial companies, most often banks. Twenty years in the financial industry has made us healthy skeptics regarding the value banks give to their assets. These assets are neither adequately defined in public filings (legacy CDOs as one primary example) nor, especially when held for investment, properly valued on the balance sheet (e.g., second liens on underwater homes). Thus, often the discount to tangible book value signals less of an out of favor sector than a mispriced balance sheet. The opaqueness of bank balance sheets is even more acute in the third world, especially China.

To avoid simply underweighting the sector, we prefer to overweight credit within fixed income (where financial firms are heavy issuers) and invest in bank issued preferred shares when the sector is out of favor. The heightened regulatory environment and resulting lower leverage ratios also benefits their credit over their equity. Lower returns on equity, even when resulting from lower leverage, are never good, but the resulting lower volatility at least increases the chances that the bank will pay its preferred dividend and bond coupon.

Preferred shares are much less liquid, though, than equity. Most preferreds are also callable subjecting the investor to negative convexity, and some don’t qualify for the lower taxes associated with dividends. We thus try to invest in those preferreds trading at a discount to their call price.

Real Estate Investment Trusts (REITs)
The balance sheets of REITs can be likewise opaque, plus REITs come with high fees. As equity in real estate, they also share similar volatility with equity, especially in distressed markets. With that said, occasionally you can make educated guesses as to the value of their underlying assets and like the second half of 2013, public REITs can trade at significant discounts to their book values. Given the hurdles mentioned, though, we typically look for at least a sizeable discounts to a realistic book value before purchasing or gain our exposure by buying their preferred versus equity shares.

High Yielding Stocks, Convertible Bonds, Master Limited Partnerships (MLPs), etc

Just as REITs exhibit similar volatility to stocks and thus as a sector do not provide the same diversification benefits as bonds, high yield stocks, convertible bonds and MLPs are also less than perfect substitutes for fixed income. We are agnostic to the dividend yield of stocks, preferring other more proven measures of value. As we discuss in our article on stock buybacks, an investor can be happy the firm isn’t hoarding cash whether it pays a high dividend or buys back stock if there are no better uses for the money. On the flip side, an investor can also be happy the firm is finding good uses for the cash and investing it accordingly. We do pay attention to the dividend yield, though, when allocating stocks between tax-deferred and taxable accounts. See section on Efficient Use of Tax Deferred Accounts.

Most convertible bonds are simply a combination of equity (warrants for equity to be exact) and bonds. They can no doubt trade cheap when compared to their underlying components, but plenty of hedge funds exist to arbitrage that differential leaving few if any opportunities for retail investors. (Of course, it’s not clear whether enough opportunities exist even for hedge funds to justify their fees.) We prefer to gain the same economic exposure as convertibles by buying combinations of equity and bonds which in turn allows us to tax-efficiently allocate across tax-deferred and taxable accounts (again, see section on Efficient Use of Tax Deferred Accounts.

MLPs are most often investing in a stream of payments typically linked to energy transportation (especially natural gas) via pipelines. As such, they can at least offer added diversification. Like a REIT, though, the fees paid to the general partner can be high and increase as assets grow, which isn’t always in the best interest of the investor. More, as a limited partnership, the tax liabilities can be complex. We thus maintain only a limited exposure, with a bias to keep “unrelated business taxable income” under the $1,000 threshold so they can be held in tax-advantaged accounts.