Cabot Dividend Investor Issue: October 12, 2022

Bonds are Back

It’s a bear market. The S&P 500 is down 24% so far YTD. That’s the worst performing year for stocks in a long time. And things are likely to get worse before they get better.

Inflation isn’t going away. It’s still at the highest level in 40 years. The behind-the-curve Fed has pledged to aggressively raise rates to tame inflation even if it causes a deeper recession. A soft landing is highly unlikely, and a recession seems increasingly inevitable.

Investors can’t get over that torrent of bummers. Buying the dips hasn’t worked. Four times this market rallied more than 5% this year only to pull back to new lows. Eventually, stocks will bottom, and a new bull market will begin. But maybe not for a while.

That said, there is good news amidst the carnage for income investors. Interest rates have soared to the point that bonds and other fixed-rate investments actually look good again. The benchmark 10-year Treasury rate has risen from just 1.5% at the beginning of the year to about 4% today. That’s the highest rate in more than a decade.

Interest rates are decent for the first time in a long time. Fixed-rate investments are no longer offering a measly 2%. Some investment grade bonds and other fixed-rate investments are now yielding 5% or 6%. A crucial element of a portfolio is viable again after a decade in the wilderness.

Historically, bonds and other fixed-rate investments have been a safe port in the storm during bear markets. They typically maintain their value while providing an income at the same time. Having a fixed-rate element in a portfolio lowers overall risk and downside and makes it easier to stay invested in down markets.

Of course, a reasonable case can be made that rates may go higher still. That’s bad for bonds in the near term as the values decrease when rates rise. It’s already been one of the worst years on record for bonds amid spiking interest rates. And there may be more pain in the months ahead. But consider the longer term.

Bonds are typically longer-term investments than stocks. They’re income and diversification vehicles, not trading vehicles. While rates could certainly spike higher in the near term, it is far less likely that rates average higher than today’s level over the next five years or so.

It’s true that interest rates have been far higher than today in past decades. But the world has changed. The government will be reluctant to tolerate much higher rates with $31 trillion in debt. It’s as bad or worse in many other countries. The rate increases so far are already driving the U.S. and global economy into recession. Sure, this might not be the bottom. But it should be a good move for the longer term to lock in rates at a 12-year high.

In an otherwise miserable year of nonstop inflation, recession, the Fed, and a bear market, an opportunity is emerging for opportunistic investors. Attractive rates on conservative fixed-rate investments have reemerged. There is a chance to lock in rates not seen since the decade before last.

In this issue, I highlight an investment grade rated fixed income security that currently yields nearly 6%, and the income offers tax advantages to boot.

What to Do Now

In one of these monthly issues, I will point out the fact that bear markets present a huge opportunity for investors to buy stocks at bargain prices ahead of the next bull market. But not this one.

It’s true that the market trends higher over time and bull markets tend to last much longer and deliver far more upside than bear markets. A bear market is a golden opportunity for longer-term investors. But, given the nature of the current problems, there remains a high probability of further downside from here.

Earnings could provide a reprieve in the next month and beyond. But they could also be a problem as the economy is likely catching up to corporate profits. There still isn’t a light at the end of the tunnel where the end of Fed tightening is visible, and the market and economy can recover.

The selling has become more widespread as stocks that had performed well this year got clobbered too. Utilities and REITs have been the worst performing sectors over the past month. The problem is rising interest rates. Competing income investments become more attractive and these stocks lose appeal, even if they have defensive businesses that can well endure the increasingly inevitable recession.

There have been few safe havens in the portfolio over the last month, with the exception of Eli Lilly (LLY) and AbbVie (ABBV). The continuing downside risk has prompted a downgrade in several portfolio stocks this week and the current market favors momentum over fundamentals.

The few remaining BUY-rated positions are the midstream energy companies including Enterprise Product Partners (EPD), ONEOK (OKE) and The Williams Companies (WMB). These stocks offer sky-high yields that should insulate them from higher interest rates as well as strong industry dynamics that should continue to buoy earnings.

Monthly Recap

September 14
Purchased Medical Properties Trust, Inc. (MPW) - $13.79

September 28
Reality Income (O) - Rating change “HOLD” to “BUY”

October 12
Medical Properties Trust, Inc. (MPW) – SELL 1/2Broadcom Inc. (AVGO) – Rating change “BUY” to “HOLD”Qualcomm Inc. (QCOM) – Rating change “BUY” to “HOLD”Buy U.S. Bancorp 4.5% Depository Shares Non-Cumulative Perpetual Preferred Stock (NYSE: USB-PS)

Featured Action

Preferred stock is a class of ownership in a corporation that has features of both stocks and bonds. Here’s how those features break down.

It’s like a bond in these regards.

• Fixed payment
  Preferred stocks generally offer a payout in the form of a dividend that is a fixed amount and never changes.
  

• Less volatile
  These investments are not nearly as volatile as stocks. The price stays relatively steady compared to stocks and the price chart generally is a relatively flat line.

• Senior to common stock
  In the event of a bankruptcy, preferred shareholders must be paid before holders of common stock. Plus, in the overwhelming majority of cases, common shareholders cannot receive dividends until after preferred shareholders have been paid.

• Interest rate sensitivity
  As an investment vehicle that pays a fixed amount in dividends, they are sensitive to changes in interest rates. When rates go higher, the price has downward pressure and vice versa.
  
• Ratings
  Preferred stocks carry ratings from major rating agencies to reflect the creditworthiness of the investment.
  
• Callable
  The stocks are usually callable, five years after issuance, and are callable in perpetuity from that date forward.

It’s also like a stock.

• Dividends
  This is an important feature. Most preferred issues have fixed payments that are classified for tax purposes as dividends and not interest. Bond interest is taxed as ordinary income but dividends are only subject to a maximum tax rate of 15% or 20%. This fact makes the after tax income of preferred stock higher.
  
• Liquidity
  Exchange traded issues can be bought and sold at a quoted price any day the market is open. Most bonds are not sold on exchanges and the price is not openly disclosed. In addition, most preferred issues sell in bite size $25 denominations where any quantity of shares can be traded. Bonds are usually sold in $1000 increments with minimum purchase amounts of $5,000, $10,000 or $25,000.

A key element of preferred stocks is diversification. Historically, there has been little correlation between the performance of preferreds as a group and the stock and bond markets. They represent a great way to not only get a high income but lower overall portfolio risk at the same time. There are also ways in which preferred stocks are superior to both stocks and bonds.

The main advantages over bonds are liquidity and tax advantages. Bonds can be hard to buy, especially at a designated price. Preferred shares are very liquid and can be bought and sold anytime the market is open. It’s also a huge benefit that most preferred stock payments are classified as dividends and are subject to a maximum 15% (or 20% is some cases) tax. Bonds interest is taxable at ordinary income tax rates. Most investors get a higher after-tax return from preferred stocks.

Buy U.S. Bancorp 4.5% Depository Shares Non-Cumulative Perpetual Preferred Stock (NYSE: USB-PS)

U.S. Bancorp (USB) is the fifth largest bank in the United States and the country’s largest regional bank with over 3,000 bank branches in 25 states in the Western and Northern U.S. The Minneapolis bank was founded in 1863 and now has more than 70,000 employees and $543 billion in assets.

The bank offers a wide range of services. There are four main divisions including consumer and business real estate banking, corporate and commercial banking, wealth management services and payment services. That probably sounds more complicated than it is.

Like most regional banks, revenues are generated primarily from net interest income (NII), which is the rate spread between the cost of money and the loan interest charged to customers. Half of the loan volume is to businesses with the rest primarily from residential mortgages and personal loans. The rest of the revenue is derived from banking fees, which provide steady income and valuable diversification during hard times.

That’s important to note because we’re not buying the common stock. The timing probably isn’t great for the common shares because profits tend to slow during a recession as loan volumes decrease. The preferred shares are simply dependent on the company’s ability to continue to make the payments.

This is one of the best run banks in the country with peer-leading return on assets (ROA), return on equity (ROE) and efficiency ratios. The high level of fee income also provides a big measure of stability that other banks don’t have. USB is one of the very few banks that remained profitable through the financial crisis, and recently the pandemic.

These shares have investment grade ratings that are higher than those of the preferred shares of the other major banks: Baa1 by Moody’s and BBB+ by Standard and Poor. The issue pays a fixed dividend, that doesn’t change, four times per year on 1/15, 4/15, 7/15, and 10/15. Payments total $1.125 per share which translates to a yield 0f 5.9% at the current price.

There is another important aspect of these preferred dividends. They qualify for the 15% maximum tax (or 20% in the highest bracket) unlike bond interest, which is taxable at ordinary income tax rates. That’s a big difference which makes these shares’ take home income higher than a bond with the same percentage interest.

This is a fairly recent issue that IPO’d on February 2, 2022 at 25 per share with a coupon rate of 4.5%. The shares are currently selling at less than 20 per share because interest rates have risen significantly since the stock began trading. The benchmark 10-year Treasury bond yield increased from 1.95% at the time of issuance to 3.65% (as of October 3).

The price decline is the reason the current yield is at 5.92% versus the original 4.5% when the stock was 25 per share. There is little credit risk to these shares. It’s highly unlikely that U.S. Bancorp faces a crisis worse than the financial crisis and can’t pay dividend interest on the preferred shares. But, as the price decline illustrates, there is interest rate risk.

If interest rates spike higher from here, the stock price will decline. That’s a risk. But it’s one worth taking at this point. Interest rates have spiked to the highest level in more than 10 years. At the same time, a recession is likely to put downward pressure on rates. Of course, that’s no guarantee. Interest rates could continue to rise.

But a spike higher from here is likely to be temporary. Over a longer-term holding period of several years, it is more likely that interest rates average lower than they are now. Plus, you can also add to the position if rates moves higher in the near future. It’s an opportunity to grab a high rate on an investment grade fixed-rate investment while it still exists.

These shares are also perpetual, meaning there is no maturity, and callable. Preferred shares are typically callable around five years after issuance and these shares can be called at 25 per share after 4/15/2027. But that would be a 25% higher price than today and more than four years from now. One of the reasons for choosing this particular preferred stock, aside from the superior credit rating of USB, is that the call date is still a while off. It wouldn’t be as good a benefit to lock in a high rate and have it called away in just a year from now.

This U.S. Bancorp preferred stock is a great way to grab a high fixed rate that has not existed on an investment of this quality in over a decade after a huge spike in interest rates.

It’s more confusing than I’d like. It seems every place uses a different variation of the preferred stock symbol.It’s the USB series S preferred stock. It trades with different symbols depending where you look. On Yahoo Finance it’s USB-PS. On the NYSE site it’s USB/PS. On some sights it’s USB.S. Different brokerages use different sites and you have to fool around a little to figure out what the preferred indication is on a particular site. It’s some derivation of USB and S.

U.S. Bancorp 4.5% Depository Shares Non-Cumulative Perpetual Preferred Stock (NYSE: USB-PS)

Security type: Preferred stock
Industry: Banking
Price: $19.00
52-week range: $18.84 - $24.87
Yield: 5.92%
Profile: The is a preferred stock of the fifth largest bank in the United States that has investment grade credit ratings.

Positives

• Interest rates are at the highest level in more than a decade.
• Dividends from preferred stock offer favorable tax treatment compared to bond interest.
• Interest rates tend to fall during a recession.
• Makes quarterly payments and is highly liquid.

Risks

• Preferred stocks, like bonds, will lose value in a rising interest rate environment.
• Interest rates could rise further with continued inflation.

Portfolio at a Glance

High Yield Tier

The investments in our High Yield Tier have been chosen for their high current payouts. These investments will often be riskier or have less capital appreciation potential than those in our other two tiers, but they’re appropriate for investors who want to generate maximum income from their portfolios right now.

Enterprise Product Partners (EPD – yield 7.7%) – Midstream companies took a big hit as the market took everything down in the second half of September. But these companies should regain footing when the market stabilizes. EPD is already significantly higher from the recent low in late September. It offers a high and safe distribution from a company that should well endure inflation and recession and investors should see that as one of the best games in town over the rest of the year. (This security generates a K-1 form at tax time). BUY

Enterprise Product Partners (EPD)
Next ex-div date: October 28, 2022

ONEOK Inc. (OKE – yield 6.9%) – OKE also got a nice bounce off the September low but has moved lower recently. The same dynamics for EPD apply to this midstream company in the form of a regular corporation. But OKE tends to be more volatile, which could be a good thing over the rest of this year. ONEOK earnings continued to grow through the pandemic because of the resilient natural gas demand. With the current supply issues and the situation in Europe, natural gas volumes should continue to be consistent even as the economy slows. This is one of the few companies that can endure inflation and recession. BUY

ONEOK Inc. (OKE)
Next ex-div date: October 28, 2022, est.

Realty Income (O – yield 5.1%) – This legendary monthly income payer recently hit the 52-week low and remains a long way from the pre-pandemic high, despite having higher earnings. REITs have been under pressure from rising rates at it raises costs for growth projects. But Realty just made a large acquisition and should get strong growth because of that over the next year.

This stock has been clobbered along with just about everything else in this market. But this legendary income stock has been a remarkably consistent performer over the years. It has averaged a better than 14% average annual return since its inception in 1994. And that performance is a lot higher when it was purchased near the 52-week low. A great company with a fantastic track record is on sale. BUY

Realty Income (O)
Next ex-div date: October 31, 2022, est.

The Williams Companies, Inc. (WMB – yield 5.7%) – This midstream energy company in the form of a corporation is one of the few stocks that has moved higher so far this month. Part of the reason in that Williams announced that it expected a strong third and fourth quarter and reaffirmed 2022 guidance near the high end of the previous range as the natural gas assets remain strong performers. WMB had great momentum before the recent selloff because it’s ideal for the current environment of inflation and recession. Hopefully, the stock will remain strong over the rest of the year. BUY

Williams Companies, Inc. (WMB)
Next ex-div date: December 8, 2022, est.

Rating change – SELL 1/2Medical Properties Trust, Inc. (MPW – yield 11.1%) – This hospital property REIT sells at a fire sale value with a stratospheric dividend yield that should be safe. But the stock continues to trend lower as investors seem more keyed on momentum than fundamentals in this market. MPT does continue to have issues with its largest tenant which is having financial problems. It is likely that MPT can replace the tenant in a worst-case scenario. But it would mean near-term trouble in an unforgiving market. Management seems confident and just announced a $500 million share repurchase program with cash on hand. But we will take half the position of the table until the stock can reestablish some positive momentum. SELL 1/2

Medical Properties Trust, Inc. (MPW)
Next ex-div date: December 14, 2022, est.

Dividend Growth Tier

To be chosen for the Dividend Growth tier, investments must have a strong history of dividend increases and indicate both good potential for and high prioritization of continued dividend growth.

AbbVie (ABBV – yield 4.1%) – This biopharmaceutical company stock sold off this spring after a huge surge earlier in the year. That’s typical behavior as the stock tends to pull back after big moves but maintain a longer-term uptrend. ABBV has been one of the very few stocks on the market to hold up and retain its price through the tumult of the past month while just about everything else took a beating. Recession fears don’t seem to bother drug companies because it is one of the few businesses that doesn’t get hurt. Meanwhile, AbbVie is one of the best big pharma companies out there with one of the best pipelines and a population aging at warp speed. HOLD

AbbVie Inc. (ABBV)
Next ex-div date: October 13, 2022

Rating change “BUY” to “HOLD”Broadcom Inc. (AVGO – yield 3.7%) – The chip maker and infrastructure software provider continues to deliver on an operational basis while getting creamed by this market. Broadcom once again delivered on earnings with 40% earnings growth and a 25% revenue increase versus last year’s quarter. It also raised guidance for the rest of the year.

But that seems to matter very little in a year when the whole technology sector continues to get crushed. I still believe the price will be a lot higher six months to a year from now. But technology is getting hammered every single day and continued selling like this often culminates in a grand selloff at the end. The rating is reduced until some positive momentum can be established. HOLD

Broadcom Inc. (AVGO)
Next ex-div date: December 21, 2022, est.

Brookfield Infrastructure Partners (BIP – yield 4.2%) – This reliable revenue generator really took it on the chin over the last month, falling more than 20% to a new 52-week low. That’s surprising because its crucial infrastructure assets are virtually recession proof and inflation adjustments are built into the contracts.

The problem is interest rates. BIP is classified as a utility and that sector, along with REITs, has been the worst performing sector over the past month. Competing fixed income investments become more competitive with higher rates. But all those other great attributes still apply. And a recession should bring interest rates back down. (This security generates a K-1 form at tax time). HOLD

Brookfield Infrastructure Partners (BIP)
Next ex-div date: November 30, 2022, est.

Eli Lilly and Company (LLY - yield 1.2%) – This big pharma stock is one of very few stocks on the market that moved higher over the last month. Healthcare has been one of the best places to be in the recent tumult. But Lilly’s pipeline continues to come through with good news as well and the stock isn’t even that far from the high. There was good news. Biogen’s Alzheimer’s drug reported very positive phase III tests and the news is seen to increase the likelihood of approval for other similar drugs, including Eli Lilly’s drug on the fast track for approval. The stock was also upgraded by UBS for another diabetes drug that has proven effective for weight loss, saying it could be one of the most successful drugs ever if approved. HOLD

Eli Lilly and Company (LLY)
Next ex-div date: November 12, 2022, est.

Intel Corporation (INTC – yield 5.7%) – The stock continues to be under pressure along with the rest of the tech sector in a market where value and fundamentals don’t matter right now. The stock is also facing headwinds as the chip sector continues to face pressure in the slowing economy while the company is undergoing a massive expansion program. The short term is ugly, but the dividend should continue to be safe with a very low payout ratio. It’s a long-term hold that should pay off over time. HOLD

Intel Corporation (INTC)
Next ex-div date: November 5, 2022, est.

Rating change – “BUY” to “HOLD”Qualcomm Inc. (QCOM – yield 2.6%) – The same things I said about Broadcom are true for Qualcomm. It continues to post great results in a market that could care less. Qualcomm is also under pressure from the weakness in semiconductors. This market doesn’t like technology now and it isn’t taking prisoners. The rating will be reduced until the technology sector stabilizes and regains momentum. HOLD

Qualcomm Inc. (QCOM)
Next ex-div date: November 30, 2022, est.

Visa Inc. (V - yield 0.8%) – As a cyclical stock, V gets selling pressure when the market reels over recession worries. But inflation isn’t a problem for Visa. On weakness, V usually falls to right around the 200 per share level. But the recent selling has taken it to a new lower level. Profits are soaring as Covid restrictions have come down internationally, but the stock has been held back by recent panic selling in the market. V is another stock that rebounds quickly when the market stabilizes. HOLD

Visa Inc. (V)
Next ex-div date: November 12, 2022, est.

Safe Income Tier

The Safe Income tier of our portfolio holds long-term positions in high-quality stocks and other investments that generate steady income with minimal volatility and low risk. These positions are appropriate for all investors, but are meant to be held for the long term, primarily for income—don’t buy these thinking you’ll double your money in a year.

NextEra Energy (NEE – yield 2.2%) – A month ago this alternative energy utility giant was flirting with the 52-week high. Then interest rates soared, and utilities got crushed. NEE fell over 15% in the past month as the market completely soured on utilities. It’s a bad time for utilities but it should be worth it to hang on to NEE. It’s still a very defensive business going into a recession. Plus, a recession should put downward pressure on interest rates. HOLD

NextEra Inc. (NEE)
Next ex-div date: November 29, 2022, est.

Xcel Energy (XEL – yield 3.2%) – Ditto everything mentioned above about NEE for this smaller alternative energy utility. XEL was soaring to new highs before it got rudely interrupted by rising interest rates. It also took a hit over the past month after soaring to a new high in early September. It’s still a defensive business and Xcel should also benefit from the passage of the CHIPs bill as it should get some generous subsidies and favorable treatment. HOLD

Xcel Energy Inc. (XEL)
Next ex-div date: December 14, 2022, est.

Dividend Calendar

Ex-Dividend Dates are in RED and italics. Dividend Payments Dates are in GREEN. Confirmed dates are in bold, all other dates are estimated. See the Guide to Cabot Dividend Investor for an explanation of how dates are estimated.

The next Cabot Dividend Investor issue will be published on November 9, 2022.