A few weeks ago, I told you about exchange-traded debt. These securities are very interesting because they provide the safety of bonds, but the yields of preferred stock and liquidity of equities.
Companies issue debt to finance operations, and that debt is usually in the form of bonds. There is a market for bonds, but they can be difficult to trade, they trade without much liquidity and often in $10,000 bunches. The advantage of debt is the regular interest payments the company must make to holders, and that debt holders have top position in the event of bankruptcy. They are first in line to receive back principal.
Preferred stock is a stock-bond hybrid that often pay dividends instead of interest, in the 5% to 9% range. It has an advantage in being behind debt for principal recovery but ahead of common stock. It tends to trade in a limited range, but often lacks liquidity as well. Preferred stock dividends also only get cut after common dividends, so that’s another advantage.
Exchange-traded debt fits right between bonds and preferred stock in the capital stack. ETD is next in line to bonds, and if it happens to be senior secured ETD, then its actually in first position. Exchange-traded debt pays interest, so it does get taxes as ordinary income, rather than at the 20% qualified dividend rate. However, ETD tends to be much more liquid.
Here are three ETDs that I think are good additions to a fixed-income portfolio:
Entergy Louisiana 6% First Mortgage Bonds
Entergy Louisiana 6% First Mortgage Bonds (ELB) are secured by a first mortgage lien on all of the company’s property, so its strongly backed by real estate. Entergy is a $14 billion electric public utility in Louisiana.
The common stock has strong free cash flow, pays a 4.1% dividend, and the company carries $6 billion in cash and long-term investments. It’s $12 billion in debt is easily serviced by cash flow. The 6% yield is perfect for income investors, especially considering the solidity of its real estate holdings.
Note the current price is $25.31 and the company can redeem the Notes at $25 beginning next March. It doesn’t mean they will, just be aware of it. Best of all, S&P rates this debt at “A-” — meaning it has “Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.”
Stanley Black & Decker 5.75% Jr. Subordinated Debentures
Then we have Stanley Black & Decker 5.75% Jr. Subordinated Debentures (SWJ), which I love because it is tied to one of America’s greatest companies. S&P rates these as “BBB+” — meaning they have more than adequate capacity to meet their obligations, although they are somewhat subject to economic conditions. I’m not terribly worried considering the company has been around this long, through all kinds of economic turmoil. The effective yield is 5.93% as the ETD trades at $24.24, about 3% below par.
When you look at the underlying stock itself, Stanley Black & Decker (SWK), you understand why an ETD offering feels like a safe bet with a high yield. SWK stock has $433 million in cash, and $3.8 billion in debt, costing less than 5% annually. Even after all these years, the venerable brand still grew Q1 revenues almost 7% YOY, in a Q1 where retail generally got hammered. It also boosted its operating margins from 9% to 11%. That kind of increase is outstanding.
Verizon Communications 5.9% Notes
I also like Verizon Communications 5.9% Notes (VZA). Like its telecom counterparts, Verizon (VZ) generates a lot of free cash flow from its existing business — from $13 billion to $22 billion each year. That’s ample enough to pay the common stock yield of 4.3%, as well as the interest on this debt. The yield is 5.71%, reflecting the above-par trading price of $25.85. It is also rated BBB+ by S&P.
But the yield isn’t the only difference between VZ and VZA. The fact that ETDs tend to trade in tighter ranges is why they are better for income investors, who may not want to risk their capital to volatility.
A Verizon ETD sits well with me, beyond all the FCF, because it sits snugly into the Peter Lynch stalwart category. It continues to grow in the 6% to 10% EPS range. It isn’t resting on its laurels. It continues to expand its operations modestly. That common stock yield is also ample enough to continue to attract retirement and income investors. That’s why the stock isn’t likely to crater.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at firstname.lastname@example.org and follow his tweets at @ichabodscranium.