Many investors expect U.S. interest rates to rise in the coming years and are looking for opportunities to profit. To say the least, this has been an unsuccessful trade so far and even at very low current yields, an outright short position on U.S. Treasury bonds still has a questionable risk/reward profile. My investment recommendation provides an alternative to shorting bonds and has the attractive characteristics that A) it will not necessarily lose money if yields remain low, as is the case with shorting bonds and B) due to its low current price relative to face value, it has significant “leverage” to rising interest rates.

I recommend a long position in SLM Series B Floating Rate Non-Cumulative Preferred Stock (symbol SLMBP). This is a $100 face value preferred currently trading at $45.00 (which includes almost $0.50 in accrued dividends). The dividend rate on this preferred is 3-month LIBOR + 1.70%, which equals 2.17% today. But since the preferred is trading at a steep discount to par value, the current yield is 4.82%.

Where things get really interesting is when interest rates start to rise. If 3-month LIBOR rates were to increase by 1%, the yield on SLMBP @ $45 would rise to 7.04%. Another 1% increase in 3-month LIBOR takes the SLMBP yield up to 9.27%. One more 1% increase on 3-month LIBOR pushes the SLMBP yield up to 11.49%. You get the picture. Due to the fact that the preferred is trading at less than half of face value, the increase in dividend yield on SLMBP will more than double the actual change in the interest rate.

I believe that the preferred will trade at a current yield of 5% or so for the next few years. So if interest rates rise 1%, the annual coupon will be approx. $3.17, justifying a $63 price. If interest rates rise 2%, the annual coupon will be approx. $4.17, justifying a $83 price. If that rise occurs within a 3-year time period, the IRR on the 1% rate rise would be around 17%; the IRR on the 2% rate rise would be 27%. Obviously, the faster rates rise and the higher they go, the higher the IRR can go.

How does this compare to other floating rate preferred issues? The table below shows some of the competition.

You can find a number of issues that have higher yields than 4.8% right now, but generally only on those preferreds that have high dividend floor rates. For example, Morgan Stanley’s Series A Preferred (MS-A) currently pays 6.13% due to a floor rate of 4% of par value. The dividend is based on 3-month LIBOR + 0.7%, though, so the dividend has no leverage until 3-month LIBOR reaches 3.3%. You would completely miss out on the rise in interest rates.

There are a few floaters that have some leverage to interest rates, but nothing comparable to SLMBP, and the current yields on those other issues are very low. UBS Preferred Funding Trust IV (UBS-D) for example, is also trading at a big discount to par value, but has a paltry current yield of just 1.81% and it would rise to just 5.65% if 1-month LIBOR rates increase by 2%. SLMBP pays 3% more currently and that margin increases as interest rates rise.

There just aren’t many issues out there that have both a decent current yield plus significant upside if/when interest rates rise.

SLM, of course, is not without risk. Moody’s has a rating of Ba3 on this preferred. Nonetheless, it is still trading cheap vs. other preferreds. The Morgan Stanley preferred mentioned above, for example, has a lower rating (Ba1); Bank of America preferreds are comparable to SLM (Ba3), but have substantially lower yields. Thus, even accounting for credit risk, SLMBP looks reasonable on a current yield basis, but very compelling to those looking to profit on rising interest rates.