Description

Some investments add “value” not from the absolute level of return they provide but by how the particular security can provide a far superior alternative than other choices.  For those of us who manage money for mom and pops in particular in a non-hedge fund fee schedule these sorts of choices and decisions are extremely important. 

That said, Tri-Continental Preferred (TY-) is an investment suitable for retired people who are considering single premium deferred annuities and/or need a specific level of income.  In theory, a single premium deferred annuity ought to be a simple investment:  an investor plucks down a sum of money in return for guaranteed stream of income for life with the benefit and the income expiring at end of life.  In reality, I’ve seen pitches for these products where 1) determining the payout amount after a teaser rate was unintelligible with 2) fee disclosure nowhere to be seen and 3) determining the financial health of the issuer a matter of relying on uncertain 3^rd party opinions.

I think TY- solves these issues and provides a better alternative.  TY- pays a 5% dividend, can only be called under normal circumstance at prices higher than the current price, is a very easy investment to understand, and finally has ironclad asset coverage and lastly won’t expire upon the investors’s death.

*TY- pays a $2.50 yearly dividend (62.5c per quarter).  Purchased at $50 per share, this provides a perpetual 5% return unless the security is called

*TY- can be called today at $55 per share (though there are some special control provisions that would enable a call at $50 but the underlying closed end fund TY's ancient history back to the 1930s would make this possibility highly unlikely) in which case a purchase today would result in capital appreciation along with any dividends collected along the way

*Tri-Continental (TY) itself is not a mysterious investment.  Sure, you can purchase a bank preferred with a higher yield but your due diligence will be challenged by the complexity of the underlying company structure which is going to be challenging for (some and definitely me) of you and impossible for the average retail investor.  By contrast, TY is a pedestrian closed end fund (see below).  I’m not going to get into the detail of this fund but it holds things like Apple, Microsoft, JP Morgan, Chevron, Blackrock in a very diversified portfolio.  Monitoring the progress and health of this investment takes about 30 minutes a year at most.

http://www.cefconnect.com/Details/Summary.aspx?ticker=TY (free; requires registration)

*Asset coverage discounts a nuclear winter.  TY- is $38m preferred while the underlying fund has $1.3b in assets.  This means that there is 1.26b in assets to cover the dividend payment of $1.9m per year.   Here's why:

*To challenge coverage on this dividend would require a 90% decline in TY itself which is certainly possible (this actually happened to a closed end fund run by David Dreman in 2008-09 but that fund seemed to have a talent in indentifying bad stock picks and was entirely concentrated in financials) but given the structure of the TY we'll all be out of work anyway if this happens to it

*Federal regs require suspension of dividends for common shareholders if 200% coverage is breached (i.e., if fund lost 1.2b in assets and fell to an AUM of  76m or 2x the amount prefered outstanding).  This automatic mechanism in 2008 and 2009 actually led to the redemption of referreds at par (even with that Dreman fund) so even if the world ended you ought to get you money back.

In essence, If you have a problem with asset coverage here, the world as we know it has been taken over by Evil Aliens (if they haven't already).

*Long history.  I’ve gotten some conflicting statements on this but the QuantumOnline website shows that TY- had its IPO in 1963 (TY has told me it goes further back).  So in essence we've had 50 years of nice history to reassure us that our 5% will be paid year after year.

*If you die, that doesn’t do anything to TY-.  Unlike a single premium deferred annuity, this investment can live on for your children (not so good for you, great news for them)

Risks are pretty obvious:

*Limited liquidity.  It takes time to accumulate a position ($38m total issue) and if you have to sell a lot quickly you’ll mostly likely get a rotten price

*Rising rates hurt it.  Course, with rates this low the impact should be less pronounced until rates rise much higehr but clearly the price would be hurt by rising rates. 

*Big drops possible.  In periods of market stress based on the history of this security you can see gigantic one day drops (obviously caused by low liquidity).

*5% returns aren’t what you want.  Obvious enough.

That’s it.  Yes, there are other closed end preferred with higher rates but most of them can be called and the asset coverage isn’t as strong.  There are other investments such as REITs and MLPs which provide much higher dividends but leverage there tends to be much higher with complexity more an issue – for me at least.  In short, I think this is an excellent investment when used properly and I hold a substantial position.

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