Ways to Hedge Interest Rate Risk of Preferred Stocks

by Mike Parker

Preferred stock is sometimes thought of as a hybrid type of investment. It represents ownership in a company, like common stock, but it typically pays a fixed dividend, much like a bond. Like bonds, the market price of preferred stocks tends to be interest-rate sensitive, moving in the opposite direction of prevailing interest rates. Investors may wish to hedge their preferred stock investments against a market price loss due to rising prevailing interest rates.

Hedging

Hedging is a risk management strategy that is designed to protect an investment portfolio against loss. One common hedge strategy is to hold equal but opposite positions in the same or fundamentally similar securities. Theoretically, if the market price of your long position in the security decreases, the market price of your short position in that security will increase and offset your loss. Hedging is an appropriate strategy for investors who are concerned primarily with capital preservation, but it also limits potential portfolio growth.

Focus on Short Term Investing

No one can predict the future. This is particularly true when it comes to interest rates because there are so many factors that can influence their movement. The longer the period of time involved, the less certain any investor can be about the direction interest rates will take. One of the simplest ways to hedge the interest rate risk associated with your preferred stocks is to maintain a short-term investment strategy. This will allow you to respond quickly to any adverse movement in interest rates, thus protecting your initial investment.

Laddering

Laddering is a term commonly associated with bond investments or certificates of deposit, but the principle is similar when applied to preferred stocks. Laddering is a hedge strategy that involves buying preferred stocks with a variety of maturity or call dates. This provides a level of diversification and returns your principal investment at face value at regular time intervals. If prevailing interest rates decrease, a portion of your investments is protected against a company call, allowing you to continue earning the higher rate of return for a longer period of time. If prevailing interest rates rise, a portion of your investments are redeemed, allowing you to reinvest at the higher rate.

Futures and Options

You may be able to hedge your initial investment in a preferred stock by purchasing an opposing position in the futures or options market. For example, you might purchase simultaneously 100 shares of XYZ preferred stock and a put option for 100 shares of XYZ stock. The put option gives you the right -- but not the obligation -- to sell your shares of XYZ preferred stock at a set price for a specified period of time. During the option's time frame you retain ownership of your preferred stock and are entitled to keep any dividend payments. If prevailing interest rates increase, resulting in a decline of the stock price, you may elect to exercise your put option and sell your preferred stock at the agreed upon strike price. If prevailing interest rates remain the same or decline and the value of your preferred stock remains the same or increases, you have no obligation to sell your stock.

About the Author

Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.

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