SYF - Franklin Templeton Says Get Out Of Cash: Buy Fixed Income Now!

2024-01-12 08:30:00 ET

Summary

• Smart money is moving out of cash equivalents.
• Fixed income remains deeply discounted, despite equity valuation creep.
• We discuss quality preferred shares with up to 8.2% yields to put your cash to work meaningfully.

Co-authored with "Hidden Opportunities."

The economy continues to provide indications of decelerating inflation, and the Fed's next steps with the rate policy are becoming clearer. Equities have rallied while fixed-income securities remain meaningfully discounted despite being best-positioned with significant upside with rate cuts.

A study of past performance tells us that the performance of investment-grade and high-yield fixed-income securities leads to terrific returns in the months following the Fed's rate pause. Source .

"Investors should be getting ready to get out of cash and into the fixed income space, as equities are in all-time highs" - Sonal Desai , Chief Investment Officer at Franklin Templeton Fixed Income.

It isn't just Franklin Templeton. Other leading firms are recommending the same approach.

"Get out of cash now, take advantage of some of these incredible things in the fixed income markets, especially in the belly of the curve. Take advantage of the companies that are still available to you at reasonable prices." - Gargi Chaudhuri , head of investment strategy at BlackRock iShares Americas.

Fixed-income securities, namely baby bonds and preferred stock from investment-grade issuers, present an attractive "baby step" from cash equivalents. Their default risk is low, they maintain good liquidity levels, and investors expect significant capital upside in addition to the high current yields. Corporate fundamentals have remained strong to satisfy the obligations to their fixed-income securities.

Looking at the research data from Investment Company Institute on money market assets, there are early signs of institutional capital moving out while retail investors continued piling on into these guaranteed instruments.

It is only a matter of time before the record cash position moves into quality yields, and for the discounts to vanish. We have two quality preferred picks lined up for you to get ahead of Wall Street on this before it is too late.

Let's dive in!

Pick #1: ESGR Preferreds - Up To 7% Yields

Companies of all sizes routinely undergo transformations in the form of mergers, acquisitions, divestitures, spinoffs, and bankruptcies. When a company or an entity completes such a transaction, there is often an old business that they are moving away from, which requires protection against liability and claims for the foreseeable future. Suppose a physician closes their practice; what would happen to any future claims (of medical malpractice) made against the former business for the treatments performed?

Runoff insurance is an insurance policy provision that covers claims made against companies that have been acquired, merged, or have ceased operations. This is also known as closeout insurance and is purchased by the company being acquired as part of the closing transaction to provide indemnity from lawsuits.

The length of the runoff policy is typically set for several years, ensuring consistent premiums for the underwriting firm. And this longevity of cash flows makes runoff insurance a terrific business.

Enstar Group Limited ( ESGR ) is a leader in this space with 30+ years of operations, a dominant global presence, and experience across the spectrum of runoff insurance. The company has executed over 117 deals since its inception.

As with any insurance company, ESGR is investing its holdings in safe financial instruments while securing a high yield, thanks to elevated interest rates. Source .

During the third quarter , ESGR generated a strong net investment income of $143 million, largely driven by improved YoY performance in the investment portfolio, supported by higher interest rates. The company also delivered YTD growth in book value per share of 7.7%. ESGR maintains a phenomenal track record of book value growth, with a CAGR of 15.3% in the past two decades.

During the quarter, ESGR also agreed to repurchase $191 million worth of ordinary shares from CPP Investments and its affiliate and from the Trident V Funds managed by Stone Point Capital LLC at a price per share of $227.18 (a 5% discount at the time of the conference call).

The company ended Q3 with $1.2 billion of cash , cash equivalents and restricted cash, and an unused $800 million credit facility capacity. ESGR also has a purely fixed-rate debt with staggered maturities, starting in 2029. The company will have no issues navigating this elevated interest environment, or even a higher-for-longer monetary policy. ESGR's senior notes carry BBB+ investment-grade ratings.

ESGR has two attractively priced preferred securities.

• 7.00% Series E, Non-Cumulative Fixed Rate Redeemable Perpetual Preferred Shares ( ESGRO )

• 7.00% Series D, Non-Cumulative Fixed-to-Float Redeemable Perpetual Preferred Shares ( ESGRP ).

Both preferreds from ESGR pay qualified dividends, bringing tax benefits to eligible investors. ESGRO is slightly discounted from its par value and offers a 7% yield.

For the nine months in FY 2023, ESGR spent $27 million on preferred dividends and $67 million on interest expenses. The company also made $340 million worth of share repurchases. The debt obligations and preferred dividends were adequately covered, and the company generated $483 million in net earnings after accounting for these expenses.

ESGR is a prosperous business with excellent operating fundamentals and spectacular growth prospects. The company is highly profitable and faces solid tailwinds from higher interest rates, which is supporting the pursuit for share buybacks. We see excellent +7% qualified yields in its modestly discounted preferreds.

Pick #2: SYF Preferred - Yield 8.2%

Synchrony Financial ( SYF ) is one of the largest issuers of store-branded credit cards in the United States. The bank is 80% deposit-funded and has the lowest cost of customer acquisition, with an average cost of $18 to acquire an account with a lifetime value of over $350.

The bank has been on a massive buyback campaign, having already reduced its outstanding share count by 5.6% in three quarters of fiscal year 2023. During Q3, SYF spent $150 million on share repurchases and has $850 remaining in its share purchase authorization.

SYF expects charge-offs to rise to 5.5%-6% in FY 2024, a percentage point above current levels but consistent with the bank's long-term loan underwriting standards. Remember that credit cards are a critical element of household finances in the United States, with the vast majority of adults (82%) having at least one credit card in their wallets. Almost half the total number of card accounts carry a balance and incur massive interest and fees. This is a very lucrative business despite delinquencies and default risks, and time-tested issuers like Synchrony Financial and Capital One are known to achieve excellent risk-adjusted returns.

SYF's long-term debt carries investment-grade BBB- ratings, while its preferred stock - Synchrony Financial 5.625% Fixed Rate Non-Cumulative Perpetual Preferred Stock Series A ( SYF.PR.A ) carries a BB- rating. SYF-A offers a whopping 46% upside to par and a healthy 8.2% yield to wait for it.

The bank's 9-month preferred dividend spend of $31 million was covered 58 times by the company's $1.8 billion net earnings. SYF's common stock dividend stands strong, with an 18% payout ratio.

Conclusion

Thanks to the hawkish Fed, the yield from fixed-income securities has risen to levels we haven't seen in decades. Investors shouldn't miss the opportunity to lock in higher yields for the long term at the cost of comfort from guaranteed instruments. As the allure of cash diminishes with potential drops in short-term interest rates, this discounted asset class presents significant capital upside.

When it comes to retirement, the last thing you want to do is have to fiddle with your portfolio to try and earn a strong income. The biggest mistake that so many market-wide investors make, especially when buying for growth, is being over-concentrated in a few names and hoping that those names will outperform in all markets. This is why we recommend at least 40 holdings in your portfolio. It's designed to help protect you, but also to help you benefit, regardless of the environment right now. If you're putting in new investment dollars, it should be in the fixed-income sector where you can see massive returns and strong income - our Model Portfolio preferred picks boast an average 8.2% yield!

This is a simple question: Will you buy income today to be able to enjoy it for decades to come, or do you want to have to play and fiddle to try and maintain your income? CDs and Treasury notes are great for short-term ideas, but when we're planning for a retirement that can span three decades, it's better to be a long-term thinker than a short-term problem solver. Those who are financially stable and financially secure plan for the long term, not just the short sprint.

That's the beauty of my Income Method. That's the beauty of income investing.

For further details see: