Preferred stocks are, in all likelihood, the income investor’s dream come true after the financial crisis. There are many factors that have helped preferred stocks during this period and in this report I want to take a look at where we stand currently. There are 478 issues in my database that trade on primary exchanges, excluding the mandatory convertible preferred stocks, which I cannot include in this mainly fixed-income report. The three biggest families are fixed rate preferred stocks (384), fixed to floating preferred stocks (51) and floating rate preferred stocks (16). All of the groups can be seen in this graph:
Believe it or not, this is the whole universe of preferred stocks available to the majority of retail investors. The ETFs and CEFs that invest in these types of securities are much more limited than the general public believes. The 10 biggest issuers have more than 70 securities outstanding and represent more than 1/7 of the overall count. Making things even harder for the large institutional investors is the fact that these instruments are not very heavily traded and a preferred stock with an average daily volume above 100K shares is considered a high-volume one. It is really hard to buy a large amount of shares in an issue that has $200 mln market cap and trades 40,000 shares a day on average without it affecting the price. Add to this the retail investor, and the pricing of all these securities becomes questionable. The most interesting part is how these securities are priced – which leads us to the next part of the article.
How are preferred stocks priced?
Preferred stocks are supposed to have their place on the yield curve, but it is not an easy task finding the appropriate place for each preferred stock. To do that I have separated my preferred stocks into several categories.
Dangerous preferred stocks
In this group I include all the preferred stocks that trade above 104% of their redemption price, have yield to call < -10% and are callable:
The higher nominal yield should be the number one trigger for the company to redeem the security, but this is not always the case. As you may have noticed, most of these securities are issued by large financial institutions and some of them have been redeemable for quite a long time, so anyone with deep knowledge of banking regulations can earn his alpha by buying extremely high yielders as long as they are certain they are not getting redeemed. For the rest of us, these are just dangerous preferred stocks that we have to stay away from. I have tried to short almost all of these stocks based on the simple logic that they are overvalued, and my results from this strategy have not been spectacular. For me personally, these stocks are the “do not touch” ones.
Dangerous preferred stocks, possible buys
In this low-rate environment, earning a nice yield from a safe company is really a hard task. I am not recommending you take on redemption risk, but in this group I have included the stocks that have negative yield to worst, yet their stripped price is < 104% par. This means that you need just a few more dividends to break even on your investment and once this period is done you can enjoy the dividend yield. These are the stocks in the group:
To really get the tasty ones from this group, I am adding another condition: current yield > 7%:
A stock like Dillard’s (NYSE:DDS) Capital Trust I, 7.50% Capital Securities (DDT) has been callable for 14 years. You need just 2 more dividends and you will be out of the redemption risk zone:
This is how the yield to call chart looks like for DDT, depending on when it is being redeemed. It is impossible to “catch” a BBB- stock with such an yield curve without risking a 20-cents capital loss. The problem is that you never know if the company will not redeem it exactly one day after you get your order filled.
Preferred stock, fixed rate, price < PAR, 5% < current yield <8%
This group of preferred stocks has to be treated as the group of “immortal” preferreds. They are most likely to be perpetual, because yield to worst is the most likely a result of our investments and here the current yield is the yield to worst:
Here is the average current yield of the securities in this family by their common stock, which readers are probably more familiar with:
To get a perpetual yield above 6% you either have to be in the news, as is the case with AmTrust Fianncial Services (NASDAQ:AFSI); be a mall REIT; or be a highly leveraged REIT. Companies like Public Storage (NYSE:PSA) will not give you anything higher than 5% before taxation. Another thing to consider when looking at this chart is the tax treatment of the dividends. REIT dividends in general are not qualified for preferential tax treatment while more than 90% of financial companies dividends are. This puts Wells Fargo’s (NYSE:WFC) 5% perpetuals in better shape than PSA’s, but the market somehow treats them equally – which may be correct.
Preferred stocks, 8% < current yield < 10% trading bellow PAR
This is the group of preferred stocks that are too good to be true, but you never know. It might be the market that is wrong to think they are so risky. Here are the tasty yielders with their issue, in millions of shares, on the horizontal axis:
One look at the common stock charts of these preferred stocks is enough to stop researching them as a long-term investment, but their volatility and low volume make these securities really attractive for trading when an arbitrage opportunity occurs. I have written articles for 3 of the companies in this chart and all of them were about arbitrage opportunities that ended up in nice winners with strong fundamental logic.
Toxic preferred stocks, Current yield > 10% and paying dividend
If you think that the last group was the riskiest of them all, wait to see these “high yielding” treasures:
I personally buy these stocks only with a proper hedging reaction and am also prepared to short them on any weakness in the common stock. They are called toxic, but these are the stocks that really move and can trade at bargain prices once in a while. This is the chart of Gastar Exploration (NYSEMKT:GST), Inc., 10.75% Series B Cumulative Preferred Stock (GST-B):
Go and tell someone who bought it at $3 that it is a toxic stock, but the other scenario is also possible. There were sellers at $3 as well.
Drawing the preferred stock yield curve
As you may have noticed none of the stocks discussed above have their place on the yield curve. Some of them have negative yield to call, others have to be treated as perpetuals, while others have their “yield at risk”. Since it is unreasonable for us to know what stocks are going to get redeemed, we can only depend on what the market is telling us. Basically if the yield to worst is the yield to call of a certain security it is most likely for it to get redeemed. There are of course exceptions to any rule, but this is the basic financial logic. There is another problem that this approach faces and it is determining what is worse. For example is a 4% yield to call in 3 years worse than a 6% perpetual yield? But let’s not make it that hard – we can find an easy solution. If a stock has a stripped price higher than 104% of par, we can conclude that the market treats it as a most likely redemption.
Probable redemptions, yield curve by yield to worst and years to call date < 5, fixed rate
As seen on the three charts, the more we filter, the more the stocks on top of the curve disappear and we have reached our desired investment grade preferred stock yield curve. This curve is supposed to bring a very strong message to investors in preferred stocks – 6% yield in the short term from an investment grade security is a mirage if you don’t do some extra work. On top of that, all the big ETFs are heavily invested in the average preferred stock, which in no way will result in greater results than what you see in the yield curve above. Preferred stocks are not in the situation they were in a few years ago when higher returns were still possible. A lot of people are looking at past performance to determine their future returns and in preferred stocks this will most likely lead to exaggerated expectations.
Fixed to floating preferred stocks
This class of preferred stocks is comparatively new for the US market. The oldest preferred stock in my database is U.S. Bancorp (NYSE:USB), 6.50% Fixed/Float Dep Shares Non-Cumul Perp Preferred Stock, F (USB-M). It was issued in January 2012. I have discussed these stocks in my previous articles and am doing a separate article on them with more detail, so here I will post the yield curve for the ones that are probable redemptions in the next 10 years. The point here is that their yield to call is the best you can get out of them, because after they become floating they also become redeemable, which pins their price to par after their call date. If the stock trades higher than its par plus accrued dividend after the call date, it will have negative yield to call, and to have such an expectation is financially unreasonable:
The high quality financial preferreds are again capped at a little above 5%. This is it – no fancy yields for buying high-quality products, no matter what they are.
Floating rate preferred stocks
This group of preferred stocks pays the higher of a spread above LIBOR and a sets minimum nominal yield. Their current yield is their yield to worst and if they trade bellow their redemption price they have some extra value in their sleeping long-term call option on the LIBOR. Currently all of the $25 par floating rate preferred stocks pay a fixed dividend, because LIBOR is still too low to trigger their floating nature. Here you can see their current yields and at what percentage of par they trade:
Later I found a lot of arbitrage opportunities in this type of security. After looking at the charts above in the article I don’t find the 4.4% current yield of the “cheapest” of these preferred stocks to be as bad as it sounds. The big risk with these securities is that they are the lowest nominal yielders, and in a rising-alternative-yields environment without their built-in LIBOR call option able to compensate, they have the highest duration and ironically enough are hit the hardest.
Very soon you will be able to join my brand new service that will search for all the mispricings in preferred stocks, bonds, closed end funds and will offer the hedging strategies me and my group use to minimize(eliminate) directional risk from our portfolios, so stay tuned if you find research like this interesting. All the charts used are from my database.
Conclusion. The market is too calm to be true and finding a bargain is a hard task. Everything seems to be priced as it should on relative basis. As for absolute values, you can never say what yield does a certain stock deserve and have to accept what the market gives you. There are some interesting stocks to be researched which we will do in future articles. The point of the article is to bring the big picture in the small world of preferred stocks to the readers and to show what are the most likely yields you will get for being invested in the average preferred stock.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DDT over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.