Preferred News

Our portfolio investment in the financials sector has come through investment in high yield bonds and preferred stocks. Most preferred securities are issued by financial companies, and many of them by the banks and insurance companies at the center of the current panic. How does the current news surrounding the treatment of preferred securities in the bailout process impact preferred share pricing?

Preferred shares are "senior" to the common stock. Whereas the common stock dividend is based on corporate profitability, the preferred shares have a fixed dividend that is based on the company’s ability to pay dividends at all. This means that the common stock has much greater upside. In a bankruptcy, preferred shares are "junior" to corporate debt. In a liquidation, if the proceeds from asset sales aren’t enough to cover the debt, then preferred holders get nothing. If there is a surplus, then the preferred holders should receive par value (usually $25) before common holders get anything.

Given that preferred have all the downside of stock, with much less upside than common shares, why would anyone buy them? The traditional buyer is actually a bond fund. Since preferreds often have no maturity date, they sometimes provide terrific sensitivity to falling interest rates. Investors can lock in a rate "forever." In addition, many preferred stocks are taxed at a lower rate than a corporate bond.

Indeed, one reason for today's unique opportunity in this sector is a result of traditional buyers not wanting to go anywhere near these hybrids, while traditional stocks investors are generally uninformed about them. Add to this a general lack of liquidity in the sector, and we believe there is ample opportunity for quick upside as this niche market begins to right itself over time.

We believe that today’s lower price, combined with high current income yields, make the preferred stock sector a very attractive place to invest in the muddle-through economic environment that we envision for the next few years. Preferred stocks are selling at below 50 cents on the dollar. At the end of February, the preferred stock ETF (ticker symbol PFF) had an income of over 14%. Given the lengths to which our taxpayers have gone to keep these banks and insurance companies solvent, the 14% tax-preferred dividend that shareholders earn certainly seems preferable to the 1% taxable return being paid to depositors. As the panic subsides, preferred yields should decline as a function of preferred stock prices rising from current levels. The total return to investors, combining the income yield with potential appreciation, is very attractive yet investors need only assume that the banking sector survives in order to receive this payoff. For common stock investors, the industry actually needs to turn around and become profitable, which is a much higher hurdle to clear.

Citigroup is the poster child of banking clowns in the current panic (as well as many prior bank panics, come to think of it). For individual accounts, we steered clear of Citigroup and AIG which were clearly going to be ground zero for the financial bust. Citigroup preferred shareholders have almost been "made whole" even in spite of Citi’s incredible showing of incompetence and the ensuing serial government bailout.

A Citigroup preferred share issued in January 2008 had a $25 par value and a dividend rate of $2.03125, for an 8.125% yield to the original buyers. As the panic unfolded, some preferred shares fell below $4 as the Treasury tried to figure out how to save this former Master of the Universe. In the latest round of Citigroup’s downward spiral, the government agreed to convert its preferred stock position into common shares, and the company announced it would no longer pay preferred dividends for the foreseeable future, but offered preferred shareholders an exit strategy of also converting $52 billion in preferred shares into common stock. This was done as an exchange offer. It was not mandatory, however a preferred stock with $25 par value, but no dividend, is of questionable value. For every $25 par value, a preferred holder would receive 7.7 shares of common stock. At today’s price for Citigroup, those 7.7 shares would be worth $20, so preferred shareholders have seen their stock prices quintuple as a result of Citigroup’s ability to muddle through the panic.

These are serious times. Our "invest with imagination" mantra stems from our belief that a simplistic "buy the dip" mentality may not pay off as well as it has during the 1982 – 1999 bull market. Our investment in preferred stocks is part defensive (fixed income) and part opportunistic (looking for significant upside potential). In a muddle through, high inflation scenario, the best investment strategies will probably look quite different than they have in the past.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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