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One of the great unsung heroes in the stock market, and in my portfolio, are preferred stocks. These stock-bond hybrids offer high-yields, stability, and replaced low-yielding bonds during this period of historically low interest rates.
Let’s review what preferred stocks are and why you should consider them.
Preferred stock is a cross between and a bond and a stock. A bond is a loan where the investor gets an interest payment in exchange for the loan. Debt always has the highest position for recovery of principal if the company files for bankruptcy.
Preferred stocks allow a company to raise money without diluting the ownership of other shareholders, while also allowing current bondholders to maintain their position in the capital stack. Preferred stock doesn’t have voting rights, but offers dividend payments that are often higher than bonds themselves. That’s because preferred stock carries more risk than bonds, but less than the common stock.
So preferred stock fits right in between common stock and bonds. They usually offer yields that range from 5% to 9%. Like bonds, they are issued at a “par value”, which is usually $25 per share. Therefore, like bonds, if a preferred stock trades below par value, it usually means the market has concerns about the company’s ability to pay that dividend or for the company itself to survive.
However, the market has inefficiencies and you have an opportunity to pick up these three preferred stocks trading below par, which means you have the chance for capital gains as well as a good dividend.
Stock symbols for preferred stocks vary by broker.
Bank of America (NYSE:BAC) is hardly the teetering giant it was during the financial crisis. It is a rock-solid bank with a massive mortgage servicing business. It is in no solvency danger whatsoever. It has numerous issuances of preferred stock, and the Floating Rate Series E Preferred Stock is trading at $21.14, a full 15.44% below par value.
I think the stock is this far below par because its yield is lower than most preferred issuances. The yield is tied to the greater of LIBOR plus 0.35%, or 4% in total – based on a trade price of $25. Investors are choosing higher-yielding, fixed-rate dividends instead. However, because it sells below par the yield is 4.84%.
I see little downside to picking up these shares with a 15% capital gain upside and a nice yield.
The same situation exists with one of my other favorite banks, U.S. Bancorp (NYSE:USB). US Bank remains one of the most conservative and stable banks in the nation, which had very little exposure to toxic mortgage assets.
Like B of A, US Bank’s Series A Preferred Stock is tied to LIBOR, plus a spread of 1.02%, or a total of 3.5%. That 3.5% yield isn’t very special to income investors, who are more entranced by common stocks like AT&T (NYSE:T) and its 5%+ yield. What income investors are missing is that with this US Bank Series A trading at a 19% discount to par, they are passing up a current yield of 4.41%.
Even if the stock recovered to par, that not only means a 19% capital gain, but a safe and reliable 3.5% yield, without the risk that other dividend common stocks offer. There is no downside to buying here.
Pacific Gas & Electric (NYSE:PCG) has a 4.5% Series H Preferred Stock that is trading at $21.12, an 18% discount to par. Consequently, the yield has risen to 5.24%. What’s going on with a preferred stock on a well-known utility that just reported strong earnings?
Investors seem to be nervous over potential liability from a 2010 natural gas pipeline explosion (which has already been assessed), and the investment of hundreds of billions of dollars over the next 30 years to upgrade its transmission systems.
There seems to be little cause for the fear in the preferred, which pays that 5.24% yield, and is more than the 3.6% yield of the common stock. I think concern over the upgrade expense is overblown. It hasn’t even begun yet.
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