Preferred Stock Manifesto
Welcome to my massive guide to preferred stock, one of my favorite little known securities. Preferred stock is not always a good choice for investing, but occasionally it can be very lucrative.
A PREFERRED STOCK INVESTING STORY
It was a cold, dark and stormy night in December, 2008 in San Pedro, California. The U.S. was in the middle of the financial crisis that would lead to the Great Recession. As stock prices crashed around me, I sat in my easy chair, in my small, warm, well-lit one bedroom apartment, reading Security Analysis, the pre-eminent tome on value investing written by Benjamin Graham and David Dodd.
Chapter 14, “The Theory of Preferred Stocks” caught my attention. Although I was familiar with this type of security, I had never really considered them in terms of where they should fit in one’s arsenal of investments.
My goal as an investor is to be the “Batman” of investing, with a utility belt full of investing options and a deep understanding of all the types of securities that are available. I want to be ready for anything. As luck would have it, I had read that chapter at exactly the right time. Once I had digested Graham and Dodd’s view of preferred stock, I turned my attention to my latest copy of Barron’s magazine and their table of preferred stock issues.
Enter jaw dropping. The financial crisis had created a plethora of low priced preferred stock issues. Preferred stock is largely held by banks and insurance companies who benefit from the dividend treatment, and were liquidating each other’s preferred stock to raise capital, and reduce counter-party risk. As the months went on, I started buying preferred stock in banks and insurance companies that had ample capital and were fairly conservative at yields ranging from 15% to 25%. Many of these issues had fallen to be priced at less than $10 against a liquidation preference of $25. It was like shooting fish in a barrel.
The cash flow I received from this portfolio was enormous and between that and the capital appreciation, generated a substantial amount of net worth for me over the following three years.
I tell you this story to show that even though preferred stock is not considered an ideal security as typically structured, there are certain periods where preferred stock can represent substantial value, and provide enormous returns at the same level of risk as common stock. This Preferred Stock Manifesto will help you get familiar with this class of security so that you can take advantage when the time is right.
WHAT IS TRUE ABOUT PREFERRED STOCKS?
Thinking about investing in preferred stock? There are few advantages of preferred stock over other securities, hence my comment about their not being ideal as typically structured. Most of the time, owning preferred stock is not better than owning bonds or common stock. Sometimes, however, preferred stock can be superior to bonds and common stock during periods of massive miss-pricing.
WHAT IS PREFERRED STOCK?
Here’s how I define preferred stock. Preferred stock is a class of security that sits in a company’s capital structure below debt and above common stock. Preferred stock combines features of debt, in that it pays fixed dividends, and equity, in that it has the potential to appreciate in price.
Here’s an example description of a preferred stock from QuantumOnline.com:
“Bank of America Corp., 6.00% Depositary Shares, each representing a 1/1000th interest in a share of Non-Cumulative Preferred Stock Series EE, liquidation preference $25 per depositary share, redeemable at the issuer's option on or after 4/25/2021 at $25 per depositary share plus declared and unpaid dividends, and with no stated maturity.
Non-cumulative distributions of 6.00% per annum ($1.50 per annum or $0.375 per quarter) will be paid quarterly on 1/25, 4/25, 7/25 & 10/25 to holders of record on the record date that will be the first day of the calendar month in which the payment date falls or such other record date fixed by the board, not more than 60 days or less than 10 days prior to the payment date
Sometimes this class of stock is called “preferred equity”, or “preference shares”.
WHAT IS THE DIFFERENCE BETWEEN PREFERRED STOCK AND COMMON STOCK?
A typical preferred security pays quarterly dividends like a common stock, but has no voting rights which is not true of common stock, unless, under certain circumstances, voting rights are triggered when dividends have not been paid for a certain amount of time. Some preferred stock has voting rights that are specific to the issue, so be sure to read the prospectus completely.
WHAT IS THE DIFFERENCE BETWEEN PREFERRED STOCK AND BONDS?
Preferred shares have more in common with bonds than common stock in the way they are structured.
Preferred stock is different from a secured bond, and more like an unsecured bond by the fact that it has no claim on the assets of the business. In fact, most preferred shareholders suffer the same fate as common shareholders if the business files a bankruptcy...a total wipeout.
Preferred stock does not have compulsory debt payments like secured and unsecured debt. Preferred stock pays a dividend, not a coupon, and the dividend must be declared each quarter by the company’s Board of Directors, just like commons stock. Each preferred usually includes a period during which the company can decide not to pay the dividend with no consequences, and this is a major risk for preferred stock of marginal businesses.
WONDERING HOW TO CALCULATE PREFERRED STOCK DIVIDENDS?
Preferred dividends are easy to calculate. Dividends on preferred stock are calculated by dividing the annual dividend by your cost per share. The dividend is the liquidation preference (usually $25), multiplied by the dividend rate (%). For example, the 6% rate in the above preferred stock would be $25x .06 = $1.50 per annum. The quarterly dividend would be $1.50 / 4 or $0.375 per quarter.
WHO BUYS PREFERRED STOCK?
Back before the financial crisis, preferred stockholders were largely banks and insurance companies, insiders, hedge funds, mutual funds, closed end funds and other institutional investors. Although retail investors can buy them as well, they are not well known to retail investors, and definitely not understood by them.
HOW IS PREFERRED STOCK ISSUED?
When issued, preferred is priced like a bond face value, but in this case it’s called “liquidation preference” that’s a reason it’s called “Preferred Stock”.
Companies are required to file prospectus form 424B5 for issuance of preferred stock in accordance with Rule 424(b)(5) of the Securities Exchange Act of 1933. This prospectus will contain important information regarding the structure, risks, and other information about the issuance and is the most important document you can read if you are considering buying a particular preferred stock issue.
The 424B5 form is available on the SEC website at http://www.sec.gov
The SEC website offers many different ways to search for form 424B5s. If you know the company who’s preferreds you are researching, you can search by ticker symbol, then search the individual company files for the 424B5.
WHAT IS THE COST OF PREFERRED STOCK AND HOW IS IT PRICED BY THE MARKET?
The average preferred stock has a liquidation preference of $25 per share, assuming the value of the liquidated assets fully covers the value of outstanding issues of preferred stock. Therefore, during normal times, preferred stock prices will fluctuate around the $25 per share level based on yield.
In the long run, preferred stock valuation is based on prevailing interest rate movements. For example, as interest rates rise, the price of a preferred issue will fall so the yield rises. This price action makes preferred act like a bond with an inverse relationship between price and yield.
In the short run, preferred prices are subject to the laws of supply and demand and imbalances between buyers and sellers. For example, during the financial crisis of 2008-2009, preferred stock prices collapsed because there were too many sellers and too few buyers. This imbalance led prices to fall from around $25 to below $10 for many issues.
WHAT TYPES OF PREFERRED STOCK ARE THERE?
Perpetual preferred stock – The issue has no maturity date and will pay dividends indefinitely unless redeemed by the issuer.
Redeemable preferred stock – The issue can be redeemed by the issuer under certain conditions.
Callable Preferred Stock – The issuer has the right to redeem shares at the issue price, or at a premium, after the specified date
Convertible preferred stock – This type of preferred stock is convertible into common stock at a predetermined ratio and after a specified date. . This gives preferred holders a chance to benefit from the common stock’s share price appreciation.
Cumulative Preferred Stock – If the issuer skips the dividend, it will continue to accrue. If the issuer begins paying a dividend again, the issuer will have to pay any skipped dividends as well. This type of Cumulative DIVIDEND stock is declining in use.
Non-Cumulative Preferred Stock - skipped dividends can be delayed for five-quarters, or even indefinitely. However, skipped dividends must still be paid before common stock dividends are paid and before the shares are redeemed.
Participating - annual dividend varies depending on firm’s net income or dividends paid to common shareholders.
Non-Participating preferred stock – This is typical of most preferred stock, where the holder of non-participating preferred does not share in the profits of the business.
Senior Notes – Issuers cannot skip preferred interest payments (dividends) without going into default.
PINES (Public Income Notes)- a.k.a. QUIBS (Quarterly Interest Bonds) or QUIDS (Quarterly Income Debt Securities). Debt securities such as debentures, notes and bonds that trade like stocks. These senior unsecured debt instruments rank below secured debt, but senior to preferred and common stocks.
Third Party Trust Preferred-a Trust Preferred issued by a third party such as an underwriter.
Trust Preferred Securities- a cumulative preferred variation that provides certain income tax and accounting advantages over traditional preferreds to the issuer, but not for the shareholder. Instead of selling preferreds directly, a corporation sets up a special trust that buys debt securities from the corporation and, in turn, issues preferred shares. If the issuer suspends dividends, shareholders may still be liable for income taxes on the unpaid dividends.
TruPS - Trust Preferred Securities are Smith Barney's brand name for Trust Preferreds.
TOPrS - Trust Originated Preferred Securities are Merrill Lynch's brand name for Trust Preferreds.
Baby Bonds- same as Senior Notes
Exchange-Traded Debt Securities: a.k.a. Preferred Equity Traded (PET) Bonds or Junior Subordinated Debentures. Debt securities such as debentures, notes and bonds that trade like stocks. These unsecured debt instruments rank below secured debt, but senior to preferred and common stocks.
HOW SHOULD PREFERRED STOCK BY ANALYZED FOR SAFETY?
Here are some selection criteria to keep in mind.
· Selling at or below liquidation preference (at or below $25). Be aware that some preferred stock has a higher liquidation preference such as $50 or $100.
· Credit Rating is generally not a reliable indicator of the true safety of the preferred stock.
· Be aware that some preferred stock can be lightly traded and have low liquidity, and if you are trying to sell your preferred stock into a buyer’s market, you may not get the price you want, or be able to sell at all.
· The issuer’s common stock price should be strong, and not below $10 per share. You want the issuer to be able to issue common stock at fair valuation if the company needs to.
· You should analyze the underlying company as if you were considering the common stock as an investment.
· If the common is in the money in the worst case, in your analysis, then the preferred above it should be fully covered in a liquidation.
· Cash flow is what companies use to pay their bills, and their capital expenditures, their interest and their dividends. Cash flow should cover all of these and then some with a comfortable cushion.
· Price is the key to successful investing in preferred stock. Give yourself a wide margin of safety by only buying preferred stock selling for less than 50% of its liquidation preference (e.g. less than $12).
· Company underlying the preferred should not be cyclical. If it is cyclical, you would only want to consider investing in it after the bottom of the cycle (and good luck figuring that out). My advice would be to avoid preferred stock in cyclical, boom and bust type industries.
WHAT ARE THE RISKS WITH PREFERRED STOCK?
These are some of the major risks when investing in preferred stock. This is not a comprehensive list, so be sure to do your own research and identify the risks that are important to you.
Interest Rate Risk - As interest rates rise, the price of yield-based securities fall. This includes preferred stock along with bonds, REITS, MLPs, and any other security that is purchased primarily for its yield. If the price of the preferred stock falls, an un-realized capital loss occurs.
Dividend Suspension - The bane of any preferred stock investor is the dreaded dividend suspension. When a preferred dividend is suspended, the price of the preferred stock plummets and ultimately may go to zero, or cents on the dollar. A company’s board of directors will typically create this situation by passing the dividend (not declaring it).
Call - If a preferred stock is called, it is typically redeemed at face value. If it is selling above face, this may result in a loss of principal market value (e.g. if the preferred was selling at $27 and called at $25, it represents a 7.4% loss in market value).
Bankruptcy - Preferred stock falls below all debt instruments in a bankruptcy and typically receives zero recovery in most Chapter 11 plans.
HOW IS PREFERRED STOCK TAXED?
Many preferred dividends are qualified and therefore taxed at a lower rate than normal income. In the cased of qualified preferred, the holder would owe 15% tax, or if the holder is in the highest tax bracket, will owe 20% on dividends. If you happened to be in the ordinary income tax bracket at 15% or below, you will pay no tax on qualified dividends.
If you are a corporation that invests in other firm’s preferred shares, enjoy a divided received deduction that allows the corporation to exclude 70% of dividends from their taxable income, dependent on ownership level in the company which your corporation received the dividend from. There is also a taxable income limitation for corporations, which means that if your corporate taxable income is less than the dividend received deduction, your deduction is limited to 70% or 80% of your company taxable income.
HOW TO BUY PREFERRED STOCK
Preferred stock is sold on the same stock exchanges as common stock. The easiest way to determine how to plug a certain preferred’s symbol into whatever brokerage platform you use, is to put the ticker symbol for Bank of America “BAC” into your brokerage quote lookup function, and look at the list of securities that show up. The securities that look like “BAC-PRE or BACpE, or BAC.E, or BAC-E or BAC_E” will be a preferred stock.
It seems every brokerage system uses a different style or symbol to denote a preferred stock. Quantum online has a fantastic description of this problem that you can read at
EXAMPLE PREFERRED STOCK CAPITAL APPRECIATION AND YIELD
Using the Bank of America 6% Non-Cumulative preferred stock, Series EE, here are some examples of how capital appreciate, yield, and total pre-tax return would be calculated
A. Capital Appreciation - Bought for $10 in 2016 and redeemed at $25 in 2021. Total appreciation of $25-$10 = $15. So $15 of appreciation divided by original cost of $10 is a capital appreciation return of 150%, which is an average annual return of 30%.
B. Cash Flow from dividend assuming purchase at $10: 5 years times (6% of $25) is 5 x $1.50 = $7.60. So the dividend returned a total of $7.50 divided by $10 original cost or 75%, which is a 15% annual return.
C. Total pre-tax return would be $15 of appreciation, plus $7.50 of dividends for $22.50 divided by the $10 original cost for a total return of 225% and an annualized return of 45%.
This is an example of the type of returns that were possible during the Great Recession for many series of bank preferred stocks, and for a few insurance company preferred stocks.
HOW TO STAGGER YOUR PREFERRED STOCK INCOME
Different preferred stock issues pay quarterly dividends in different months, so it is entirely possible for you to put together a portfolio of preferred that pays you monthly dividends every month. Check out the descriptions of each issue you are interested in and look for the payment schedules. Put together a spreadsheet that lays out these dividends on a monthly basis so you can see how much cash will be coming in the door each month.
HOW TO FIND PREFERRED DIVIDENDS
Here are some of my favorite resources for researching preferred stocks, and sources for lists of preferred stocks:
My favorite website for researching preferred stocks is Quantum Online, which you can visit at http://www.quantumonline.com/Index.cfm
The Edgar system on the SEC website is where I look up company information.
Security Analysis by Benjamin Graham and David Dodd. – Chapter 14 of the 1940’s classic edition has an entire chapter devoted to preferred stock
Most of the preferred shares that I have invested in where found by perusing the preferred stock listings in Barron's weekly newspaper. The type of listing they incorporate in the newspapers makes it easy to see the higher yielding preferreds. You should definitely consider subscribing.
PREFERRED STOCK GLOSSARY
Adjustable Rate: annual dividend varies depending on predefined factors.
Callable: issuer has the right to redeem shares at issue price after a specified date.
Call Date: earliest date that shares can be called. Usually five years after issue date.
Call Price: price issuer will pay for redeemed shares. Usually the same as the issue price.
Coupon Rate: yield based on initial issue price
Current Yield: yield based on current share price.
CUSIP: unique identifier for each security.
Ex-Dividend Date: you must purchase shares prior to the ex-dividend date to receive the corresponding payout.
Issue Price: original share price.
Liquidation Preference (Value): same as issue price.
Market Yield: same as current yield.
Maturity Date: the date the preferred shares must be redeemed by the issuing firm, typically 30 to 100 years after issue.
Par Value: same as issue price
Redemption Date: same as call date.
Yield to Call: return you would receive assuming the preferred is redeemed on the call date.
Yield to Maturity: return you would receive assuming the preferred is redeemed on its maturity date.
Did you find this manifesto useful? Was there anything missing? Any more questions I can answer on this topic? Send me a comment below!
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