Preferred stocks

Let us take a look at what constitutes a preferred stock. From investopedia, we have the following definition:

A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights.

Many of the preferred stocks are callable. Let us see what does this mean, again from investopedia:

A type of preferred stock that carries the provision that the issuer has the right to call in the stock at a certain price and retire it. Also known as "redeemable preferred stock".

The preferred stock is different than a convertible. A convertible is typically a bond that pays a certain interest that later can be converted to common stock.

When we analyze some of the preferred stocks, it is common to see the term "debenture" in the literature. Let us see what this stands for. Investopedia helps us again.

"A type of debt instrument that is not secured by physical asset or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both corporations and governments frequently issue this type of bond in order to secure capital."

Now, let us take a look to see who issues preferred stocks. It is typically the financial institutions and utilities that issue preferred stocks. The banks typically issue preferred stocks as they are able to raise capital without diluting the equity holders.

Typically, a preferred is not a great investment as they may not be called on the callable date as they typically pay a dividend to perpetuity. The second problem with preferred stocks is that the dividend doesnt increase with the companies earnings but the price of the preferred may see wide fluctuations.

So, why is the preferred stock interesting? From Wall Street Journal page, many preferred stocks are generating attractive yields. Some of the banks are particularly interesting. The strongest banks in the US include Wells Fargo and USB. How do we analyze the preferred stocks? There are two tests that come to play.

1. Is the bank stable enough to pay the dividends and outlast this downturn?
2. How is the interest rate calculated? E.g: If the interest is a fixed percentage, one may lose out if the market rebounds and inflation creeps in. However, if the interest is pegged to the LIBOR, the odds of failing against inflation is low.

Investopedia helps us define LIBOR again:

The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year.

Now, let us see which banks have yield against the LIBOR and which ones dont. The WSJ article shows us the current yields on preferred stocks. The yields are wider on banks with troubled assets - e.g: Bank of America and MBNA. The yields are lower on Wells Fargo and USB which have stronger franchises. The regional banks such as Suntrust also enjoy a higher yield as they are perceived to be weaker franchises compared to the larger operations.

The website Quantum Online lists some exotic securities one can follow through. Let us look at a couple of securities.

The first one is USB-L and USB-H. USB-L is currently trading at a higher price but offers about the same dividend as USB-L. While there is certainly more downside risk for both, there is a key difference between these two offerings. While offering identical yields, USB-H is trading at a significantly lower price than USB-L. This is because USB-L offers a higher yield that is fixed at a specific rate. If the inflation is to increase, USB-H will become more attractive than USB-L. From a longer term point of view, USB-H is more attractive than USB-L as USB-H offers more upside. Specifically, USB-H offers more opportunities for capital gains than USB-L.

There are other preferred stocks that one can browse in the above links. Each of them offers its own risks and rewards. One should do one's own due diligence before jumping and buying these stocks.