From an old CC post:
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David Merkel |
| Why I Don’t Like Preferred Stock | ||
| 6/9/2006 9:19 AM EDT |
If I take risk, I want a decent probability of getting paid for taking the risk, and paid well. If I don’t want to take risk, I want a high degree of certainty that I’m not going to lose money, and if I do lose money, it won’t be much.
Having been a corporate bond manager in my last job (2001-03), I learned that I had all of the downside of stocks, with little of the upside of stocks. (One exception: buying MBNA floating-rate trust preferreds in late 2002 for $68 — they were at par ($100) in less than a year, matching the performance of MBNA stock, but that is rare, outside of distress situations. Another exception: fixed-income risk arbitrage was, in many cases, wider than that of equity arbitrage … examples from that era: Golden State, Household International and Allfirst, but I digress…
The situation is worse with preferred stocks. At least with corporate bonds you have a priority call on the assets of the firm in insolvency. Preferred stock typically gets 10 cents on the dollar in insolvency vs. 40 cents or so on senior unsecured corporates and 80 cents on bank debt.
Preferred stocks are called preferred because the dividend on the preferred must be paid for the common stock to receive a dividend. But with speculative ventures where the common doesn’t pay a dividend anyway, that is a small safeguard. Another small safeguard is the ability of the preferred holders to elect a few directors if the dividend is not paid. Nice, but it usually doesn’t tip the balance of corporate governance.
The recent troubles with Fannie and Freddie preferreds, where they lost 80%+ of their value, has hurt the preferred stock market.? Well, good.? Preferred stock is a vehicle that hates volatility.? The preferred holder just wants to clip his dividend payments and receive his principal back eventually.? He doesn’t benefit if the common rises (I leave aside convertible preferreds), and he is not protected during times of default.
This applies to all hybrid debt, trust preferreds, etc.? They may act like fixed income securities in good times, but in situations of economic stress, they behave more like equity than debt.
Be wary of those that promise high income relative to safer strategies.? It is rare that they succeed.
Well, what you may say is true in today’s markets or the 2000-03 period, but I made a lot of money for my company in the 80’s on preferreds because of one thing that I was able to do with them. Remember for corporations you got 91.5% tax free income and I was able to get in the private placements, (demanded it) non callable for life. Thus as interest rates came down the portfolio ( mainly very good credits, never had one default) got a very good total rate of return. Always beat the index because of it.
David, excellent points. All of my investing is in my IRA and taxable account, so I also think it’s a big deal that corporations can deduct a significant amount of the value of preferred dividends from the tax bill. So the after-tax yield on preferreds will *always* be higher for a multibillion-dollar corporation than little old me. Therefore there will always be millions of dollars willing to pay more for the preferred than I should pay for it.
Also, I have been looking at “synthetic preferreds” where I use a preferred issuer’s common and senior debt to try to create a mix of those two securities with the same base-case expected return. For the financials that are still paying dividends, it’s not hard. Then, as you wisely note in your article, the equity you hold as the potential for unlimited upside.
I wish I would have read your article in January before buying some preferreds of MER, CIT, AEG, and RBS. I got them all at around 80% of par and they rallied a bit but now they’ve all declined by about 40%.
I was considering swapping them out for the common since the worst-case downside is the same, but the common offers a higher upside, although I feel like the likelihood of the common dropping, say 30%, is higher than for the preferred.
Since the preferred market is so much smaller than the equity market, and there have been so many high coupon preferreds issued in the past year, does it make sense to expect lower coupon issues to remain discounted for a while?