Preferred stock dividends are an income source that I rarely discuss. I have a strong presumption against them because: (1) Preferred stock dividends present an unfortunate trade-off compared to common stock dividends because there is no dividend growth or substantial capital appreciation; (2) Preferred stock dividends usually come from the finance and energy sector, creating an incongruity between the stereotypical retired investor that wants safe preferred stock dividends compared to the relatively unstable sectors of the economy that fund them; and (3) the low interest rates available through traditional channels have led income seekers to consider preferred stock dividends at a time when the general valuation of publicly traded preferred stocks is unattractive.
It’s not an area of the economy that interests me because the payoff of trying to develop expertise in the world of preferred stock dividends is not nearly as lucrative as trying to gain an edge in the world of common stocks. The best case scenario in the world of preferred stock dividends is that you learn how to build a portfolio that generates 7% to 8% in preferred stock dividends on an annual basis–but the net result is still a percentage point or so lower than what you’d get by knowing nothing about finance and spending a lifetime of putting surplus capital into a Vanguard S&P 500 Index Fund. The best case scenario in the world of common stocks is that you learn how to compound wealth in the 10-14% range for the long term, which can result in millions of dollars in extra lifetime wealth compared to what the surplus from your labor would generate if you never developed the skill.
Still, I understand why people take a liking to preferred stock dividends. It only takes a portfolio of $171,429 put into a carefully selected collection of sturdy preferred stocks to give you a monthly income of $1,000. The downside is that the $1,000 per month is pretty much all you get subject to the nominal change in the price of the preferred stock. Even if things go splendidly, you will still only be collecting $1,000 per month years from now–there is no “dividend growth” with nearly all preferred stock dividends, and there is no meaningful capital appreciation over time. Your only inflation hedge is if you use the $1,000 in monthly preferred stock dividends as a cash generating base to make other investments into productive assets as an offset to the decreased purchasing power of your preferred stock dividends.
First off, you should understand that preferred stock is considered part of a firm’s equity base, even though the preferred stock dividends seem bond-like as flat payments. This means that a publicly traded corporation needs to go out and find an underwriter like Morgan Stanley or Goldman Sachs that will agree to serve in the role of the underwriter for the preferred stock offering.
Typically, a firm issuing preferred stock will receive between $22 and $24.50 for the issuance of a $25 share of preferred stock. If you are a low-quality oil upstream driller that needs capital to stay solvent right now, you might receive only $22 from the underwriter to compensate them for the risk of being “stuck” with the preferred stock (e.g. having to offer it to investors below the $25 price). If a large, liquid, high-quality bank like Wells Fargo wants to issue preferred stock, another like Goldman Sachs might agree to underwrite the preferred stock offering at only $0.50 per share because it is well-known that the underwriter won’t have any trouble turning around and selling it to investors for $25 or greater. Also, the offerings of large financial institutions tend to be larger, so the absolute fee may be greater even if the per share amount is lower (and the underwriting bank also has an obligation to unload even more of these shares).
The sequence of relationships works as follows: Wells Fargo management may want to raise $100,000,000 by issuing 4,000,000 shares of preferred stock. If Goldman Sachs is the underwriter that only takes a $0.50 fee per share, it will give Wells Fargo $98,000,000 net of fees that it can use for its general business purposes. Assuming that Goldman Sachs is the sole underwriter, which would be unusual for a preferred stock offering of this size (normally there would be coordination between multiple banks), it now has an inventory of 4,000,000 Wells Fargo shares to unload.
Goldman Sachs will coordinate with Wells Fargo to prepare a prospectus and registration statement, and then a two-step process must occur. First, Goldman Sachs will act on the behalf of Wells Fargo to apply to the SEC as a security that can be publicly traded (this takes three to seven business days), and then it must apply with the Nasdaq or NYSE for listing (this process usually takes thirty days).
Goldman Sachs, sitting on 4,000,000 shares of Wells Fargo stock, will do this in the interim. It will call around and shop some shares of the Wells Fargo preferred stock to its top clients as a reward/incentive for doing business with the bank. The sale will be for $25 or thereabouts per share–the profit for Goldman Sachs shareholders will be $0.50 minus the expenses of bringing the Wells Fargo preferred stock to market, and it will benefit down the road by offering more value to its top clients (things like the Facebook stock IPO are usually discussed as the main reason for well-heeled investors to develop close relationships with banks, but often, the incentive for investors is to be as close to origination as possible for preferred stock issuances that regularly come up.)
After these premier clients are taken care of, Goldman Sachs (or whoever the underwriter might be) will next look to the over-the-counter (OTC) markets which don’t require the thirty-day waiting period that is customary for listing on the New York Stock Exchange (NYSE) or National Association of Securities Dealers Automated Quotation (NASDAQ) system. The incentive for an underwriter like Goldman Sachs to use the OTC market is that it can “de-risk” by unloading some of the shares prior to the arrival on the NYSE or Nasdaq. The incentive for a retail investor is that the deals are going to be better than what can be found by waiting for the NYSE or Nasdaq listing.
In 78% of situations, an investor that buys a preferred stock through the OTC markets will get a better price than waiting for the listings on the two major exchanges. The downside is that these trades are less transparent and the market for the preferred stock is less liquid and developed, and so you must have the proper sophistication to understand the quality of the firm that is issuing the preferred stock. In the 22% of cases in which the price of a preferred stock falls between the time it trades on the OTC markets compared to the formal listing on the NYSE or NASDAQ, the average price decline is 15.7%. In other words, the probability of sustaining a loss when purchasing a preferred stock through the OTC markets is low, but the magnitude of the loss in those one-in-five instances is somewhat great.
When you are considering buying a preferred stock, there are two things you want to focus on: whether the preferred stock is cumulative or non-cumulative, and whether the preferred stock is callable. In truth, every preferred stock is eventually callable–it’s just a matter of when the firm is able to redeem the preferred stock offering.
First, we should discuss the bundle of rights that a preferred stockholder does and does not have. The big differences between buying a preferred stock compared to a common stock for a firm is that preferred stockholders have no voting rights, and no opportunity for dividend growth or meaningful capital appreciation if the intrinsic value of the firm increases. This is why preferred stocks are often referred to as bond-like instruments even though they are technically equity.
In exchange for accepting this drawbacks, preferred stockholders receive certain rights that common stockholders do not have: the contractual right to fixed preferred stock dividends and a priority placement over the common stockholders in the event that the firm goes bankrupt. But don’t let that mislead you: If a firm goes bankrupt, all contract claimants (employees, vendors, bondholders, etc.) get paid first. Then, if there is any residue leftover, that pot goes to the preferred stockholders first, and after them, the common stockholders get a cut. But, in corporate bankruptcy, there is nothing left over for preferred stockholders in 84% of the bankruptcies so it a right that translates into material economic value too often.
But the contractual right to collect income before common stockholders is an important difference, and the question of whether a preferred stock is cumulative speaks to the scope of that contract right. The rights of preferred stockholders to collect a dividend is measured against whether a company pays out a dividend to common stockholders. There is where it is most distinguishable from a bond. If you purchase corporate debt from Wells Fargo, you have a contract claim to collect 3% or whatever the interest on that debt might be. If they don’t pay, you can haul Wells Fargo into court and you will receive a judgment for whatever they owe you might be.
But the contract claim of a preferred stockholder is much weaker than that. The only contract right you inherit through your purchase of a preferred stock is collection of income before anything is paid out to the common stockholders. In other words, if you purchase a preferred stock from Wells Fargo, and it decides to never again pay out a common stock dividend and instead put all cash flows towards buybacks instead, then you don’t have a right to income.
This is where the distinction between cumulative and non-cumulative matters a great deal. Usually, the reason why a firm won’t pay a preferred stock is because it has fallen on hard times and cannot make even common stock dividends to shareholders. If the preferred stock is cumulative, then each missed payment period accrues–the firm must pay back all preferred stockholders before it can begin making common stock dividend payments again. If it is non-cumulative, then the only requirement is that a firm cannot pay a common stock dividend that quarter unless it also makes a preferred dividend payment.
Obviously, all else equal, cumulative preferred stock is better than non-cumulative because it makes preferred stockholders whole consistent with initial expectations at the time it resumes common stock dividend payments after some temporary period of business difficulties. Meanwhile, non-cumulative preferred stockholders can miss out on the collection of preferred stock dividends for as long as the company declines to make common stock dividend payments–a riskier proposition. Usually, this additional risk is compensated, as non-cumulative preferred stock tends to offer a few additional points of yield than cumulative preferred stock.
The second question that is important in the world of preferred stock dividends is the call date–this is the date at which the company is able to liquidate your investment in common stock. Usually, when a call date has already arrived, is at the discretion of the company, or is nearly approaching, the preferred stock is considered “callable.” It is considered “perpetual” otherwise. The term perpetual is measured from the vantage point of the company–they have the legal authority to keep paying out the dividend perpetually passed the call date if they want. It also means that you, as the preferred shareholder, could theoretically be collecting income from the company perpetually–but there is a call date that you must be aware of because you want to know when the company can liquidate your ownership position.
I’ll give an example. I was recently studying the Bank of California (BANC), a small $500 million bank in Irvine, California. One of its preferred stock listings is aa 7.375% Non-Cumulative Preferred Perpetual Stock offering, Series D that trades under the ticker symbol BANC PRD (although it also sometimes listed as BANC.PRD or BANC.PR.D.)
If you are trying to get a feel for the terms of the arrangement, you will have to get a copy of the prospectus that accompanied the preferred stock listing. As of today’s close, the preferred stock trades at $25.93. This is a 3.72% premium to the $25 origination price, as well as a $25 premium compared to the $25 liquidation value.
If you purchase shares of BANC PRD, what do you get? Since it is a perpetual preferred stock with a call date of June 15th, 2020 that is a non-cumulative type of bond, you stand to collect payments of $0.460938 every March 15th, June 15th, September 15th, and December 15th. The annualized payments from Bank of California amount to $1.843752. In other words, your yield if you buy the bond at $25.93 is 7.11% compared to the 7.375% yield that got locked-in by the preferred stock investors that got their hands on this stock near the issuance.
The call date of June 15th, 2020 means that Bank of California can terminate the relationship at any point from that date after–maybe it will exist in 2021, maybe it won’t. It’s at the company’s discretion. In order to terminate the relationship, Bank of California will have to pay you $25 for your shares that currently trade at $25.93. Your principal will go down 3-4% at the time of calling, but you will get at least eighteen payments of $0.460938 before that date arrives (the first record date for Bank of California preferreds is March 1st, 2016 so the payments for this year have not yet begun).
Between now and June 15th, 2020, each preferred share of Bank of California stands to generate $8.30 in preferred stock dividends. If you buy 100 shares of BANC.PR.D., then you stand to collect $830 on your $2,593 investment or 32% of your initial outlay between now and the early summer of 2020. At that point, the Bank of California can redeem the preferred stock and give you $2,500 and terminate the relationship, or it can keep paying out the $0.460938 each quarter for as long as it desires–the Bank of California gets to decide when to liquidate the preferred stock from June 15th, 2020 onward.
Now, the risk of this preferred stock offering is that is not cumulative. If Bank of California ever cancels the common stock dividend, and misses a preferred stock dividend payment, it doesn’t have to make it up later. Is this a high probability risk? Well, during the financial crisis, Bank of California cuts its quarterly dividend from $.185 to $0.05. As long as anything is paid out to the common stockholders, the preferred stockholders get paid in full. If you owned Bank of California preferred stock through the financial crisis, you would have gotten paid in full.
Nowadays, Bank of California is earning $51 million in annual profits and paying out $18 million in common stock dividends. The common stock dividend is on the rise now, and the firm is profitable, meaning it is more likely than not that the Bank of California preferred stockholders will collect their preferred stock dividends in full between now and June 2020.
What I perceive as the real risk of preferred stock dividends is the opportunity cost of not owning the common stock. You’re basically assuming nearly the same risks as the common stockholders face, and however you do quantify the lower risk of preferred stock ownership compared to owning the common stock, the magnitude of potential gains for common stockholders is going to be significant compared to what the preferred stockholders settle for. But still, preferred stock dividends may find a place in the investor’s arsenal simply because there is a role for something that generates 7% to 8% and is a regular source of dry powder. Even if preferred stock dividends don’t maximize wealth, there is something appealing about a $171,429 laddered portfolio of preferred stocks that give you $1,000 per month to invest elsewhere.
Additional Commentary: This source is amazing for locating preferred stock offerings that are only accessible on the OTC markets.
Originally posted 2016-02-22 17:56:06.