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Quick Summary

This month's High Quality Preferred Stocks article describes how there are still plenty of investment grade preferred stocks available below their $25 par value to pick from. Out of the 959 preferred stocks and exchange-traded debt securities that were trading on U.S. stock exchanges at the end of April 2013, our preferred stock search engine found eight specific issues. (jump to article)

The Preferred Stock News article  isolates differences in how investors and Moody's are viewing risk. Looking at the Baa3 rating level, there is no agreement whatsoever between the market and Moody's. The 33 high quality preferred stocks that Moody's is saying are exposed to the same level of risk are providing yields from 4.9% all the way up to 8.8%. That's a 3.9% spread. If the risk level is the same (Baa3), is the preferred stock with the 4.9% yield overpriced (pushing its yield down) or is the one with a 8.8% yield underpriced (pushing its yield up)?  (jump to article)

The Special Announcement article announces a new and very powerful subscription program for preferred stock investors. Our Preferred Stock List^TM database and search engine, long enjoyed by subscribers to our comprehensive CDx3 Notification Service, is now available as a separate subscription for do-it-yourself investors. The database includes last trade price, today's trading volume, current yield, ex-dividend dates and much more, all of which can be sorted, downloaded and printed at any time. You can create and save your own filters and watchlists of trading symbols, too. (jump to article)

The Preferred Stock Facts article is presented both here and on the PreferredStockInvesting.com website. Test your knowledge by clicking on any preferred stock question to see the multiple-choice answers. You will receive an automatic email that provides you with the correct answer and my explanation. (jump to article)

The Free Special Offer article explains how you can now have continuing preferred stock research delivered to you for free. Why wait until next month's CDx3 Newsletter to find out what is going on in the preferred stock marketplace? Throughout the month I post regular research articles on the Preferred Stock Investing Reader's Forum and make them available to you for free. (jump to article)

Enjoy this month's issue. I look forward to reporting back to you in next month's issue of the CDx3 Newsletter.

Learn To Screen, Buy and Sell The Highest Quality Preferred Stocks

Preferred Stock Investing includes the information, websites and other resources needed for you to be a very successful preferred stock investor. The Fourth Edition is now available at your favorite online retailer. For those who would rather someone else do the research and calculations, I offer the CDx3 Notification Service. Subscribers to the CDx3 Notification Service receive an email alert whenever a new preferred stock or exchange-traded debt security is introduced. Subscribers also receive their own non-promotional preferred stock research newsletter every month, have their own website that hosts the Preferred Stock List^TM database and have access to the CDx3 Discussion Group, the only online forum just for preferred stock investors.

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Preferred Stock Investors Giving Up Yield for Call Protection

Rating agencies and preferred stock investors, while using different methods, usually judge the investment risk of a preferred stock with very little disparity. Where agency ratings come in the form of a quantitative rating on a scale, investor conclusions about risk are reflected in today's market price (and hence yield).

Preferred stocks that are viewed as having similar risk frequently have similar yields -- same risk, same reward.

We learned during the Global Credit Crisis though that agency ratings were imperfect for a variety of reasons. Shortcomings of both mathematics and character led to grossly incorrect ratings in too many cases.

But historically, short of such crisis conditions, agency ratings of securities have served millions of investors all over the globe very well for many decades. And as imperfect as these ratings are, the fact is that most investors have little choice but to use such ratings as a proxy for investment risk -- even though what the investor wants to know and what the rating is measuring are, at least to a certain extent, two different things.

Investors are usually trying to determine the likelihood of a bankruptcy of the company they are considering investing in while rating agencies are trying to quantify creditworthiness (the likelihood that the company will be able to meet its prospectus obligations).

To most investors, these are usually two views of the same scenery.

Moody's Versus the Market

When rating agencies and investors see risk the same way, a group of preferred stocks with the same rating would be priced by the market such that they offer the same yield [1].

This theory is easily demonstrated by comparing the current yield of two similar preferred stocks issued by the same company. For example, in October 2012 General Electric (GE) introduced GEB with a 4.875% dividend. Three months later, the company introduced GEH at the same rate [2]. These two securities are essentially identical and both have the same A1 investment grade rating from Moody's Investors Service.

Since both of these preferred stocks carry the same investment risk (as rated by Moody's), we would expect investors to price them such that they have a similar return (as measured by dividend yield) -- and they do. The spread between their yields is rarely more than 0.05% [3].

By finding preferred stocks where this is not the case (same rating but substantially different yield), we should be able to identify specific issues that warrant a closer look; are there buying opportunities where such securities have been underpriced or is something else going on?

To maximize the comparability of the preferred stocks used for this analysis, I limited the sample to today's preferred stocks that:

- have a par value of $25.00;

- are currently trading on U.S. stock exchanges (excluding the Over-The-Counter exchange);

- are rated as investment grade by Moody's Investors Service;

- have cumulative dividends;

- are call protected;

- are paying dividends (issues with deferred or suspended dividends were excluded);

- have a fixed dividend rate (preferreds with variable or adjustable dividend rates were excluded);

- had a non-zero trading volume on the day that the data was collected; and

- are not convertible to another type of security.

Figure 3 illustrates how the market's assessment of risk (as measured by yield) compares to Moody's assessment (as measured by their investment grade ratings, highest to lowest) for the resulting group of 96 securities. Each diamond represents a specific preferred stock. If the market and Moody's were in agreement (which they usually are), we would see the diamonds above any given Moody's rating (risk level) stack up very close to each other (they would have similar yield).

But that is not the case with this group of 96 similar preferred stocks.

Looking at the Baa3 level, you can see that there is no agreement whatsoever between the market and Moody's. The 33 high quality preferred stocks that Moody's is saying are exposed to the same level of risk are providing yields from 4.9% all the way up to 8.8%. That's a 3.9% spread.

What's more is that today's preferred stock investors are paying an average market price of $26.14 per share for this type of security, $1.14 beyond these securities’ $25 par value (see the table under the chart).

While all of the preferred stocks that are included here are currently call protected, these buyers are exposing themselves to a capital loss in the event of a future call (since shareholders will receive the $25 par value if the issuing company redeems the shares downstream).

Has the market blown the call here or has Moody's misjudged the risk? If the risk level is the same (Baa3), is the preferred stock with the 4.9% yield overpriced (pushing its yield down) or is the one with a 8.8% yield underpriced (pushing its yield up)? Or is something else going on here?

A Closer Look

The disparity that we see between preferred stock investors and Moody's can be explained when we take a closer look at how risk is being defined. Investors and Moody's are currently applying two different definitions of risk to preferred stocks.

In Figure 3 I have highlighted in purple two securities from Prudential Financial (PRU) and two from CenturyLink's (CTL) Qwest Corporation in yellow.

Notice how different these cases are from the General Electric pair that we saw earlier. In both the Prudential and Qwest cases, we have two very similar securities issued by the same company that are rated at the same Baa3 risk level by Moody's but have vastly different yields (i.e. the market is pricing them as if they represent very different levels of risk).

The reason becomes clear when the call dates of these securities are taken into consideration. Figure 4 shows the same preferred stocks with a Baa3 Moody's rating, but now I have sorted the presentation by their respective call dates.

Preferred stock investors are currently willing to give up yield in favor of call protection.

Many of today's preferred stock investors are willing to pay more than $25 per share for these particular securities as long as a call remains unlikely. And the easiest way to help protect against an unwanted call is to buy securities with a call date out into the future as far as possible.

Consequently, we have a market where certain preferred stock investors are willing to pay high prices (above par) if doing so allows them to reduce their risk of a capital loss triggered by a redemption of their shares. The wisdom of this approach depends entirely on your personal goals, resources and risk tolerance. But the result is a market where yield is given up for additional call protection.

While call protection is currently a key component in the risk assessment performed by today's preferred stock investors, no such component is included in the evaluations performed by rating agencies. Preferred stock investors and rating agencies are viewing the same market but seeing different risks.

Footnotes:

[1] Source for all preferred stock data in this article: CDx3 Notification Service database. The CDx3 Notification Service is my preferred stock email alert and research newsletter service and includes the database of all preferred stocks and exchange-traded debt securities traded on U.S. stock exchanges used for this article.

[2] General Electric's GEB and GEH are exchange-traded debt securities (ETDs) which are very similar to, and often referred to as, preferred stocks but are actually individual bonds that trade on the stock exchange (rather than the bond market).

[3] The yield values seen here uses the same yield formula that you see in your brokerage account or websites that show yield for dividend-paying securities. It does not consider the potential for a future capital gain or loss but, rather, is intended to be used for comparison purposes here. Other yield formulas can be used for this analysis as well (e.g. yield-to-call, yield-to-maturity, effective annual return, etc.). As long as you are consistent and use the same calculation throughout, the results shown here will not change.
 

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FROM DOUG K. LE DU

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