PREFERRED
STOCK NEWS
New
Preferred Stock IPO’s, March 2017
The March 15 hike in the
federal funds rate had little-to-no effect
on the average market price of preferred
stocks. Where the last two hikes (December
2015 and December 2016) were characterized
by falling preferred stock prices for
several months in advance, prices did not
start dropping in advance of the March 15
increase until March 1, only to regain that
ground by the end of the month.
March’s new
issues
While this was going on, four new preferred
stocks were introduced during the month for the
consideration of preferred stock investors, with
three of the four coming from new comers to the
U.S. preferred stock marketplace. March’s four
new issues follow three new issues last January
and only two new preferreds last month. Maybe
with the rate hike now behind us, issuers are
starting to offer a more robust collection of
new preferred stocks.
There are currently 105 high quality preferred
stocks selling for an average price of $25.24
(March 31). And 41 of these high quality issues
are selling below their $25 par value, offering
an average yield-to-call of 7.22 percent. By
high quality I mean preferreds offering the
characteristics that most risk-averse preferred
stock investors favor such as investment grade
ratings, cumulative dividends and
call-protection.
But with 41 high quality issues currently
available for less than their $25 par value to
pick from, the number of new preferred stock
IPOs becomes much less relevant to today’s
buyers.
There are now a total of 958 of
these securities trading on U.S. stock exchanges
(including convertible preferred stocks).
Note that I am using IPO date here, rather than
the date on which retail trading started. The
IPO date is the date that the security’s
underwriters purchased the new shares from the
issuing company.
About the new issues
Three of the four new March
issues offer the fixed-to-float rate structure,
where the security pays a fixed dividend rate
until its call date then becomes a variable-rate
security based on a formula specified in the
prospectus. While a variable-rate structure
sounds appealing during a period of increasing
rates, buyers should consider the historical
tendency of issuers to redeem variable-rate
securities on or near the call date if the rate
is going to adjust upward (see ”Variable-Rate
Preferred Stocks Underperform Their Fixed-Rate
Cousins”).
PMT-A, issued by PennyMac
Mortgage (PMT), is the company’s only preferred
stock issue, raising a net of $111 million on
March 2. As a mortgage REIT, PennyMac does not
own physical property; rather, PMT raises
capital (such as through a preferred stock
offering) that it uses to buy bundles of
residential mortgages from financial
institutions. If the cost of the raised capital
is less than the bundled mortgage rate, mortgage
REITs make money on the spread. The cost of
investment capital that mortgage REITs are able
to raise is determined by today’s prevailing
interest rates while the revenue coming from the
mortgages, at least to some degree, remains
fixed until the mortgages mature. So during a
period of increasing interest rates, the
profitability of mortgage REITs tends to get
squeezed. In PennyMac’s case, this mechanism can
be amplified since the company specializes in
distressed mortgage loans for its revenue. At
8.125 percent, PMT-A was the only fixed-rate
preferred stock offered during March.
TWO-A from Two Harbors (TWO) shares a number of
similarities with PennyMac’s PMT-A. Like
PennyMac, Two Harbors is also a mortgage REIT,
although with a somewhat more diverse business.
Introduced within five days of each other, both
of these traditional preferred stocks offer the
same 8.125 percent coupon and cumulative
dividends (if they miss a payment, they still
owe you the money; their obligation
accumulates). And both of these securities
raised about the same amount of capital, with
TWO-A generating $121 million for Two Harbors.
But there are differences, too. While PMT-A
offers a fixed 8.125 percent coupon, TWO-A’s
8.125 percent dividend is fixed until its April
2027 call date. At that time, the coupon rate
for TWO-A shareholders will be equal to the
three-month LIBOR (currently 1.09278 percent)
plus 5.660 percent.
SPKEP, issued by Spark Energy (SPKE) on March 8,
is a small traditional preferred stock, its 1.4
million shares raising about $34 million. Spark,
based in Houston and founded in 1999, is in the
energy business, distributing natural gas and
electricity to its residential and other
customers located in 18 states. Like PMT-A and
TWO-A, SPKEP also offers cumulative dividends,
but at a more generous 8.750 percent coupon
rate. This rate is fixed until SPKEP’s April 15,
2022 call date, and then becomes equal to the
three-monthly LIBOR rate plus 6.578 percent.
NYCB-A from New York Community Bancorp (NYCB) is
the only rated preferred stock among March’s
offerings, commanding speculative grade ratings
from Moody’s (Ba1) and S&P (BB-). NYCB-A’s 6.375
percent dividend is non-cumulative, allowing
NYCB to count the $490 million value of this
security toward its Tier 1 Capital regulatory
reserves (as of 2010, cumulative securities
issued by banks cannot be counted toward Tier 1
Capital reserves since, with cumulative
securities, shareholders have a claim to the
cash, defeating the purpose of reserves). New
York Community Bancorp is a retail bank founded
in 1859.
(Sources: Prospectuses
PMT-A,
TWO-A,
SPKEP,
NYCB-A. CDx3 Notification Service database,
PreferredStockInvesting.com)
Tax
treatment
When purchasing preferred stock
in a non-retirement account, many preferred
stock investors will favor shares that are
designated as paying Qualified Dividend Income
(“QDI” in the Status column of the above table)
since QDI dividends are taxed at the more
favorable 15 percent tax rate.
If a company pays your dividend out of their
after-tax cash (i.e. the company has already
paid tax on the cash), you are obligated to pay
additional tax on this same money, but at the
lower 15 percent rate (this taxing of the same
money twice is the “double taxation” of
dividends that often serves as a favorite
political football).
On the other hand, if the company pays your
dividend out of pre-tax earnings, such as the
case with REIT preferred stocks (both property
REITs and mortgage REITs), the government
collects the full tax from you, taxing such
dividends as regular income (no tax break).
Looking at the Status column, dividends received
from Spark Energy’s SPKEP and New York Community
Bancorp’s NYCB-A are a distribution of the
company’s after-tax earnings and are therefore
designated as being Qualified Dividend Income
(see prospectus for exceptions and conditions).
In Context: The U.S.
preferred stock marketplace
So how do the new March issues
stack up within the context of today’s preferred
stock marketplace?
After the Fed’s December 2015 rate hike, market
prices of income securities predictably fell, at
least for about eight weeks. But throughout
2016, skeptical income investors came to doubt
that the rate hike of the previous December was
anything more than a one-shot deal; prices shot
up shortly thereafter by an average $3.05 per
share.
Similarly, anticipating a Q4 2016 hike, sellers
started selling their shares in August 2016 with
the expected rate hike becoming a reality in
December 2016. But notice in the next chart how
income investors pushed prices right back up
immediately following the December 2016 hike.
Income investors were still skeptical of the
idea that rate hikes were likely to continue.
That multi-year skepticism ended in March.
On March 15, 2017 the Fed made believers out of
income investors. By raising the federal funds
rate for the second time within four months, the
price increase then underway was cut off at
$1.15. Reminiscent of the Greenspan Fed,
back-to-back rate hikes are, in fact, possible
once again.
The notion that additional rate hikes are more
likely has more credibility with income
investors now than it has in several years. If
that continues to be the case, seeing another $3
increase in the average market price of
U.S.-traded preferred stocks, as we did after
the December 2015 rate hike, seems unlikely.
With the idea of additional rate hikes now
having more creditability, 2017 could bring more
favorable pricing to preferred stock buyers.
The average market price of U.S.-traded
preferred stocks is now at $25.57 per share, an
annualized value increase of 13.8 percent for
2017.
For many months now, two of the most significant
contributors to upward price pressure have been
(1) continued zero-to-negative rates implemented
by foreign central banks and (2) insensitivity
by member banks toward changes in the federal
funds rate.
Foreign investors continue to be attracted by
U.S. income securities since they are facing
zero-to-negative rates at home. This foreign
demand puts upward pressure on prices here. And
U.S. banks are holding over $2 trillion in
excess reserve cash - that's above and beyond
the elevated 2010 Dodd-Frank requirements. The
demand by member banks for overnight loans from
the Fed has been, and remains, minimal,
rendering changes to the federal funds rate less
compelling.
But many things affect the market prices of
these securities such as the proximity to their
call or maturity date, proximity to their next
ex-dividend date, industry and/or overall health
of the issuer, perceived direction of interest
rates, pending government regulatory or policy
changes, cumulative versus non-cumulative
dividends and tax treatment of dividend
payments. So what we really need to look at is
current yield, which calculates the average
annual dividend yield per dollar invested
(without considering re-invested dividend return
or any future capital gain or loss). Current
yield is a “bang-for-your-buck” measure of value
that normalizes differences in coupon rate and
price to give us a single, comparable metric.
While the continuing strong demand for U.S.
preferred stocks can be attributed to several
factors, the next chart makes it pretty clear
that the lack of attractive alternatives is
certainly among them.
U.S.-traded preferred stocks are currently
returning an average current yield of 6.5
percent (blue line) while the annual return
being offered to income investors by the 10-year
treasury is 2.4 percent and that of the 2-year
bank CD is a meager 1.6 percent.
For comparison, I have set the
Yield column in the first table above to show
the current yield of the new March preferreds on
March 31.
It is into this marketplace that March’s new
issues were introduced.
Income
versus Value Investing, Year-To-Date
With an average current yield of
6.5 percent, plus the 13.8 percent annualized
value gain, those investing in U.S.-traded
preferred stocks since the beginning of 2017 are
currently on pace for a total annualized return
of 20.3 percent (6.6 percent of which is
realized in dividend cash).
Starting at 2252 at the beginning of the year
(January 3, 2017 open), the S&P500 common stock
value index closed on March 31 at 2363, an
unrealized annualized value gain of about 19.7
percent plus about two percent in average
annualized dividend yield – a year-to-date
annualized gain of about 21.7 percent for common
stock investors.
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