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High Quality Preferred Stocks

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Welcome to all of the new CDx3 Newsletter readers who signed up over the last month. This is your first issue of the CDx3 Newsletter, a free monthly newsletter devoted to the interests of CDx3 Preferred Stock investors.

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Quick Summary

This month's High Quality Preferred Stocks article describes how, after over two years of being distorted by the Federal Reserve, the market prices of the highest quality preferred stocks have started to return to more normal levels. Out of the 955 preferred stocks and exchange-traded debt securities that were trading on U.S. stock exchanges at the end of August 2013, our preferred stock search engine found 26 specific high quality issues selling below their $25 par value. (jump to article)

The Preferred Stock News article reminds preferred stock investors that while agency ratings can be meaningful, going just a little further can add a significant amount of risk mitigation. Because preferred stocks have more "knowns" that most other types of investments, there is no reason to sell yourself short. This month's article provides two examples of things to look out for. (jump to article)

The Special Announcement article announces the availability of the all new 5th Edition of my book, Preferred Stock Investing. The new Fifth Edition of Preferred Stock Investing started shipping last month. I update the book every other year with the most recent preferred stock research, focusing on the conditions that preferred stock investors are expected to be facing (upward pressure on rates). Learn to screen, buy and sell the highest quality preferred stocks. (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 my blog 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 Fifth 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.

Invest in the best. Subscribe to the CDx3 Notification Service today.

All Investment Grade Preferred Stocks are not Created Equal

Looking Beyond Agency Ratings Provides Additional Protection

Unlike many other investments one can make, preferred stocks have more "knowns." By that I mean that these securities come with a variety of characteristics (as specified in the prospectus) that allow an investor to tailor their choices to the issues that are most consistent with their personal goals, resources and risk tolerance [1].

The biggest "known," of course, is that you know exactly how much you are going to be paid each quarter in dividend income and the exact day that the dividend cash is going to show up in your brokerage cash account (unlike common stocks, most mutual funds and ETFs). That known dividend amount and payment schedule also serves to lower the volatility of preferred stock prices since these characteristics remove most value speculators from the market (see "Why Falling Prices Should Be Welcomed by Preferred Stock Investors" for more on preferred stock price behavior).

Beyond the known income amount and payment schedule, preferred stock investors also know how long the issuing company is obligated to continue making those payments for and what happens if they fail to do so. Preferred stocks with the "cumulative" dividend characteristic, for example, require the issuing company to ultimately make up any skipped dividends to you (short of a bankruptcy); their obligation to you accumulates (see "Cumulative Preferred Stock Dividend Characteristic Saves Citizens Republic Shareholders" for a cumulative preferred stock case study).

Moody's Versus the Market

In addition to having more "knowns," preferred stocks are rated by companies like Moody's Investors Service and Standard & Poors [2]. 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 [3], investor conclusions about risk are reflected in today's market price (and hence yield).

Figure 3 compares the risk assessment made by Moody's versus how the market is assessing the risk of these same preferred stocks (as reflected by current yield). Each diamond on the chart is a preferred stock. The preferred stocks shown on this chart are very similar in that they all meet the characteristics shown in the Included and Excluded lists seen beneath the table.

Looking at the table under the chart, while all of these securities are rated as investment grade by Moody's, the higher risk preferred stocks provide a higher current yield - no surprise there [4].

But this chart illustrates why investors (including preferred stock investors) are often encouraged to go a step or two beyond agency ratings when shopping for purchases. The fact that preferred stocks have more "knowns" than many other types of investments allows you to do so.

Redemption Likelihood

For example, notice the yield spread at the Baa2 risk level. The two preferred stocks shown as green diamonds are both assessed by Moody's as having the same risk and, looking over their specific characteristics, both of these securities do, in fact, have a lot in common (see the Included and Excluded characteristics listed below the table). So why the massive 3.3 percent yield difference?

The top green diamond is NEE-F from NextEra Energy (NEE). NEE-F offers a whopping 8.75 percent dividend rate (coupon). A preferred stock with the characteristics listed below the table that is offering an 8.75 percent dividend rate in today's 7 percent market should be selling for about $31.25 per share but NEE-F is selling today for a mere $25.63. What a bargain, right?

But this is where a closer look beyond agency ratings can be helpful.

Looking at the current yield of NextEra's four other call-protected preferreds, the company could probably issue a new Baa2-rated preferred today at about 6.5 percent and use the proceeds to redeem NEE-F. Issuing a new preferred and using the proceeds to redeem NEE-F would save NextEra about $8.5 million dollars per year in dividend expense. That means that NEE-F is highly likely to be called when its March 1, 2014 call date arrives. In that event, shareholders will receive the security's par value ($25 per share) in cash plus the final quarter's dividend payment which computes to a maximum redemption amount of $25.55 per share to shareholders.

NEE-F’s market price is being set accordingly at $25.63. It is the likelihood of redemption that is creating this security's seemingly attractive market price and 8.53 percent current yield, more so than its Baa2 rating [5].

Overpriced

The bottom green diamond at Baa2 is PBI-A from Pitney Bowes (PBI). PBI-A offers a miserly 5.25 percent dividend rate (coupon) and is selling for $25.02, right at its $25 par value (at par, the security's current yield will equal its declared dividend rate, 5.25 percent in this case).

PBI-A does not become callable until November 27, 2015 so it does not suffer from the price distortion of an approaching call date that we saw with NEE-F.

But with the average Baa2 yield at 6.7 percent in today's preferred stock market, why is PBI-A being priced such that it only returns a 5.25 percent current yield?

PBI-A currently has two problems - it is unlikely to ever be redeemed by Pitney Bowes and, accordingly, it is overpriced at $25.02.

Historically, the dividend rate offered by these preferreds with the characteristics listed under the table ranges between 6 percent and 9 percent with the long-term average being 7 percent. At 5.25 percent, PBI-A is providing historically cheap money to Pitney Bowes making it unlikely that the company will ever redeem PBI-A prior to its November 27, 2022 maturity date.

Even for those who are content to make 5.25 percent on their money until late-2022, looking at the Baa2 stack on the chart shows us that PBI-A is overpriced at $25.02. To confirm that the market has overpriced PBI-A, Pitney Bowes also offers PBI-B, a nearly identical preferred but PBI-B has a much higher 6.7 percent dividend rate and a March 7, 2018 call date. PBI-B is selling for $24.28 today (August 30), $0.72 below its $25 par value.

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. While such ratings are meaningful, the market's definition of risk can vary from what agency ratings are measuring, leading to the yield spreads illustrated by the above chart (see “Moody's And Preferred Stock Investors View Same Market But See Very Different Risks“ for a similar analysis from last April).

As the table below the chart quantifies, the preferred stock market is transitioning back to one that favors buyers - higher returns available for lower market prices. The alternatives available to us are the best that we have seen in over two years with several high quality issues now offering 7 percent dividend rates (coupon) for sub-$25 market prices (see Figure 2).

Preferred stock investors have an enormous advantage since preferred stocks comes with more "knowns" than many other types of investments. While agency ratings are helpful, going a step or two further can help separate the real candidates from the pretenders.

Footnotes:

[1] Source for all preferred stock data in this article: CDx3 Notification Service database and Preferred Stock Investing, Fifth Edition.

[2] We learned during the Global Credit Crisis 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.

[3] Moody's investment grade ratings, strongest to weakest: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2 and Baa3.

[4] The "current yield" values seen here use the same current yield formula that you see in your brokerage account or other websites that show yield for dividend-paying securities. Current yield does not consider the potential for a future capital gain or loss nor the duration of your investment but, rather, is intended to be used for comparison purposes here. For more on the strengths and weaknesses associated with the various methods for calculating the return from a preferred stock investment see "Preferred Stock Investors: What Is Your Rate Of Return?"

[5] Using a different return calculation that considers the duration of the investment, such as Effective Annual Return or Yield to Call, would show a lower value for securities that are closer to their call dates. See Footnote #4.

More Preferred Stock Research

FROM DOUG K. LE DU

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Test Your Knowledge With These Preferred Stock Facts!