PREFERRED
STOCK NEWS
New
Preferred Stock IPO’s, August 2017
There were two pieces of
great news for preferred stock buyers during
August – (1) prices realized the second
largest drop of the year and (2) issuers
treated us to the largest menu of new
preferred stock issues that we have seen
since June 2014.
After June’s eight new offerings and seven new
preferred stocks introduced during July, August
brought fourteen new issues with an average
coupon of 6.45 percent for the consideration of
preferred stock investors.
August’s new issues
With the surge of new issues over
the last three months and August’s long-awaited
drop in prices, maybe issuers have started
rushing to the low-rate trough before it’s too
late. After all, a market with falling prices
pushes up yields, requiring that any new issues
pay a more generous dividend to buyers.
Here are the fourteen new issues introduced
during August.

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.
There are currently 94 high quality preferred
stocks selling for an average price of $25.96
(August 31), offering an average coupon of 5.57
percent and a current yield of 5.36 percent. And
10 of these high quality issues are selling
below their $25 par value, providing an average
yield-to-call of 5.14 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.
There are now a total of 955 of these securities
trading on U.S. stock exchanges (including
convertible preferred stocks).
About the new issues
The diversity of the fourteen new
August issues is striking: five properties
REITs, four mortgage REITs, three business
development corporations, an insurance company
and one management investment company issue were
all introduced during the month.
Property Real Estate Investment Trusts (pREITs)
DLR-J from Digital Realty (DLR),
KIM-L from Kimco (KIM), FPI-B from Farmland
Partners (FPI), AHT-H from Ashford Hospitality
(AHT) and CDR-C from Cedar Realty (CDR) are all
cumulative, traditional preferred stocks offered
by property REITs. ‘Cumulative’ means that if
the issuer misses a dividend payment to you,
they still owe you the money (short of a
bankruptcy); their obligation to you
accumulates.
Diversity can also be found
within this group – Digital Realty, data centers
; Kimco and Cedar Realty, retail; Farmland
Partners, farmland; Ashford Hospitality, hotels.
Farmland Partners is unique
within the preferred stock space. Holding close
to 150,000 acres of farmland throughout the
United States, the company is incorporated as a
property REIT. Contrary to its name, FPI is not
a partnership but is, rather, a $330 million
publicly traded corporation founded in 2013. The
proceeds from their FPI-B issue will be used to
help fund their acquisition of the American
Farmland Company (AFCO).
Mortgage Real Estate
Investment Trusts (mREITs)
Mortgage REITs typically do not
own physical property; rather, they raise
capital (such as through a preferred stock
offering) that is used to buy bundles of
residential and/or commercial mortgages. 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 the prevailing interest rates at
the time 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, cost is
rising while revenue remains relatively flat,
squeezing the profitability of mortgage REITs.
SLDA from Sutherland (SLD), IVR-C
from Invesco (IVR), CHMI-A from Cherry Hill
(CHMI) and AGNCP from AGNC Investment Corp. (AGNC)
are cumulative income securities, but use
varying methods to determine their dividend
rate. While Sutherland’s SLDA and Cherry Hill’s
CHMI-A pay fixed dividend rates (7 percent and
8.2 percent, respectively), the dividend rates
offered by IVR-C and AGNCP are fixed until their
respective call dates, then becomes variable.
For IVR-C, its 7.5 percent coupon
is good until its September 27, 2027 call date,
then IVR-C’s dividend rate floats based on the
then-current three-month LIBOR (currently at
1.32 percent) plus 5.289 percent. In AGNCP’s
case, its 7.0 percent fixed rate is good until
this security’s October 15, 2022 call date, then
floats based on the three-month LIBOR rate plus
5.111 percent.
Sutherland’s SLDA is easily the
most complex (not to mention unusual) security
among the August offerings. SLDA is an
Exchange-Traded Debt Security (a bond,
discussion more below) but includes an optional
conversion provision that allows shareholders to
convert their SLDA shares into the company’s
common stock (on the above table, note that SLDA
appear in green font, indicating an ETDS, and
the “OptConv” notation under the trading
symbol). The terms of this provision appear on
page 1 of the prospectus and are spectacularly
complex. Further, since ETDS’s are recorded as
debt on the company’s books, any shares
converted to the company’s common stock by
shareholders converts debt into equity, diluting
the value of equity shares.
Business Development
Corporations
KCAPL from KCAP Financial (KCAP),
SCA from Stellus Capital (SCM) and HCAPZ from
Harvest Capital (HCAP) are Exchange-Traded Debt
Securities from these three business development
corporations. ETDS’s are bonds recorded on the
company’s books as debt (rather than as equity,
as in the case of preferred stock). As debt, the
obligation to pay the interest on these bonds is
cumulative. As bonds, ETDS’s are often seen as
having lower risk than the same company’s
preferred stock shares. ETDS are very similar to
preferred stocks and are often listed on
brokerage statements as such.
Typically, these types of income
securities will offer a five-year call period
and a maturity date that is several decades into
the future. Curiously, the fuses on these three
securities are much shorter. KCAPL, SCA and
HCAPZ become callable in just two years
(September 2019) and mature in just five years
(September 2022).
Insurance
Arch Capital (AGCL) is a
Bermuda-based insurance company, offering its
ACGLO on August 14. ACGLO is the only
non-cumulative preferred stock among August’s
robust offerings. Paying 5.45 percent
non-cumulative dividends, Arch is taking full
advantage of its double-investment grade ratings
with this new issue.
The new ACGLO is an 8 million
share issue, raising just under $200 million for
the company. These proceeds are being used to
partially redeem ARH-C, a 13 million share
preferred stock with a 6.75 percent coupon.
Assuming that Arch uses all of the $200 million
from the new ACGLO toward redeeming 8 million
ARH-C shares, the resulting annual dividend
expense savings pencils out to about $2.6
million to the company.
Management Investment Company
Rounding out the August offerings
is ECCY from Eagle Point Credit (ECC). Like
KCAPL, SCA and HCAPZ, ECCY is also an ETDS.
Being incorporated as a Management Investment
Company, ECC invests in equity positions and
loan instruments that are “…unrated or rated
below investment grade and are considered
speculative with respect to timely payment of
interest and repayment of principal.”
(Sources: Prospectuses
ECCY,
DLR-J,
SLDA,
KIM-L,
KCAPL,
IVR-C,
CHMI-A,
FPI-B,
ACGLO,
AGNCN,
AHT-H,
CDR-C,
SCA,
HCAPZ. CDx3 Notification Service database,
PreferredStockInvesting.com)
Tax
treatment
The tax treatment of the income
you receive from income securities can be a bit
confusing, but it really boils down to one
question – Has the company already paid tax on
the cash that is being used to pay you or not?
If not, the IRS is going to collect the full tax
from you; if so, you still have to pay tax, but
at the special 15 percent rate.
With that rule in mind, here is
how the tax treatment of August’s fourteen new
issues plays out.
Companies incorporated as REITs,
be they property REITS (Ashford Hospitality,
Cedar Realty Trust, Farmland Partners, Kimco,
Digital Realty) or mortgage REITS (Sutherland,
AGNC, Cherry Hill, Invesco), are required to
distribute at least 90 percent of their pre-tax
profits to shareholders. Doing so in the form of
non-voting preferred stock dividends is the most
common method of complying and because these
dividend payments are made from pre-tax dollars,
dividends received from REITs are taxed as
regular income (i.e. they do not qualify for the
special 15 percent dividend tax rate).
Interest that a company pays to
those loaning the company money is a business
expense to the company (tax deductible), so the
company does not pay tax on the interest
payments it makes to its lenders (i.e. interest
payments made to lenders are paid with pre-tax
dollars). Since Exchange-Traded Debt Securities
are debt (KCAP Financial, Stellus, Harvest
Capital and Eagle Point), ETDS shareholders are
on the hook for the taxes. Income received from
ETDS’s is taxed as regular income.
Lastly, if a company pays your
preferred stock dividends out of its after-tax
profits, the dividend income you receive is
taxed at the special 15 percent tax rate. Such
dividends are referred to as “Qualified Dividend
Income” or QDI. QDI preferred stocks are often
seen as favorable for holding in a
non-retirement account due to the favorable 15
percent tax treatment. Looking at the Status
column in the above table, dividends received
from Arch Capital’s ACGLO 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 August issues
stack up within the context of today’s preferred
stock marketplace?
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.
Since December 2016, preferred stock buyers have
totally ignored the Fed’s three rate increases.
That may have started to change
during August, as preferred stock prices
realized their second most significant drop so
far this year.

Normally, the $0.13 drop that we saw during
August would not attract much attention, but
this time may be different. Just over 60 percent
of preferred stocks use the calendar quarter to
pay their dividends, so upward pressure on
prices typically builds as March, June,
September and December approach. Because of this
mechanism, we would normally expect to see
prices increase during August as September’s
dividend payments come into view.
But preferred stock prices went down last month,
not up. When combined with the surge of new
issues that we have seen over the last three
months, there may be reason to be optimistic
that upward pressure on rates has finally built
up enough to start pushing prices down in a
meaningful way. As the coming months unfold,
August 2017 may be seen as the month that
preferred stock prices finally started to return
to normal (closer to their $25 par values).
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 6.4
percent (blue line) while the annual return
being offered to income investors by the 10-year
treasury is 2.2 percent and that of the 2-year
bank CD is a meager 1.7 percent.

For comparison, I have set the
Yield column in the first table above to show
the current yield of the new August preferreds
on August 31. It is into this marketplace that
August’s new issues were introduced.
Income versus Value
Investing, Year-To-Date
With an average current yield of
6.4 percent, plus the 7.8 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 14.2 percent (6.4 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 August 31 at
2472, an unrealized annualized value gain of
about 14.7 percent plus about two percent in
average annualized dividend yield – a
year-to-date annualized gain of about 16.7
percent for common stock investors.
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