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Stormy Weather

(Guest Commentary by Rick Konrad – July 17, 2008)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick is one of our two regular guest commentators (besides Bill Rempel, who will be writing a guest commentary for us next Thursday – as his schedule did not allow him to pen his usual commentary during the first Thursday of this month) and usually writes for us every third Wednesday of the month.  Rick has also been writing for us for 18 months now.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will be offering his thoughts on the values that he currently sees in various preferred shares of financial services companies.  Not only will he cover the general features of preferred shares, but he will be giving us detailed examples as well.  As usual, Rick does not disappoint!  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “When Cheap Ain't Good Enough” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

Needless to say, markets have provided some incredible volatility in the last few weeks. Certainly, many new clients are frozen into inactivity, mesmerized by the action. In every stock market downturn I have experienced, one feels completely powerless. Almost everything that you do is wrong; almost everything that you have bought gets cheaper; there is a tendency to close one's mind to new ideas since it is unlikely anything will work anyway! Fighting the storms, putting out the fires has been especially difficult for holders of financial stocks. Like the old Billie Holiday classic song “Stormy Weather,”

“Life is bare, gloom and misery everywhere
Stormy weather
Just can't get my poor old self together
I'm weary all the time, the time
So weary all the time.”

Investors often extrapolate from most recent experience. Brief snippets of stock market history are not terribly useful unless our principal focus is short-term volatility. It does not hurt to stand aside, and reflect on what capital markets are telling us…all segments of the capital markets.

As a young portfolio manager in the midst of the 1980-1982 collapse of equities, one part of the capital markets that intrigued me was preferred shares. Canadian corporations were meeting their needs for capital largely by offering preferred shares that had spectacular features, whether in terms of coupon, or in terms of optionality such as extendibility or retractability, Some even had warrant sweeteners to entice our capital. After all, corporate survival was paramount, and of course investment bankers would create product that would provide the solution.

One of the great things about downturns is that the product offerings of investment bankers can be useful and innovative. In bull markets, investment banking becomes me-too-ism, in bear markets, clients can dictate terms.

That is what I am beginning to see in preferred shares at the moment. Fear is rampant. We like to focus on the notion that whenever fixed income vehicles begin to offer equity-like returns, then it is a great time to be looking at fixed income.

Let's spend some time looking at this much-maligned asset class. A few fundamental tenets:

  • Preferred shares offer yields that are higher than bond yields, money market yields, and stock yields.
  • Preferred shares are a hybrid offering characteristics of both stocks and bonds.
  • Preferred stock returns have low correlations with equity returns making them good diversifiers. Similarly, they have relatively low correlations with bonds with usual expected returns somewhere between stocks and bonds.
  • Preferred stocks have very little price appreciation potential. The return consists primarily of dividend yield.
  • Some preferred stocks come with a call or mandatory conversion feature. This results in reinvestment risk should the preferred stock be called or converted.
  • One of the biggest issuers of preferred securities is the banking industry and other financial institutions. Regulators require banks to have a minimum level of Tier I capital. Tier I may include equity, disclosed reserves and preferred securities. Since preferreds are typically cheaper to issue than equity, banks issue preferred shares quite often.

So why bother looking here? I strongly believe that an investor is much better off with an investment in the subordinated security of a strong, credit-worthy company when you are paid for that subordination, as opposed to owning a senior debt security of a weak, deteriorating credit.

We all know that equity is at the bottom rung in the capital structure ladder…the lowest form of junk debt, it doesn't even get a coupon! We also know that the bank always gets paid first followed by the holders of mortgages and debt. The preferred shareholder gets a coupon but has some equity type of risk because of his subordinate position to the debtholders.

So what sorts of yields are available?

Let's start with a controversial choice, Barclays.

BARCLAYS BANK PLC SP ADR 7.1% PF3, or  BCS Preferred Class A

 Barclays Bank plc, 7.10% Dollar-denominated Non-Cumulative Callable Preference Shares, Series 3, sold in the form of American Depositary Shares, liquidation preference $25 per share, redeemable at the issuer's option on or after 12/15/2012 at $25 per share plus declared and unpaid dividends, and with no stated maturity. Non-cumulative distributions of 7.10% ($1.775) per annum are paid quarterly on 3/15, 6/15, 9/15 & 12/15 to holders of record on the date fixed by the board. Note that this is a traditional preferred rather than trust preferred and unlike most preferred, is eligible for 15% tax treatment.

Rated Aa3 / A+  
Currently yielding 10.515% Yield to call 18.175%
Maturity: No stated maturity  
Tier I Capital 7.80%  

We admire the strategy of this bank though the capital replenishment was delivered haltingly but on what we view as minimally dilutive terms. One could argue that the best part of recent Barclays strategy was missing out the acquisition of ABN Amro. Recent UK mortgage trends have concerned some observers but in the first quarter, the loan-to-value of the mortgage portfolio was only 34%. The withdrawal of other banks from the mortgage business has provided BCS market share of 28% versus 8% a year ago. Clearly, the great credit uncertainty is being harvested as an opportunity by BCS. The loan to value of new mortgages averages 53% consistent with last year. Barclays has the world's largest family of ETFs known as iShares.

Here's an example of a trust preferred that I like:


USB Capital Trust XI, 6.60% Trust Preferred Securities, liquidation amount $25 per share, guaranteed by U.S. Bancorp (NYSE: USB), redeemable at the issuer's option on or after 9/15/2011 at $25 per share plus accrued and unpaid dividends, and maturing 9/15/2066. Distributions of 6.60% ($1.65) per annum are paid quarterly on 3/15, 6/15, 9/15 & 12/15 The company has the right, at any time, to defer interest payments for up to 20 consecutive quarters (but not beyond the maturity date) and up to 10 years subject to the alternate payment mechanism.

Rated Aa3 / A+  
Currently yielding 9.02% Yield to call 17.72%
Maturity: 2/15/2067  
Regulatory Leverage Ratio 7.90%  
Tier I Capital 8.5%  

Trust preferreds are as the name implies, structured within a trust whose only asset is a bank's corporate bond. Hence, they offer greater principal protection than a conventional preferred since they are in fact specifically collateralized.

There are distinct advantages for the bank issuer of these securities. Trust preferreds are considered a “hybrid” instrument because they have the properties of both equity and debt instruments. Counting trust preferred securities as tier-one capital for regulatory capital purposes makes them similar to an equity. Having a fixed maturity, paying a fixed or floating dividend, and not offering voting rights to investors make them similar to a debt instrument. Trust preferreds are essentially a form of debt that can be treated as equity for regulatory capital purposes, with the interest being tax-deductible.

In order to qualify as Tier I capital, trust preferreds have a provision to defer their dividend distributions for a minimum of five years. In practice, at least for the well-capitalized banks, this has never occurred. This creates the appearance of having equity-like characteristics to this fixed income instrument.

For those who do not wish to invest directly, there are other pooled ways to participate in this market.

The PowerShares Financial Preferred Portfolio (PGF) is based on the Wachovia Hybrid & Preferred Securities Financial Index (WHPSsm Financial Index). The Index tracks the performance of U.S. listed preferred stocks of preferred stocks issued in the US market by financial institutions and currently includes approximately 30 securities selected by Wachovia pursuant to a proprietary selection methodology. The market-cap weighted Index is rebalanced monthly. The yield is about 10% with average quality of A/A2. The expense ratio is somewhat high relative to many fixed income competitors at 60 basis points.

Another interesting ETF with broader industry diversification if PowerShares Preferred Portfolio (PGX)

Finally, there are a number of closed end funds which utilize about 30-35% leverage to enhance the returns on their preferred portfolios. Closed end funds, which generally sell at a discount, can sell at huge discounts when the underlying assets are out of favor. Some funds to consider include:

BlackRock Preferred Income Strategies Fund,(PSY) which currently sells at a 11.6% discount to net asset value and yields about 9%.

First Trust Tax-Advantaged Preferred Income Fund (FPI) which currently sells at a 17.9% discount to NAV and a distribution yield of about 13.58%.

The disadvantage of closed-end funds is that the management fees can seem high relative to ETFs.

Bottom line, remember that as interest rates rise and fall, you own a fixed income instrument that will respond to these changes as well as changes in credit. Call features are meaningless in a rising interest rate environment can be rewarding, or of concern in a falling interest rate environment. Those yields to call look very tantalizing if rates drop.

Remember as well, that you only accept a subordinated position in the capital structure in businesses that are credit-worthy and fundamentally sound. Being backed by a junior debenture in a rotten business still leaves you naked.

Disclaimer: I, my family, or clients own a position in the USB Capital Trust XI preferred. My firm also has acted as a sub-advisor to a number of First Trust sponsored unit investment trusts.

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