High Yielding Preferred Stocks Could Also Get the Dividend Ax

Preferred shares are typically equity with a higher ranking than ordinary shares. Preferred stock does not have voting rights but has a fixed dividend payment, just like a bond. In a bankruptcy or liquidation of the corporation, preferred shareholders have a superior priority over common shareholders, but a lower priority in comparison to bond holders. Preferred stockholders are also first in line to receive dividend payments, which are typically fixed. They don’t typically get to share in the prosperity of the enterprise however as preferred stock dividends do not increase. In tough economic conditions however, preferred stock dividends are much less likely to be cut or suspended; as long as the company continues operating as a going concern preferred stock dividends continue getting paid.

There are several ETF’s, which enable investors to participate in a basket of preferred stocks. One of the most active ETFs is the iShares S&P U.S. Preferred Stock Index (PFF) and the other is Powershares Financial Preferred (PGF). PFF currently yields 10.77% and has an expense ratio of 0.48%. Financials account for over 81% of PFF’s asset allocation, while materials and Health Care account for 8% and 7% respectively.

PGF currently yields 13.60% and has an annual management fee of 0.72%. PGF’s holdings consist only of financial preferred shares. The main difference with PFF is that PGF holds preferred stock in foreign banks such as Credit Suisse (CS), HSBC (HBC), Royal Bank of Scotland and ING Group (ING).

Preferred stocks have typically enjoyed above average dividend yields. In addition to that preferred shares have usually come from financial companies. Regulators require banks to have adequate capital to support their liabilities and require that they hold a certain minimum level of Tier 1 capital. Because preferred shares are normally less expensive to issue than common stock, banks issue preferred stocks quite often.

The financial crisis that started in 2007 has affected negatively the market for preferred shares, which have taken a beating. Investors who chased high yielding preferred stock ETFs got burned in the process as well. The iShares S&P U.S. Preferred Stock Index, which lost almost 24% in 2008 are down 45.70% year to date. The Powershares Financial Preferred ETF also lost 27.30% in 2008 and 55.7% so far in 2009.

Main reason why investors are fleeing preferred stocks is the high allocation of financial companies. The bailout of Freddie Mac (FRE) and Fannie Mae (FNM) by the US government resulted in elimination of dividends for preferred shareholders. Most recently Citigroup (C) announced that it would suspend dividends on some preferred shares, which could be a final blow to investors seeking fixed income. Investors are worried that the rest of financial stocks, which received TARP money, such as Bank of America (BAC), Wells Fargo (WFC) and US Bancorp (USB), could be next to cut the dividend payments on their preferred shares.

Because of the current uncertainty in preferred dividends, I do not view PFF and PGF as buys at these levels. Investors who learned the hard way not to chase yield should think twice before diversifying into preferreds.

Comments

[Alan Young:]

How much of PGF/PFF is in cumulative vs. non-cumulative preferreds? That makes all the difference. Cumulative preferred shares will always get the dividend, eventually, unless the company goes bankrupt, so they are a much better value.

I would be really grateful for some real research into whether dividend cuts are permitted by the prospectus of each security in the ETF.
Absent that research, it is misleading to simply assert that the dividends might be cut.

Mar 11 11:11 AM

[klarsolo:]

PFF and PGF are quite different plays on preferred ETFs. PFF primarily owns trust preferreds of financials, and most of them are cumulative. Altogether, about 55 % of all preferreds in PFF are cumulative, similarly to PGX.

PGF on the other hand exclusively has non-cumulative, regular preferreds. Not a single trust preferred can be found in here and as I said, NONE of them are cumulative. On top of that you have a high concentration in nationalized Royal Bank of Scotland, who is at the whim of the government.

PGF is priced lower than PFF/PGX, but the risk is also much higher. I'd go with PFF/PGX for the time being.

Mar 11 11:17 AM

[MarkTwain:]

If you go to the Powershares site, they will give you a list of the components, which change month to month. You'll see that some of the troubled banks have dropped out of the WHPS index and are no longer included in PGF. You can also calculate the exposure to RBS, which I would not call a "high concentration."

Not sure where the author got the 13.6% yield. It's more like 25% and tax advantaged.

Mar 11 02:40 PM

[klarsolo:]

MarkTwain, it could just be me, but 6 % of a fund in a high risk position is too much for my taste. Of course it all depends on your overall asset allocation. But I generally dislike funds that have a high allocation to any one name.

Mar 11 02:45 PM

[David Clayton:]

The stated yields are incorrect. Current yields (at specific prices):

PGF ($6.50): 21.5% - www.invescopowershares...
PFF ($13.62): 14.4% - us.ishares.com/product...

Also, the management fee of PGF is scheduled to increase to 1.00% in August.

You failed to mention that Citigroup's action suspending the preferred dividend included an offer to convert them to common shares at a premium. The preferreds jumped 30-60% on the day of the announcement.

Cutting dividends on preferreds is very much a last-gasp survival tactic. With the common stock so low, a secondary of common isn't feasible due to the dilution, so preferred is the only viable capital raising mechanism. Killing the preferred dividends damages their value tremendously, and makes raising capital with additional non-cumulative preferred issues impossible. When Ford deferred its cumulative trust preferred dividends last week, the shares lost 40% of their value and now trade at 21% of par. And those are dividends that will be paid eventually if the company survives.

So what C was doing was throwing in the towel. Citi does not expect to raise private capital again (though they left the trust preferreds intact, so there is a small window there), and so it is taking extreme steps, backed by the government, to preserve every dollar it can.

BAC might find itself in a similar position, but I don't think any other national U.S. bank is in anything close to this condition.

In addition to the fact that PFF holds a significant amount of trust preferreds, the other differential between these two ETFs is the foreign exposure in PGF. Many of the foreign banks are struggling at least as mightily as Citigroup, and investors are much more inclined to believe that governments will take them over. Currently, the highest-yielding U.S.-based components are BAC, averaging about 25%. Yielding more than this are preferreds of Aegon (34%), ING (37%), and RBS (42%).

Compare the average 25% yield on BAC preferreds with the current yields of WFC-J (14.8%), USB-L (12.0%), and JPM-I (11.5%), and you can see that the market does not share your concern about those dividends.

While I own the PGF (and have taken a bath), the European shares definitely make it quite speculative. I am fairly confident about the BAC preferreds at this point, and moved some of my PGF holding into BML-Q after the Citi debacle (my opinion here: seekingalpha.com/artic...). I hope to write a piece soon explaining my opinions on a number of preferred issues.

Glancing at the holdings of PFF, which I don't own, it looks very solid to me. Yes, there are a few problem children, but I don't think there's much question about the vast majority of the components' ability to pay dividends indefinitely. That's why the dividend is only 2/3 that of PGF.

Mar 11 03:16 PM

[kewgardens:]

I bought the WFC-J, held it through the ex-dividend date in February and then sold it at a small profit. I am thinking of getting back into this security (perhaps accompanied by a short position in the common as a hedge) as well as purchasing the USB-L, which has declared its quarterly dividend and goes ex-dividend in late March. Thoughts on these securities.


On Mar 11 03:16 PM David Clayton wrote:

> The stated yields are incorrect. Current yields (at specific prices):
>
>
> PGF ($6.50): 21.5% - www.invescopowershares...
>
> PFF ($13.62): 14.4% - us.ishares.com/product...
>
>
> Also, the management fee of PGF is scheduled to increase to 1.00%
> in August.
>
> You failed to mention that Citigroup's action suspending the preferred
> dividend included an offer to convert them to common shares at a
> premium. The preferreds jumped 30-60% on the day of the announcement.
>
>
> Cutting dividends on preferreds is very much a last-gasp survival
> tactic. With the common stock so low, a secondary of common isn't
> feasible due to the dilution, so preferred is the only viable capital
> raising mechanism. Killing the preferred dividends damages their
> value tremendously, and makes raising capital with additional non-cumulative
> preferred issues impossible. When Ford deferred its cumulative trust
> preferred dividends last week, the shares lost 40% of their value
> and now trade at 21% of par. And those are dividends that will be
> paid eventually if the company survives.
>
> So what C was doing was throwing in the towel. Citi does not expect
> to raise private capital again (though they left the trust preferreds
> intact, so there is a small window there), and so it is taking extreme
> steps, backed by the government, to preserve every dollar it can.
>
>
> BAC might find itself in a similar position, but I don't think any
> other national U.S. bank is in anything close to this condition.
>
>
> In addition to the fact that PFF holds a significant amount of trust
> preferreds, the other differential between these two ETFs is the
> foreign exposure in PGF. Many of the foreign banks are struggling
> at least as mightily as Citigroup, and investors are much more inclined
> to believe that governments will take them over. Currently, the highest-yielding
> U.S.-based components are BAC, averaging about 25%. Yielding more
> than this are preferreds of Aegon (34%), ING (37%), and RBS (42%).
>
>
> Compare the average 25% yield on BAC preferreds with the current
> yields of WFC-J (14.8%), USB-L (12.0%), and JPM-I (11.5%), and you
> can see that the market does not share your concern about those dividends.
>
>
> While I own the PGF (and have taken a bath), the European shares
> definitely make it quite speculative. I am fairly confident about
> the BAC preferreds at this point, and moved some of my PGF holding
> into BML-Q after the Citi debacle (my opinion here: seekingalpha.com/artic...).
> I hope to write a piece soon explaining my opinions on a number of
> preferred issues.
>
> Glancing at the holdings of PFF, which I don't own, it looks very
> solid to me. Yes, there are a few problem children, but I don't think
> there's much question about the vast majority of the components'
> ability to pay dividends indefinitely. That's why the dividend is
> only 2/3 that of PGF.

Mar 11 11:02 PM

[kewgardens:]

What do you think of PGX? Better or worse than PFF? Both seem to be heavily invested in cumulative preferreds and trust preferred. As far as I can tell, the main difference is that PGX has foreign exposure while PFF does not. So it would seem that PFF may be the better choice. Thoughts?


On Mar 11 11:17 AM klarsolo wrote:

> PFF and PGF are quite different plays on preferred ETFs. PFF primarily
> owns trust preferreds of financials, and most of them are cumulative.
> Altogether, about 55 % of all preferreds in PFF are cumulative, similarly
> to PGX.
>
> PGF on the other hand exclusively has non-cumulative, regular preferreds.
> Not a single trust preferred can be found in here and as I said,
> NONE of them are cumulative. On top of that you have a high concentration
> in nationalized Royal Bank of Scotland, who is at the whim of the
> government.
>
> PGF is priced lower than PFF/PGX, but the risk is also much higher.
> I'd go with PFF/PGX for the time being.
>

Mar 11 11:08 PM

[THofler:]

kewgardens,

I've started to nibble on USB-F. It is a trust preferred and cumulative I think. Also, it will mature in 2035 when I hope to be still alive.

USB-L is a traditional pref., non-cumulative, perpetual.

The Citigroup traditional preferreds had their dividends suspended, but not so for the trust preferred. They are still paying. They have higher seniority than traditionals, but almost never qualify for the dividend tax break.

Mar 12 02:39 AM

[User 227081:]

Aalan - If you go to QuantumOnline.com and register (free), you can type in the ticker for any preferred and get a full description. When you look at a bank preferred, you will see that most give themselves as much as 20 quarters when they can suspend payments and they are not cumulative. If you look at REIT preferreds, you will see that they are cumulative.
There is a new book out, INVESTING IN PREFERRED STOCK, Paul Josephs. Only 88 pages and you can order from Amazon. After reading it, I determined to buy only preferreds titled TRADITIONAL CUMULATIVE PRFEFERREDS and TRUST PREFERREDS, all with with A ratings. And to avoid preferreds titled THIRD PARTY TRUST PREFERREDS and the NON CUMULATIVE preferreds.


On Mar 11 11:11 AM Aalan wrote:

> How much of PGF/PFF is in cumulative vs. non-cumulative preferreds?
> That makes all the difference. Cumulative preferred shares will always
> get the dividend, eventually, unless the company goes bankrupt, so
> they are a much better value.
>
> I would be really grateful for some real research into whether dividend
> cuts are permitted by the prospectus of each security in the ETF.
>
> Absent that research, it is misleading to simply assert that the
> dividends might be cut.

Mar 12 10:43 AM

[notsosmart:]

this ponzi is more complicatd than craps in vegas.what has happened to investing?LOL

Mar 12 12:10 PM

[MarkTwain:]

Well, I recommended PGF to some colleagues earlier this week and it's up 45% today. Of course, it's also down by huge amounts depending on when you bought it.

I think if you can get a 30% yield tax-advantaged which is where it was earlier this week, there is a margin of error that is attractive. Of course there are risks and assumptions -- for that yield, equivalent to 40% pre-tax cash pay for a high income taxpayer, there'd have to be.

I've written elsewhere about this but two key insights:

- the banks in the index will not be allowed to fail. Contrast that to high yield bonds where the credit risk is effectively unknown.

- the government cannot afford to wash out the preferred because they would never attract private capital back into the banks. It's like the cat eating a mouse and telling its brother mice that they should come for lunch too. As pointed out above, the Citigroup preferred got treated much better than market in the recap.

Yes, if the banking system truly is insolvent and yes if the government ends up owning all the banks in the ETF, then you'll be wiped. But imagine what will happen to other asset prices under such a bad scenario.

Mar 12 04:52 PM

[MarkTwain:]

By the way, I posted the following on March 3rd elsewhere on this site:

I've been buying PGF over the past month. My rationale is as follows:

- governments will not let the components of the WHPS index fail - that doesn't mean they might not punish the preferred but it's unlikely given the need to attract private capital (this is not a French style nationalization for the long-term and screwing the shareholders a la Paulson is no longer seen as smart)

- my quick review of the portfolio (remember to look at the Powershares site for the latest composition as for instance Schwab's summary is way out of date) indicates that only around 17% of the portfolio is at risk of a government intervention (this is a big assumption based on the cushion of common equity value below the preferred)

- this means that you might lose part of the 17% (but with Citigroup you actually should have ended up with more given the deal proposed) but in return you are getting a 20% tax-advantage cash yield (caveat that the yield will decline as the weaker preferreds get washed out)

- the real risk is my mind is a deferral of the preferred dividends even by some of the healthier groups. I judge this as unlikely unless the banks' situations are even worse than feared since it would again making raising private capital problematic. But if it does happen it will clearly impair the pricing although in the longer term dividends will be restored and there will be a recovery in value. I have not investigated whether the larger components have cumulative preferreds in which case you won't lose the dividend, just have it delayed. It's possible also that mergers would occur which would be likely to result in a payment at par.

So for someone who is able to take a 3 year view, I think this looks like a great investment: if I assume buying at 33% of par, holding for 7 years and receiving a 20% yield on purchase price and return of principal, I get a 7 year IRR of 32%. If I assume 33% of par, hold for 7 years, and yield of 10% (whack half of the dividends) and assume I get 70% of par, the IRR is 19%, both of these tax-advantaged. So clearly there is panic built into the pricing of these securities. Or I'm missing something....Armaggedo...

And if my hypothesis is correct, then there should be a major uplift as several factors converge:

- confidence about which banks are healthy is established through the stress tests
- the governments (RBS, Citigroup) continue to protect preferred shareholders
- risk premia decline from the completely manic levels of today and investors focus on the longer term instead of using a 2 year discount period
- there is more transparency on this ETF (as I said I think there is misinformation in what is actually in the ETF as it gets rebalanced every month

Mar 12 04:57 PM

[sergio scro:]

AIG will pay preferreds shares (AVF)?

Mar 12 07:49 PM

[Conan the B...:]

Clayton: Have you done any research on on the Capital Trust preferreds.

You appear to be lumping them into the same category as regular Preferreds. (Even the C conversion excluded the Trust Pfds.)

"BAC is in danger" of what pray tell? I imagine they may be in danger of producing earnings far greater than anticipated by any of the Analysts out there. MER unencumbered by writedowns can produce zero?

The Cap. Trust Pfds get priority over the Governments pfds for both C and BAC.

I am prejudiced of course. I own the BAC-PX at an avg. cost of $9. My payout will be about 20%. I will be paid before the Government is.

Nationalization is a risk, a very low priority risk. IMO

Mar 12 11:07 PM

[axisbogner:]

Thanks for calling the bottom in PGF and PFF. Really appreciate the insight. lol.

Mar 13 01:11 PM

[David Clayton:]

@paultaut: when news of the C deal broke, I looked up the TruPS of C and also BAC, since its the most likely bank to be forced into a similar kind of deal. The idea being that the C action would be a model for BAC if things get worse. It was very interesting that C's TruPS remained unscathed and actually reaffirmed. I guess that was because converting that debt to common would be complicated by the trust structure. Since C specifically said the TruPS would continue to be paid, I thought they would gain stability from the announcement. Didn't happen. I thought BAC's preferreds would get support. Didn't happen. If I wrote something that indicated I thought BAC is in danger it was a mistake--I moved some of my PGF into the former Merrill Lynch preferred BML-PQ because it was the highest-yielding of the BACs. I think the C news moves the chance that BAC stops preferred payments to near-zero. As with C, which will no longer have any non-TruPS preferred, BAC would also offer a conversion to common. Of the TruPS I like MER-PK best because of the higher yield and trading volume.

I also looked at the Ford TruPS when the Ford debt conversion news came out, and wrote something about it here: seekingalpha.com/artic...

Mar 13 01:24 PM

[Vox Rationalis:]

"I guess that was because converting that debt to common would be complicated by the trust structure."

No. Citigroup wiped out all of the preferred and none of the debt. The trusts are funded by debt, so from the company's point of view payments to them are equivalent to debt, not preferred equity.

Mar 14 02:24 PM

[djhernandez:]

PGF, PFF, PGX (all ETFs) are up 40% since march 9. All of these are
"preferred and financial" type.

BTZ, FLC, JHP, BPP (all CEFs) are up only 10% since march 9. These are
also preferred and financial.


I am trying to find the differences in their investments, or anything
that helps me understand why is there such a difference, knowing that
they all invest on very similar assets...

If anyone knows anything that can help, I would appreciate it.. thanks

Mar 16 01:46 PM

[MarkTwain:]

I don't have the time to investigate in detail but, looking at BTZ, my guess from the following excerpt would be there are several factors:

complexity -- this is a highly complicated, split level trust which does not seem to have much disclosure of the underlying assets. It uses options and apparently issues auction rate preferred. By contrast, PGF is an index which is rebalanced monthly with the values of the underlying assets available minute by minute by public quotes.

concentration - PGF is completely concentrated in preferred of relatively few financial institutions.

In summary, PGF is just a purer play.

Having said that, I have no idea whether BTZ is a better buy or not. It's too complicated to actually analyze it, at least given my simple brain.

Mar 17 03:50 PM

[MarkTwain:]

sorry, here's the excerpt I mentioned:

NEW YORK--(Business Wire)--
Fitch Ratings has affirmed BlackRock Preferred and Equity
Advantage Trust's auction-rate preferred stock series T7, W7, R7, and
F7 at 'AAA'. The preferred stock totals $231,000,000. The rating
affirmation follows redemption of 9,240 shares of the above mentioned
series in the total amount of $231,000,000, or 50% of the total amount
of preferred shares outstanding. The 'AAA' rating denotes expectations
of very low credit risk.

The trust intends to change its primary method of leverage from
preferred shares to a combination of preferred shares reverse
repurchase transactions. A proportionate amount of each series of the
trust's auction-rate preferred shares is expected to be redeemed on or
after June 9, 2008.

BlackRock Preferred and Equity Advantage Trust is a
non-diversified, closed-end management investment company, whose
common shares are traded on the NYSE under the symbol 'BTZ'. Organized
on Dec. 27, 2006, the trust had approximately $1.3 billion in assets
under management as of April 25, 2008.

The trust's investment objective is to provide current income,
current gains and capital appreciation. The trust invests majority of
its assets in preferred and equity securities and derivatives with
economic characteristics similar to of equity securities. The trust
may invest up to 35% of its assets in non-U.S. securities and up to
20% of its assets in securities other than preferred and equity. The
trust also seeks to achieve its investment objective by employing
option in an attempt to generate gains from option premiums.

The affirmed rating is based on the strength of the trust's
underlying portfolio that provides preferred stock liquidation
coverage as well as the quality and experience of the trust's
investment advisor. At the time of the rating affirmation, the trust's
pro-forma preferred stock coverage ratios that take the above named
redemption into effect, calculated in accordance with the requirements
of the 1940 Act as amended and the Fitch coverage ratio satisfied
regulatory requirements mandating an asset coverage ratio of at least
200% as well as Fitch's minimum coverage ratio requirements of at
least 100%.

BlackRock Advisors, LLC is the trust's investment advisor.
BlackRock Financial Management, Inc., a wholly owned subsidiary of
BlackRock, Inc., serves as a sub-advisor to the trusts. BlackRock Inc.
and its affiliates had approximately $1.364 billion in assets under
management as of March 31, 2008.

Fitch's rating definitions and the terms of use of such ratings
are available on the agency's public site, fitchratings.com.
Published ratings, criteria and methodologies are available from this
site, at all times. Fitch's code of conduct, confidentiality,
conflicts of interest, affiliate firewall, compliance and other
relevant policies and procedures are also available from the 'Code of
Conduct' section of this site.

Mar 17 03:51 PM

[David Clayton:]

@djhernandez - I only know PGF, and it tends to trade very near its NAV, so it's traded up because the underlying preferreds have traded up. I haven't looked at these closed-end funds before. The first thing I noticed on BlackRock's page for BTZ is that they say it's trading at a 20% discount to NAV. Next thing I see is total expenses of 1.65%. The quick answer is that PGF is almost entirely bank preferreds, while BTZ is much more diversified.

Mar 17 03:52 PM

[MarkTwain:]

Again, I haven't looked into BTZ fully but it's a blind pool with multiple layers of capital and using options. Sounds like exactly the sort of complex asset has been so hard to value. Transparency is king in today's market.

Another point that I've been trying to make is that between the UK Government and the US government, you have two very strong guarantors of the issuers underlying PGF. There are no other companies, including GE, where their survival is effectively guaranteed by sovereign governments. That doesn't mean you can get restructured away but now is precisely the time when the government is trying to attract capital into public/private partnerships. Not a good idea to try that and then wipe out those who provided capital to the banks already: "this time we promise we really won't hurt you....really....no really....."

Mar 18 10:50 AM