I did a double take when I ran across a new JPMorgan Perpetual Preferred stock IPO on 4/16/2013. JPMorgan (NYSE:JPM), the largest bank in the U.S. and second largest globally, raised money selling a Ba1 rated preferred stock with a 5.15% interest rate -- which is now selling at a premium to par value. The new issue is structured as a fixed-to-floating Rate Non-Cumulative Preferred Stock, redeemable at the issuer's option on or after 5/1/2023 and has no stated maturity. Dividend payments are uniquely structured to reset beginning in 2023 based on Three-Month LIBOR plus a spread of 3.25% per annum.
JPMorgan is not the only bank issuing new preferred stock:
So what's up with all these new offerings? There are a high number being launched recently, as well as a high number of older issues being called.
The new issues listed above (JPYYL) (WFC.PP) (CFR.PA) (BBT.PA) are issued under the new rules of what the banking regulators now define as qualifying Tier 1 capital on a bank balance sheet. All of the issues are non-cumulative, meaning that the bank at its discretion can declare a suspension of dividend payments at any time in the future, and the dividends will not accrue as a company liability. The issues are all structured with a stated par value per share, $100 in the case of the JPMorgan preferred, and $25 for the BB&T (NYSE:BBT), Cullen & Frost (NYSE:CFR), and Wells Fargo (NYSE:WFC). Since all of the issues have no stated maturity, they will trade as a perpetual security in the market, and par value is only relevant as it relates to determining the dividend payment rate, and also the value paid if the issue is called. All of the issues are callable at the discretion of the banks, usually 5 to 10 years from when they went IPO.
On a historical basis, these are very aggressively priced bank preferred stock issues. The 4 banks in this article have all recently called most if not all of their outstanding preference shares that no longer qualify as Tier 1 capital and are re-financing at lower rates given the repressed interest rate environment (thank you Federal Reserve). JPMorgan recently set the call date of 5/8/2013 for $5 Billion in outstanding preferred stock issues. And Wells Fargo has been calling outstanding preferred stock issues as well. You can find called preferred shares across the entire banking sector. The called issues are characteristically cumulative, and usually provided for a length of time that dividends could be deferred, and were issued with much higher interest rates than the new issues being sold. Many also had a "survivor option," also known as a "death put," meaning that in the case a shareholder became deceased, the shares could be put back to the bank by the deceased's estate at par value. The days of this bank preferred stock structure are currently in the history books.
The structure of the new preferred securities is now much more "common equity-like." The securities have virtually no upside potential given such low coupon rates, but there is plenty of downside. If interest rates rise, there is high risk of price depreciation. If the bank, or banking sector gets in trouble, a la 2008, there is systemic sector risk and individual stock credit risk that could result in a dividend stoppage, a force conversion with equity hair-cut or, heaven forbid, even a complete wipe-out. The credit risk in a bank is particularly worrisome because they have very high leverage, and no matter how big they are, any systemic banking crisis can quickly hammer equity holders into oblivion unless Uncle Sam comes to the rescue…
So much greater care needs to be taken in reviewing these securities as additions to your income generating portfolio. The new issue structure and pricing are much more loaded in favor of the banks currently, and the risks taken on by the investor are much greater.
So how is it that such a "heads I win, tails you lose" structured security is getting priced so aggressively by the market? And are these new issues a good or bad addition to your portfolio? I take a look at these questions in the remainder of this article.
Interest Rate Sensitivity Now Much Greater
In the recent past, Tier I Capital preferred stocks were issued in the 6.5% to 7.5% coupon rate range. However, these new issues are being sold today at a coupon of close to 5%, which introduces a far greater amount of interest rate sensitivity. A $25 perpetual bond at 7.5% moves 10% in price every 75 basis points. With a 5% coupon, the price variability due to rate movements becomes much more magnified:
The much lower rate on these perpetual securities makes them much higher in duration risk -- except in the case of the JPMorgan structure.
Depending on your perspective on future interest rates, the JPMorgan issue is subject to even greater risk, or greater opportunity to hedge risk, over the long term due to its fixed rate to floating rate structure. It is a 5.15% Depositary Share, which beyond 5/1/2023, the non-cumulative distributions will be paid at a floating rate equal to Three-Month LIBOR plus a spread of 3.25% per annum. This means that post 2023, if 3-month LIBOR is less than 1.9%, the JPM preferred stock dividend will actually go down. Three month LIBOR is presently .28%, and has been there for an "extended period." Historically it has been much higher than 1.9%. However, since 2002, with the exception of 2006-2008, it has averaged well below 1.9%.
There is one clear advantage that the JPMorgan structure over the other preferred stocks being offered, the duration risk from interest rate changes beginning in 2023 will go down dramatically. And if you review history, that advantage might be very valuable in a portfolio long-term because it could stabilize principal price fluctuation in your portfolio.
History Lesson from Last Time Long Bond Rates Were Very Low
When buying a long-dated or perpetual interest rate security, it is a good idea to understand how the coupon payments will allow you to make a return above inflation through time. I have researched this issue using the most long dated "risk-free" bond in the U.S. market, the 30 Year T-Bond. In the graph below, I provide the traded yield on the 30 year bond from the time period 1941 to 1967. I chose this time period for a reason. In 1941 to 1951, the U.S. government "pegged" the interest rate structure exactly the way that it is doing today, and the 30 YR T-Bond fell into the same range it is trading today -- below 3%.
I then provide a "real-rate of return" line for review. This line deducts the level of recorded inflation in the economy for the 30 years to maturity date of each bond. For instance, a bond purchased with a YTM of 4% in 1963, the real rate of return deducts the realized inflation level from Sep 1963 to Sep 1993 from the interest paid on the bond. As you can see in the analysis, until the 30 Yr T-Bond was above 5%, the 30 Yr T-Bond did not provide an investor a real rate of return when adjusted for inflation over the entire period studied.
Over the time period, the 30 Yr market rate under-performed economic the rate of return needed by an investor to just protect themselves from inflation by 1-2%. This is important because current market rates for interest rate bearing securities tend to be priced as a "spread" to the Treasury curve. But the tendency in the repressed rate period in the U.S. was to mis-price forward inflation risk in the spread. The true inflation protected "risk-free" rate for 30 year money in the U.S. over recent history is at least 4% and more likely 5%, the point in 1967 when real returns actually went positive for an "extended period" in my research.
I point this out because the preferred stocks in this article are all precariously priced close to the 5% level. But none of these securities is anywhere near qualified to be considered a "risk-free" security. The spread above risk-free for a qualified BAA1 investment grade perpetual corporate bond is at least 2% above 4.5% to 5%. Add in the more equity like feature of these newly issued stocks, and you would rationally expect a premium of 2.5%+. This information makes a good rationale for the way the called preferred stocks have been priced in the past. But other than the structure of the JPMorgan preferred, this data clearly shows investors of the low fixed rate preferred stocks are entering a "heads I win, tails you lose" structure at the current premium price level.
Linking History to Current Interest Rate Conditions
We live in a time period when interest rates are being aggressively repressed by the Fed through active Quantitative Easing and rate manipulation in the auction process of Treasuries. The last time rates were pegged this aggressively was the Depression Era, and similar rate conditions were experienced in the 1940s (For a more in-depth review, see How and Why the Zero Interest Rate Extended Period Ended Last Time).
The most relevant issue regarding the choice of a preferred security with a 5% coupon is the expected term structure of interest rates moving forward. My current 4 year forecast is shown below:
The most relevant line in the forecast relative to bank preferred stocks is the BAA1 rate level. As you can see, the rate has trended down to the 5% level (currently 4.85%). The bank preferred stocks are lower in credit quality and perpetual, and therefore have been priced slightly higher in relation to other credit securities of similar quality.
My view is that government policy throughout the entire second term of President Obama can be expected to continue to repress interest rates with the 30 year and 10 year being the areas on the curve that QE3 will continue to repress to even lower levels. But the money printing will come with a price, and unfortunately, that price is longer-term market instability. This will become evident later this year as QE3 is withdrawn from the market as it becomes evident that real economic conditions cannot support the recent run-up in stock market price levels. The lower credit quality issues will be the first to experience issues. I would place the bank preferred stocks in this category -- and their sensitivity to interest rates will be very pronounced in a scenario where the general stock market goes through a correction.
My general expectation is that over the next 5 years, BAA1 rates will probably remain in the 5%-6% range, with a bias toward 5%, but there will be a spike upward at some point in this time period. However, as the long-term analysis showed, markets never seem to properly price the long-term risk when rates are this low, and since these issues are all perpetual, care must be taking in entering the investment.
What about Default Risk?
We are in much more tranquil times with respect to bank stocks in 2013. In my analysis, the current pricing of preferred stocks does not reflect much, if any, default risk premium. Oh, how things have changed in just 4 years. Luckily, the stock exchange databases were not destroyed in the crash. I have pulled together data showing the performance of the bank common equity so that an evaluation of the risk involved can be made.
As you can see below, and probably remember, the share prices of the banks were very low back in early 2009, reflecting the fears of nationalization as President Obama took office and dilution expectation were high as TARP was implemented. The preferred shares of these institutions traded down in lock step. For example, JPM.PS, a 6.625% JP Morgan preferred stock, was trading around $20 in January 2009, and JPM.PK, a 5.875% preferred, was trading close to $18. This trading price correlates with the increase in BAA1 interest rates during that time. The potential default risk in these shares showed up in February and March of 2008, when they briefly gapped down below $15 as there were fears of a force convert into common shares, which abated as JPMorgan clarified its capital plans.
The history of the preferred security price action in the event a bank needs to raise capital when common share prices are low is very important. The new Tier I Capital rules make the preferred securities even more "equity-like" than in the past, and the likelihood of a dividend suspension, and even a conversion in this scenario in the future is much higher now. The four banks I cover in this article are relatively strong as far as the banking sector goes -- even considering the junk rating on JP Morgan. There are many smaller banks also issuing Tier I category preferred stock at higher, but still relatively low historical yields. In short, these are upside limited common equity securities with a slightly higher dividend near-term.
So the analysis of whether you should buy these newly issued preferred stocks is deeply inter-twined in the question of whether you would actually buy the common stock. I have included important information in the table for a high level comparison of the bank common stock to the preferred issue. It includes the trading price of the banks from January 2009, a contemporary period low point for the shares, through the present time period, which is a period high trading range. The dividend current yield is also included. Since TARP, the banks have all been restricted on the dividends that they can pay to shareholders by regulators until they meet certain regulatory stress test requirements. Many of the banks are returning to a stronger capital position, and dividend increases and share buybacks have been announced. Expectations are currently that this trend will continue over the intermediate term for the banking sector -- and certainly applies to the four banks in this article.
Low Interest Rates a Trigger for Dividend and Common Share Buybacks
On a 1 to 1 comparison basis, the 5% dividend rate of the preferred stock is better than the 2.5% to 3% current yield on the bank common stocks. But the option for dividend increases to common equity holders in the future has to be considered. In the case of JPMorgan and Wells Fargo, they are both taking advantage of the low interest rate environment to call existing higher rate preferred stocks and issuing new shares, usually at 100-150 basis points less in coupon. The net impact of this change is immediately accretive to existing common shareholders. I do not expect this new internally generated capital due to dividend payout savings to be put to work for lending growth. It will be used primarily for increasing common dividends and to buyback existing common shares.
In the case of BB&T, it does not have the same level of publicly traded Tier I capital preferred stock to do refinancing, but it has called all outstanding higher dividend rate preferred stock, and issued lower rate preferred stock. Cullen and Frost only shows issuance, and has no outstanding publicly traded preferred stock previously issued to refinance.
Bank Stock Performance from 2009 to Present Relative to Interest Rates
In the table below, I have calculated the change in share price of the bank common share price from Jan 2009 until 4/23/2013, as well as from Jan 2011. I have done this to compare the performance of the shares relative to a perpetual 5% coupon bond -- a good relative benchmark for how the new preferred stocks will trade as interest rates change.
The data is enlightening. You can readily see how the big TARP banks bounced back dramatically post the 2009 bank crisis, with factors of 2.53 changes in stock prices over the time period. BB&T and Cullen/Frost did not experience the same magnitude in downward panic driven price adjustment, and have not shown the same upward share price change on the rebound. BB&T share price growth is only slightly above the change from the downward move in interest rates. Cullen and Frost has underperformed, but definitely was a relative safe haven bank in the panic. JPMorgan, Wells Fargo and BB&T all outperform the share price change of the benchmark bond since Jan 2009 before dividends. After dividends only JPM and WFC outperform.
Taking a look at another segment in time, the last two years, the performance of the 5% benchmark bond greatly surpasses the share price growth in all banks except BB&T. BB&T now has a 3.09% dividend yield. At its current price, it shares are approaching a level in which they will surpass the performance of the bond if the dividend rate is able to grow and the company continues to return shareholder value. All the other banks underperformed the bond over the last 2 years.
Recent past performance is usually never indicative of near future outcomes. The underperformance lately in the WFC and JPM is most likely due to the rapid initial run-up post 2009, and then the market realization that a return to pre-financial crisis dividend levels is going to be a slow roll. But, as stated previously, in the case of Wells Fargo and JPMorgan, room to expand shareholder returns is actually being created by the accretive preferred share refinancing. Additionally, the lower share performance in this interest rate window (decline of 6% to 4.85% on the BAA1) is also reflecting a drag on earnings performance as rates trended lower due to compressed net interest margins. Any upward move in business interest rates would likely be a positive for banks, at least if it did not result in a market panic as in 2008.
Given this analysis, I see the following:
- If rates continue to fall, there is a case that 5% bank preferred stocks could outperform bank common stock as they have done over the past 2 years. However, I see this as a less and less likely scenario. It ignores the diminishing ability of the Fed to repress the long end of the yield curve for risky assets, and it also ignores the opportunity that is likely to emerge that current banks will be able to raise their dividends, which does not appear to be fully priced into the shares. On this measure, I give the common equity the performance edge for all 4 banks in this article.
- If rates do go up, interest rate sensitivity of the preferred stock will cause it to underperform relative to the bank shares (just as the opposite happened when rates fell from 6% to their present level). Again, the expected equity performance edge goes to the common equity shares.
- If rates go above 6%, and there is clearly much greater risk building in the banking sector, preferred stocks will essentially outperform as rates rise further -- but depending on why rates are rising, they could just be a high risk "dog."
- Only the JPMorgan preferred share offering is structured longer term to protect the investor from a rising interest rate risk due to inflation scenario. It does very little to protect the investor in a banking sector default scenario.
Income Investing Strategy
If you are being chased out of the existing JPMorgan or Wells Fargo preferred shares, and are wondering whether you should just roll the shares into the new preferred stock or you are just evaluating the new shares as an investment, my recommendation is that over the very near term, the bank common equity is the better "relative" play. If you are not comfortable investing in the common stock of the bank, I advise you don't invest at all.
Unless you believe drastic deflation is imminent, I see only downside in the share price of the preferred shares, which have a fixed coupon. The long-term fair market pricing of these new preferred securities is probably $19 yielding 6.5%, not $25 yielding 5%, if the Fed was not repressing interest rates with their large intervention programs. But we live in a time when aggressive monetary policy is distorting the pricing of future risk. My recommendation is to set your long-term watch alerts for these shares at $19-$21 on the fixed rate preferred stocks. If the alerts are tripped in the future, evaluate the situation.
The JPMorgan preferred structure is the only one that I advise as an appropriate issue to consider in the near term as a potential trade rather than the JPMorgan common stock because it has far lower duration risk long term. This type of protection has portfolio hedging properties that, to me, appear useful in a potentially deflation near term, inflation long term world.