Seeking Alpha
Newsletter provider, dividend investing, author, preferred stock researcher
Profile| Send Message| ()  

Preferred stock investors are accepting more investment risk to receive the same dividend reward when compared to last January. Using Moody's ratings as a proxy for investment risk, preferred stock investors have become more risk-tolerant this year.

This chart illustrates the risk versus reward trade-off that preferred stock investors are currently (ending May) making. Using current yield as a measure of reward, investors are accepting 6.15% at the lowest Moody's investment grade level of Baa3. At the end of January 2013, these investors were demanding a 6.43% return at this same level of risk [1].

Risk versus Reward - May 2013

Each diamond on this chart represents a preferred stock or exchange-traded debt security trading on the New York Stock Exchange [2].

The Cyprus event that occurred earlier this spring is probably responsible for much of the change since January. When European banking officials announced a new model requiring struggling countries to seize the savings of citizens in order to receive bailout cash (starting with Cyprus), many Eurozone investors fled to U.S. assets. That sudden surge in demand, along with several other factors, pushed up common and preferred stock market prices here, lowering yields across the board.

2.87% Spread at Baa3

The Baa3 risk level is interesting to look at. Moody's ratings come in two flavors - investment grade for the highest quality issues and speculative grade [3]. Within investment grade there are ten sub-categories with Aaa being the highest (hardest to qualify for) and Baa3 being the lowest (still hard but easier than Aaa). Because the investment grade bar is lower at Baa3, there are always more choices to pick from (49 in this May 2013 data set).

The yield spread at Baa3 for May is startling. At supposedly the same risk level, ENJ from Entergy Corporation (ETR) is offering 4.88% (the bottom yellow diamond) while DRU from Dominion (D) is providing a much more respectable 7.75% (the top yellow diamond).

That's a 2.87% spread at the same Baa3 risk level [4].

Why the Disparity?

The huge May spreads that we see at any given Moody's rating are being caused by the fact that Moody's and preferred stock investors are defining risk two different ways.

The article "Moody's And Preferred Stock Investors View Same Market but See Very Different Risks" provides a more complete analysis but, as illustrated by the charts in that article, preferred stock investors are currently more concerned about a call than they are about the company defaulting.

Many of today's preferred stock investors, buying shares above these security's par values, are intending on selling their positions at the first sign of a future price drop (such as what would happen in the event the issuing company calls these issues). So call protection has become more important than default risk to these investors.

For example, at Baa3, ENJ (bottom yellow diamond), with its miserly 4.88% yield, does not become callable until December 1, 2017. DRU (top yellow diamond), on the other hand, is almost certain to be redeemed next year on or near its June 15, 2014 call date.

Call protection is commanding a premium in today's preferred stock market, putting downward pressure on yields and, in turn, causing the diamonds on the above risk versus reward chart to spread out vertically.

In the Sweet Spot

The yellow diamond in the center of the Baa3 stack is CTY from CenturyLink's (CTL) Qwest Corporation. CTY is an exchange-traded debt security trading such that its yield falls right in the center of the pack at the Moody's Baa3 risk level.

Others joining CTY at this point of market equilibrium are PFG-B from Principal Financial Group (PFG), VNO-J from Vornado Realty (VNO), NNN-D from National Retail (NNN) and DLR-F from Digital Realty (DLR), all with call dates several years out.

Compared to January 2013

The blue line on the above chart is the "best fit" line. As expected, the best fit line slopes up and to the right, indicating that investors are demanding a higher reward (yield) for higher risk (Moody's rating). No surprise there.

The article "New Preferred Stock From Public Storage Illustrates Trade-Off Between Risk And Reward" includes this same analysis (using the same selection criteria) for preferred stocks and exchange-traded debt securities at the end of January 2013.

The next chart compares the best fit line from last January's analysis (gray line) to the best fit line that you see above for May (blue line). By putting both best fit lines on the same chart, we can see how the risk tolerance of preferred stock investors has changed this year.

Investors Become More Risk Tolerant

The best fit line will be steeper (become more vertical) as investors become more risk-averse; that is, if they demand a higher return for the same risk (during the Global Credit Crisis this best fit line looked like the launch profile of a Polaris missile). Conversely, and as we are seeing this year, a flattening of the best fit line indicates that preferred stock investors have become more risk-tolerant, accepting a lower return for the same risk.

Looking at the Baa3 risk level again, preferred stock investors were commanding a return of 6.43% last January but are now willing to accept a more modest 6.15%, a reduction of 0.28%.

The Federal Reserve's low-to-no interest rate policy has decimated savers; bank CDs are paying 1.1% while investment grade corporate bonds are offering a mere 3.6% [5]. Giving up over 1/4 point in return over the last four months is an indication that investment grade, U.S.-traded preferred stocks and exchange-traded debt securities, at about 6%, continue to provide an attractive alternative to many income-oriented investors.

Footnotes:

[1] Source for all preferred stock data in this article: CDx3 Notification Service database at www.PreferredStockInvesting.com. Disclosure: The CDx3 Notification Service is my preferred stock email alert and research newsletter service and includes the database of all preferred stocks and exchange-traded debt securities traded on U.S. stock exchanges used for this article.

[2] Criteria used to select securities for this article: Call-protected, trading on the NYSE, fixed-rate, non-convertible, Moody's rated, non-zero trading volume. Data date: May 24, 2013.

[3] Moody's Investment Grade: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3. Moody's Speculative Grade: Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C.

[4] The yield values seen here uses the same current yield formula that you see in your brokerage account or websites that show yield for dividend-paying securities. Current yield does not consider the potential for a future capital gain or loss but, rather, is intended to be used for comparison purposes here. Other yield formulas can be used for this analysis as well (e.g. yield-to-call, yield-to-maturity, effective annual return, etc.). As long as you are consistent and use the same calculation throughout, the results shown here will not change. 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] Sources: www.sec.gov for corporate bond rate; www.bankrate.com for national CD interest rate.

Source: Investment Grade Preferred Stocks At 6.15%, Buyers Become More Risk Tolerant

Additional disclosure: This article is intended to provide preferred stock investors with a sense for the current risk/reward trade-off being offered by today's marketplace and the position of specific securities therein. Securities identified within this article are for illustration purposes only and are not to be taken as recommendations.