Stay Away From The New Bank Preferreds

Includes: BNY, C, FITB, GS, JPM, WFC
by: Kraken

We all know that the Fed's QE is driving down rates and forcing income investors to chase yield. Even though we desire a strong yield, we shouldn't force ourselves and go into unattractive assets to get it.

The new bank preferreds have been disastrous. Oh, don't get me wrong, these preferreds are great for the institutions issuing them, but for us everyday investors it's a constant uphill battle to find good assets with a decent yield.

Given that Bernanke has already mentioned "tapering" of buybacks to occur soon, investors are trying to be cautious on fixed yield investments. So with some banks issuing floating rate securities, it might help investors get a good night's sleep, right? Wrong. The reason why these floating rate preferreds are terrible investments is written in the fine print.

Recently, four banks have issued floating rate preferreds. These banks are Fifth Third Bancorp (NASDAQ:FITB), Bank of New York Mellon (NYSE:BNY), JPMorgan (JPM) and Goldman Sachs (NYSE:GS).

So how exactly do these floating rates work? Well for one thing they are not officially floating, at least not for several more years. All four preferred securities become switched from fixed to floating in 2023. So essentially investors would still see a fix rate for 10 years. I strongly believe rates will be at a significantly higher level within 10 years. So clearly investors are getting the short end of the stick here because they will be forced to have a fixed rate for 10 years.

Many of you might be saying that at least after 10 years, investors would be able to get the benefit of a floating rate to adjust to higher rates, right? Well let's look at the floating rate spreads on these preferreds. All of these preferreds have a spread over 3-month LIBOR. BNY Mellon has a spread of 2.46%. Fifth Third is 3.033%. Goldman is 3.64% and JPMorgan is 3.25%.

Now assuming none of these banks call their preferreds by 2023, all of the fixed rates will start floating. In order to understand what rates could be like, we need to look at the history of 3-month LIBOR.

The peak of LIBOR rates in the last decade were in 2007. Those rates were about 5.5%. Now given that the spreads range from 2.46% to 3.46%, the adjustable rates could see 7.96%-8.96% yields if LIBOR were to reach that same level. Here is the problem with this. In 2007, several top banks issued preferreds with rates near those yields. Wells Fargo (NYSE:WFC) issued its series A preferred with an 8% yield. Citigroup (NYSE:C) had a series F preferred with an 8.5% yield.

So what is the conclusion here? Well the idea of having a floating rate vehicle in a low rate environment is appealing, but it doesn't make any sense when the yields don't adjust for another 10 years. Between now and 2023, investors will be forced to take a low yield investment while rates continue to rise. In addition to this, when rates continue to rise, banks are likely to issue higher rate preferreds within the next 10 years. So there is no need for income investors to force themselves to purchase these securities.

I recommend investors stay away from these floating rate preferreds as it really won't help against interest rate increases in the short-term. There will be plenty of other opportunities going forward. I believe many banks are trying to lock in these rates while they still can before they begin to rise.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.