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For the first time this year, preferred stock buyers are demanding higher dividend yields in return for taking the same risk. Using Moody's ratings as a proxy for investment risk, the average yield of preferred stocks with Baa3 investment grade ratings ended July at 6.55 percent, an increase of 0.40 percent over the last three months.

This chart illustrates the risk versus reward trade-off that preferred stock investors are currently (ending July) making. Using current yield as a measure of reward, investors are now demanding 6.55 percent at the lowest Moody's investment grade level of Baa3. At the end of May 2013, these investors were demanding a 6.15 percent return at this same level of risk [1].

Rivsk versus Reward - July 2013

Each diamond on this chart represents a preferred stock or exchange-traded debt security trading on the New York Stock Exchange [2]. Moody's investment grade categories are indicated in bold font along the horizontal axis of the chart [3].

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 (see "Preferred Stock Investors: 'Exchange Traded Debt Securities' Offer Same Reward, Lower Risk") trading such that its yield falls right in the center of the pack at the Moody's Baa3 risk level, offering a 6.55 percent yield [4].

Sub-$25 Prices Favor Buyers

For comparability, the securities used for this analysis all have $25 par values so the market favors buyers when these issues can be purchased for sub-$25 prices. In the event of a redemption by the issuing company, shareholders receive the $25 par value in cash in exchange for their shares so purchasing shares below that price positions the shareholder for a downstream capital gain in the event of a call (on top of the regular dividend income in the meantime).

Looking at the table below the chart, notice how average market prices for investment grade preferred stocks are now below $25, favoring buyers. For example, the 40 investment grade preferred stocks at the Baa3 risk level are providing an average yield of 6.55 percent for an average market price of $24.29.

Issues and Issuers

The table below the chart provides examples of securities at each level of risk. Specifically, the trading symbols are provided for the diamonds that you see at the top and bottom of each stack.

A couple of years ago the securities able to qualify for this analysis would have been dominated by banks, but notice that is no longer the case in a post-Wall Street Reform Act/post-Basel III world.

GRX-A from Gabelli (GAB) is the only issue to qualify for this analysis with a Aaa rating, offering a 5.11 percent yield when this data was collected on Friday, July 26.

At the A1 risk level, only four securities were able to qualify for this analysis, all of which are offered by General Electric Capital (GE). GE-A (top diamond at A1) provides the highest yield at 6.39 percent while the lowest diamond at A1 is GEB, an exchange-traded debt security offering a 5.26 percent yield.

The number of offerings tends to increase as we move down the investment grade scale since more companies are able to meet Moody's requirements. The A3 risk level includes 25 securities, the most generous of which is GAT, an exchange-traded debt security from Southern Company's (SO) Georgia Power Company. At A3, Comcast's (CMCSA) CCV, another exchange-traded debt security, offers a more miserly 5.18 percent yield.

Moving to Baa1, the average yield increases to 6.23 percent with AEK from AEGON (AEG) leading the way at 7.18 percent. State Street's (STT) STT-C is the lowest performer at Baa1, offering 5.51 percent, hampered by its non-cumulative dividends.

NextEra Energy's (NEE) NEE-F is the diamond on top of the Baa2 stack offering an 8.21 percent yield. Buyers were paying $26.33 per share for this 8.75 percent coupon security last Friday. With a call date of March 1, 2014, these buyers are exposing themselves to a capital loss of $1.33 per share, hoping to make it back in dividend payments. PBI-A from Pitney Bowes (PBI) is holding down the bottom of the Baa2 stack, offering a 5.12 percent yield, creating a 3.2 percent spread between top and bottom at this risk level.

DRU from Dominion Resources (D) marks the high point at Baa3. Like NEE-F, DRU offers a high coupon (8.375 percent) selling for $26.37 last Friday. With a June 15, 2014 call date, these buyers are willing to take the high risk of a capital loss, hoping that the dividend income makes it worth their while. BXP-B is offered by Boston Properties (BXP), a Boston-based property REIT. At Baa3, BXP-B is providing a 5.36 percent yield, the lowest offering seen as the bottom diamond at this risk level.

Higher Return for Lower Risk - Three Month Trend

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 "Investment Grade Preferred Stocks At 6.15 percent, Buyers Become More Risk Tolerant" includes this same analysis (using the same selection criteria) for preferred stocks and exchange-traded debt securities at the end of May 2013, just before the jump in rates that we saw during June.

The next chart compares the best fit line from last May's analysis (gray line) to the best fit line that you see above for July (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 over the last two months.

Investors Become Less Risk Tolerant

Looking at the Baa3 risk level again, preferred stock investors who were accepting a return of 6.15 percent last May are now demanding 6.55 percent, an increase of 0.40 percent over the last two months.

The June sell-off moved the preferred stock marketplace closer to the "Fed-free" market that buyers have been waiting for, delivering the best prices seen for two years for the highest quality preferred stocks available, pushing up yields accordingly.

At the end of July, investment grade corporate bonds were offering a mere 4.34 percent and bank Certificates of Deposit (CDs) came in at 1.09 percent [5]. While the Federal Reserve's low-to-no interest rate policy continues to decimate savers, investment grade, U.S.-traded preferred stocks and exchange-traded debt securities 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 and Preferred Stock Investing, Fifth Edition (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: July 26, 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.). 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] Corporate bond yield is the average daily yield offered by investment grade corporate bonds during July 2013 (FederalReserve.gov). Bank CD interest rate is the average APY of the top ten 24-month certificates being offered by U.S. banks on July 26, 2013 (BankRate.com).

Source: Preferred Stocks End July Favoring Buyers - Higher Reward For Lower Risk At Sub-$25 Prices

Additional disclosure: Securities identified within this article are for illustration purposes only and are not to be taken as recommendations.