Variable-Rate Preferred Stocks Underperform Their Fixed-Rate Cousins

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Includes: MET
by: Doug K. Le Du

Over the last ten years, variable-rate preferred stocks have offered consistently lower returns, delivering about half the dividend income as fixed-rate preferreds, at higher risk to investors.

Variable-rate preferred stocks offer the promise of keeping up with interest rates in the event that rates increase. If rates rise, the return paid by variable-rate shares presumably increases as well. Shareholders not only receive additional dividend income but also avoid the price erosion that can occur as higher paying alternatives become available.

There are several variable-rate preferreds trading today that have been around for a decade now, surviving through booms, busts, rising rates, falling rates - you name it. So how has the promise of variable-rate preferred stocks compared to actual performance?

How Rates are Set

There are four primary methods used by variable-rate preferred stocks to set the dividend rate paid to shareholders: (1) LIBOR-based, (2) CMT-based, which use the constant maturity bond rate of certain U.S. treasuries, (3) inflation-based, using the Consumer Price Index and (4) fixed-to-floating, which offer a fixed dividend rate until the security's call date, then a variable rate thereafter.

The LIBOR-based method is the most common (although fixed-to-floating has regained some of its prior popularity recently; more on this in a moment). Variable-rate preferred stocks that use the LIBOR-based method will usually reset the dividend rate each quarter by adding some amount to the three-month LIBOR published at the time (unless the LIBOR is exceptionally low, then a minimum rate kicks in).

Example: MET-A

MET-A was introduced by MetLife, Inc. (NYSE:MET) in June 2005. MET-A is the most generous LIBOR-based variable-rate preferred stock that is still trading today.

As described in MET-A's prospectus, the dividend rate paid by MET-A is reset each quarter by adding one percent to the 3-month LIBOR rate published at that time, but has a minimum dividend rate of four percent (so whenever the LIBOR falls below three percent, the minimum rate of four percent kicks in).

This chart shows the three-month LIBOR rate since 2004 (light gray line) along with the dividend rate paid by MET-A using its variable-rate formula (dark gray line).

You can see how the minimum four percent rate kicks in during periods where the LIBOR falls below three percent.

Compared to High Quality Fixed-Rate Preferreds

This analysis compares the performance of the LIBOR-based preferred stocks issued over the last ten years to that of high quality fixed-rate alternatives that were issued at the same time.

High quality fixed-rate preferred stocks are defined here as those having a $25 par value, pay quarterly dividends that are cumulative and have a Moody's investment grade rating (see Preferred Stock Investing, Fifth Edition, page 117).

For comparability, the variable-rate LIBOR-based preferreds used here have a $25 par value, pay quarterly dividends and are still trading (on an exchange other than the Over-The-Counter exchange).

Here are the resulting 19 variable-rate preferred stocks.

Continuing with our MET-A example, you can see how MET-A stacks up to the other variable-rate preferreds. Applying MET-A's dividend formula to the movement of the LIBOR has resulted in $9.32 per share in dividend payments to shareholders since MET-A's June 2005 introduction.

In June 2005, the average dividend rate being offered by new high quality fixed-rate preferred stocks was 6.75 percent (Preferred Stock Investing, Fifth Edition, page 259). Preferred stock buyers who purchased such fixed-rate shares, as opposed to the variable-rate alternative offered by MET-A at the time, have earned $13.92 in dividend income, putting them $4.60 per share ahead.

Almost Double the Income

As itemized in the above table, extending this analysis to all 19 variable-rate preferreds shows that high quality fixed-rate preferred stocks have outperformed their variable-rate cousins in all cases with those investing in the fixed-rate alternative earning a total of $114.45 per share beyond what those going with variable-rate preferreds have earned. High quality fixed-rate preferreds have paid almost double the income (180 percent more) that variable-rate preferreds have paid over the same investment period.

This final chart presents the same dividend income data in bar chart format.

You can see MET-A's $9.32 (gray bar) compared to the $13.92 from high quality fixed-rate preferreds being offered at the time (June 2005).

Fixed-to-Floating

Fixed-to-floating preferred stocks have been around for many years and have recently become popular again with banks.

Fixed-to-floating preferreds are what you get if you take a traditional fixed-rate preferred stock and a variable-rate preferred stock and staple them together at the call date; they are two very different securities sharing the same SEC filings, prospectus and trading symbol (which allows the issuer to avoid the cost of issuing two separate securities).

Fixed-to-floating preferreds are attractive to issuers during a period of increasing rates for several reasons. The call date is typically longer than normal (usually ten years versus five) so the issuer realizes a dividend expense savings as interest rates raise. Also, once the call date arrives, the issuer will generally redeem the shares if the expected interest rate increase materializes or, if rates have fallen, realize a nice dividend expense savings as the rate paid to shareholders adjusts downward.

For the investor, the extended call date provides stable dividend income for an extended period of time and dividends typically qualify for favorable tax treatment. Also, during the extended fixed-rate period, a fixed-to-floating preferred stock's market price behavior is just like that of a traditional fixed-rate preferred giving the shareholder an opportunity to sell downstream for a capital gain should rates fall.

But as the call date approaches, the difference between fixed-to-floating preferreds and their traditional fixed-rate cousins will start to become apparent. If rates have fallen, the market price of a fixed-to-floating preferred stock will fall as well since its dividend rate will adjust downward. This is the opposite of what happens with the market price of a fixed-rate preferred where falling rates produce an increase in the market value of your shares.

On the other hand, if rates have gone up, the issuer is highly likely to redeem the shares in order to avoid the higher dividend expense. It is specifically for this reason that the floating-rate period is pegged to the security's call date; investors should not count on the dividend income generated by fixed-to-floating shares to rise along with rates. In an increasing rate environment, variable-rate preferred stocks are typically redeemed (which is why there are no callable fixed-to-floating preferred stocks currently trading; all that were able to be called have been).

Lastly, dividends on fixed-to-floating preferred stocks are typically non-cumulative, meaning that the issuer is allowed to suspend dividend payments to you at any time without penalty or obligation to ever make up the payments.

As the above data illustrates, variable-rate preferred stocks have provided about half as much dividend income as their high quality fixed-rate cousins while offering an unknown rate of return with riskier non-cumulative dividends. While attractive to some, it is not clear how these characteristics favor risk-averse preferred stock investors.

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. 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.