Wells Fargo: 6.6% Yield And Free Upside Potential

| About: Wells Fargo (WFC)

In the never ending search for yield many investors find themselves engaging in, we can often overlook the best sources of current income. I believe this to be the case with most investors regarding preferred stock as information on preferred shares can be murky at best at times. And since they are essentially debt instruments, stock investors may overlook them as potentially great sources of current income. In this piece, we'll take a look at an issue by Wachovia, now part of Wells Fargo (NYSE:WFC), which can provide your portfolio with a boost of current income while offering some free upside potential as well.

In the depths of the financial crisis Wachovia issued the Series L 7.5% Non-Cumulative Perpetual Convertible Class A Preferred Stock (WFC.L, could differ depending on your broker). This source of funding was offered at $1,000 per share with a quarterly dividend of $18.75 per share. At today's price of $1,140 the shares are yielding approximately 6.6%. This implies a decent premium to the liquidation preference but that isn't unusual in the low interest rate environment we find ourselves in. Additionally, Wells is perhaps the strongest too-big-to-fail bank so as a creditor, you can't do much better.

This issue is a non-cumulative preferred which simply means that if Wells misses a dividend payment, it has the option but not the obligation to make up the missed payment(s). This is an undesirable trait, for obvious reasons, but if you want to invest in financial preferreds, it is largely unavoidable. While I don't see missed payments as a huge risk for Wells given its robust balance sheet and strong profitability, the risk exists nonetheless and it is something you need to keep in mind should you decide the Series L is for you.

The issue holds no voting rights, which is pretty standard for a preferred, but it also has no maturity date and, very importantly, cannot be redeemed by Wells at any time. This means that no matter how high the premium to the liquidation preference gets on the Series L, Wells cannot decide to retire it to save on the relatively high dividend payments. However, there is a clause in the prospectus that allows Wells to convert the Series L into common shares at its option if the price of the common stock at the conversion ratio exceeds 130% of the issue price for a period of 20 out of 30 consecutive trading days. At present, the conversion ratio is 6.3814 common shares of WFC per Series L share. With WFC shares trading for roughly $43 at present, we are a long way from conversion becoming a possibility.

However, the beauty of this is that for a long-term investor, the Series L provides not only tremendous current income from perhaps the most financially sound bank in the country but also a free option on upside in the common stock. In order for the common stock to make you money on the Series L we'd need to see a price of $179 based on today's prices. Of course, that is a very long way away but as a long-term holder, if you've got the time to wait, the Series L could pay for itself in the time it takes to achieve that price on WFC common shares and you could be left with free upside to your preferred investment. This is out of range for many investors and I understand that but having the option to wait and achieve some capital gains as well is a nice perk.

The Series L provides investors a very nice current yield with a very strong bank that not only survived the financial crisis but came out the other side much stronger. In addition to providing investors with a great dividend with quarterly income and a yield more than three times the S&P 500's (NYSEARCA:SPY) yield, the Series L could provide long-term holders with the option to reap some free upside in the common shares. While this won't happen for many years, long-term holders could find themselves in a situation where they've received enough dividends to pay for the Series L shares and the common stock drives the price of the Series L higher. But even if you can't wait that long, the Series L is a good buy now for current income and safety.

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.

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