Wells Fargo: 6.6% Yield And 25%+ Upside

Dec.30.13 | About: Wells Fargo (WFC)

Wells Fargo investors (NYSE:WFC) have enjoyed owning one of the strongest banks around during and after the financial crisis including a robust common stock dividend. In this article, however, we'll take a look at a Wells preferred stock issue that can offer holders twice the current income of the common stock and without the inherent stock market risk of owning WFC common shares.

The preferred in question is the 5.25% Depositary Shares Non-Cumulative Perpetual Preferred Stock Series P (WFC-P, may differ depending on your broker). That is a mouthful so we'll explain exactly what this security is to begin with. This is a traditional preferred stock security meaning it has no stated maturity date and is also not backed by some sort of debt issue. The preferred on which WFC-P is based is the Series P which was issued at a price of $25,000 per share. However, each WFC-P share represents a 1/1000th interest in the Series P, meaning you can own the Series P by simply buying the depositary shares, WFC-P. The depositary shares were issued to allow for greater liquidity and access for smaller investors.

This preferred issue, like many other preferreds, is non-cumulative. That unfortunately means that if Wells were to miss dividend payments on WFC-P you would not be entitled to receive those missed dividend payments. While that is an extraordinarily remote possibility given this is a Wells Fargo issue, the possibility remains and it is something to keep in mind. With a higher risk payer I'd consider this provision a sizable negative but the risk of Wells missing dividend payments is ridiculously low and as such, I personally don't care about this issue being non-cumulative.

WFC-P also has a call date after which Wells can redeem WFC-P at the full $25 per share call price. Beginning in June of 2018 WFC-P can be redeemed by Wells at any time plus any declared but unpaid dividends. If this were to happen, which nobody can know for sure whether it will or not, holders would be entitled to a large capital gain, making it a desirable scenario for many holders. Just how large of a capital gain would it be?

Currently, WFC-P is trading for $19.89, meaning that if you were to purchase today and Wells called the issue in 2018 or later, you'd receive a capital gain of nearly 26% on your position. This is over and above any dividends received in that same time period so you can see how the returns can add up by purchasing a preferred at a huge discount to its call price. Again, I'm not suggesting it will or won't be called because only Wells knows that but, in the event that it is, holders who purchase around $20 will not only be made whole but also enjoy a very large capital gain of 25%+ as well.

In addition to the prospect of capital gains the large discount to the issue price means the current yield is quite a bit higher than the stated coupon rate. In fact, the current yield on WFC-P is 6.6%, representing a great value in terms of risk/reward for income securities. As Wells is perhaps the strongest large bank around a 6.6% yield is quite enticing, particularly in the context of the stock market reaching all-time highs. And since the distributions are made in quarterly installments, WFC-P is a good choice for those seeking current income.

WFC-P also has the favorable dividend tax treatment of its distributions as a positive characteristic. Since WFC-P distributions are classified as dividends and not interest payments, holders of WFC-P in a taxable account are subject to a much smaller taxation liability and thus, see an increase in the after-tax return of owning WFC-P versus a comparable interest-bearing security. This means that if you hold WFC-P for current income you are subject to much lower taxes than you otherwise could be.

The biggest risk of owning WFC-P, since I see default as a laughably small possibility, is interest rates. As with any income security prevailing interest rates are going to determine where WFC-P trades and what it yields. This is the reason shares have plummeted to under $20 (from $26 earlier this year) as of this writing because interest rates in general have moved up. If this continues to happen WFC-P could be subject to further losses. However, the opposite is true and if interest rates moderate, WFC-P could trade up towards its issue price again. This is something you'll need to decide for yourself before investing in WFC-P because if you cannot handle interest rate related volatility, WFC-P probably isn't for you.

Overall, WFC-P represents an interesting mix of safety and yield. The 6.6% yield is very strong and Wells is one of the best capitalized and fundamentally sound banks our country has to offer. In addition to this the favorable tax treatment of WFC-P distributions makes this a great candidate for a taxable account that is seeking stable, safe current income. While the perpetual nature of this issue introduces more interest rate risk than may otherwise be present, it also means you have a chance to buy at a huge discount to the issue and call price of $25. And in the event it is called at some point, you'd be entitled to a large capital gain on top of your dividends. WFC-P certainly isn't for everyone but for those seeking a sound source of current income and the possibility of capital gains, you can do much worse.

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.