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Summary

  • Cliffs Natural Resources' Series A preferred stock offers investors a yield nearly three times that of the common stock.
  • Conversion date of February 2016 means this preferred will trade in tandem with CLF shares.
  • Understanding risks is key, as holders of CLV own CLF shares indirectly, participating in capital gains and losses.

Cliffs Natural Resources (NYSE:CLF) is a mining company that produces iron ore and coal in the Eastern US. Dividend investors enjoy its 3% yield, but in this article, we'll take a look at another way to gain exposure to CLF with a much higher yield and some upside potential. In this case, we'll be taking a look at the company's Series A Convertible Preferred Stock (CLV) to see if it is a good fit for your income portfolio.

To begin, we need to define CLV to understand what we're looking at. CLV is a traditional preferred stock, except that it has a clause that makes it convertible into common shares. It still pays regular quarterly dividends like a traditional preferred, but its convertible clause means that it trades with a maturity date of February 2016. On the first of that month, CLV will be mandatorily converted into common shares of CLF at a ratio that depends on the then-current price of the common stock. If CLF shares trade over $35.53, CLV will convert at a ratio of 0.7037. If CLF trades below $29, the ratio is 0.8621. For prices between $29 and $35.53, the settlement rate is simply $25 divided by the market value of CLF shares. In addition, if you hold CLV and don't want to wait until 2016 to convert your shares, they are convertible at any time by the holder at a ratio of 0.7037.

Right now, CLV trades for $20.21, meaning that the conversion clause implies an intrinsic common value of $14.22. In other words, you wouldn't want to convert these shares right now, because you'd be losing nearly 30% of your capital to do so; it would be better to simply buy common shares instead of CLV. However, that doesn't mean it won't be a good idea in the future at some point, and if you choose to just hold CLV, the conversion rate becomes more favorable if the common shares languish. The only reason you'd convert early is if CLF shares rally big, but in that case, CLV would likely rally as well and you could simply sell your CLV shares for a gain.

The real value in holding CLV is for the dividend, which is $1.75 annually per share of CLV. This is good for a 7% coupon yield on the $25 issue price, but as I mentioned, CLV is trading at a significant discount to that right now, so the current yield is actually much higher, at 8.7%. This is a terrific yield, one of the highest in the preferred universe, and could be a jolt of income to your high-yield portfolio, but it's not without risks.

There are the usual risks with preferred stock of the issuer not being able to pay and interest rate-sensitivity, both of which are important issues to understand. However, CLV has a unique risk, and that is the price of CLF common stock. Since CLV is mandatorily convertible into CLF shares, it will trade in tandem, more or less, with CLF until the conversion date, becoming more and more correlated as that date gets closer. Thus, you really need to be a CLF bull in order to want to hold CLV, as you are indirectly holding CLF shares, just with a much larger dividend. If CLF shares trade down into the $15 range, you could end up with capital losses on your CLV position. However, with CLF already near its multi-year lows, the odds are likely stacked in your favor here, assuming you like CLF's prospects. Whether CLF is cheap or not is outside the scope of this article, but at less than $20, shares are certainly cheap relative to recent history.

On the plus side, CLV is eligible for the preferential dividend tax treatment of 15% for most holders. This means the after-tax yield is significantly higher than it otherwise would be, if it weren't eligible for this treatment. For those holding CLV in a taxable account, this is a material positive.

In addition, dividends on CLV are cumulative, meaning that even if CLF misses dividend payments on CLV, it is obligated to make them up. This is a very nice feature, as it means that your dividends are essentially guaranteed, barring some kind of bankruptcy event, a condition which does not exist for any common stock dividend. This is highly desirable and makes CLV much easier to own.

Overall, CLF bulls may find CLV to be an interesting option. The preferred offers an enormous yield, nearly three times that of the common stock, and also offers the unique chance to participate in the upside of the common stock. If you are okay with the risks of owning a convertible preferred stock in terms of capital loss potential, the upside for CLV could be large. If CLF trades back towards $30, CLV will rally hard, and not only will you be collecting an 8.7% dividend, but you could see significant capital gains as well. CLV is not for investors who don't like CLF; this is a common stock replacement strategy that gives holders a much larger dividend, while still participating in upside potential and downside risk of the common. As long as you understand what you're getting, CLV could be a nice option.

Source: An 8.7% Yield And Upside Potential For Your Income Portfolio