- The DRU preferred issue yields close to 8.2%.
- This issue is structured as debt and not equity, making it senior to other preferred issuance.
- Debt covenants make this issue very unlikely to be called.
Preffered Equity (An Introduction)
A small and overlooked area of the equity market is preferred issues. Preferred shares issued in a company have attributes of both equity and fixed-income issues. Like equity, preferred issues typically fall below all debt in the capital structure, however, like fixed-income issues, preferred shares typically trade as a function of the yield which they pay and not as a function of company profitability or value. The advantage of the yield on preferred shares versus the yield on most corporate bonds is that the preferred dividend is typically qualified and is therefore taxed at a lower rate. On the other hard, the disadvantages of preferreds are that their dividends are occasionally suspended (more on that later) and their subordinated position in the capital structure.
Dominion Resources (NYSE:D) is a conglomerated energy utility headquartered in Virginia. In late 2009, Dominion floated a $625 million preferred issue yielding 8.375% on the $25 par value. This preferred issue trades under the ticker (NYSE:DRU) on the NYSE. This issue differs from the typical preferred issuance in a number of ways.
The primary way in which the Dominion preferreds differ from typical preferreds is that these shares are subordinated debt and not equity. This aspect has both pros and cons. The downside is that interest payments are taxed at the regular rate and not at the lower rate for qualified dividends. On the other hand, these preferreds are higher in the capital structure that most preferred issues.
According to FactSet, industrial bonds in the BBB range should yield just a bit above 5%. These bonds, which are currently yielding 8.2%, offer a huge yield premium to comparable corporate issues even accounting for their subordinated place in the capital structure.
Yield Spreads Imply A Discount
Using yield spreads, we can determine how the Dominion preferreds have performed versus a benchmark yield and versus a similar Dominion issue. This data shows that these preferreds have underperformed against every reasonable benchmark. First, let's look at the spread between the Dominion issue, which matures in 2064 compared to the 30-year treasury.(click to enlarge)
In the lower graph we can see how the yield on the Dominion issue tracks the yield on the 30-year. The fact that the two issues don't track well at all indicates one of two things. The fact that Dominion's debt yield has increased against the treasury benchmark indicates that either the default risk of Dominion increased, or that the markets are mispricing the Dominion bonds.
To further investigate the movement in the yield spread and determine whether credit-worthiness or mispricing caused the spread to widen, we will use another dominion debt issue as a control case. In this chart, we will look at the yield on a 2038 Dominion bond versus the 30-year treasury. (click to enlarge)
In the lower graph, we can see that the Dominion bond tracks the 30-year treasury quite closely. In fact, since 2010 the spread has barely moved out of the 100-150 basis point premium range except for between late 2011 and 2012 where S&P downgraded U.S. sovereign credit. Had there been a credit event effecting Dominion's worthiness, we should have see a similar chart to the first one with the yield spread rising on these bonds too. The fact that we don't see that implies that the market is mispricing these preferreds.
If you observe the top graph, you will see it appears to be almost identical to the first graph comparing the 2064 issue to the 30-year. This shows that the preferreds have trailed the 2038 issue by virtually the same margin as they have trailed the treasury, while the 2038 issue has traded at a constant premium to the treasury.
These three graphs provide conclusive evidence that the 2064 bonds are clearly being mispriced by the market. To determine the fair value of these preferreds, we can use yield analysis. For the bonds to trade at 300-350 basis points above the 30-year treasury, they should trade at a face value of over $30. (This assumes that the $2.09 annual interest payment should be 6.3% of the bond price, a straight algebraic calculation.)
The Fine Print
When buying a bond or preferred stock, it's always important to read the prospectus. The first thing that is important is that Dominion's dividend on the preferreds is cumulative. While companies must pay the dividend on preferred stock before the dividend on common stock, in many cases, if the dividend on the common stock is eliminated, the company can stop paying the dividend on the preferreds. Dominion dividends are cumulative, meaning that any skipped dividends must be repaid in the future. This is a friendly clause that essentially ensures that dividends will never be skipped.
We also will look at callability. With the Dominion preferreds, the bonds are callable from now until maturity. This creates an immediate downside risk of approximately 1% (premium to par less accrued interest) if the bonds were to be called today. But investors need not worry that the bonds will be called anytime in the near future. That's because there is a second covenant in Dominion's prospectus requiring that Dominion provide replacement capital equal to or below these preferreds in the capital structure if these notes were to be called. In essence, as long as Dominion's cost of equity stays above the 8% level, these bonds won't be called.
Investors looking for a safe 8% yield will want to give these preferreds a serious look. Dominion is a powerful player in the utility sector that is well diversified with excellent natural gas downstream assets in the Marcellus shale. These notes are trading at an unreasonable 30% discount to implied value.