JPM Preferred: Profit From the Bank's 'TBTF' Status While Earning Above Average Yield

| About: JPMorgan Chase (JPM)

The stock market bounce from the March 2009 lows was led by strong results from the financial segment, but since September 2010, financials have lagged the broad market during the QE2 stock rally. Since September 2010, the SPDR S&P 500 (NYSEARCA:SPY) rose around 27% while the Financial Select Sector SPDR (NYSEARCA:XLF) rose around 15%. As a result, there is clearly still some apprehension within the investor community when it comes to the financial sector.

While the Federal Reserve has given some banks the go-ahead to increase dividend payments, it could be years before they return to healthy levels. JP Morgan (NYSE:JPM) currently yields 2.5%, Wells Fargo (NYSE:WFC) yields 1.70%, Bank of America yields 0.30% and Citigroup (NYSE:C) yields 0.10%.

Considering the market's concerns about the financial industry and the low dividend yields of money center banks, investors should take a closer look at JP Morgan's preferred stock which offers a better yield than the common stock and potentially benefits from the "Too Big to Fail" doctrine.

High Yielding Equity
Preferred equities and trust preferred equities are a great option for financial industry investors looking for high dividend yields. Their risk/reward payoff is very different from that of common stock because outside of extreme turmoil, preferred securities have less upside and less downside. As we discuss later in the article, JP Morgan's Series J, non-cumulative preferred stock pays a coupon of 8.625%. For investors that are leery of financial stocks, preferred equity could provide an interesting way to carry industry exposure.

Good Way to Bet on "Too Big to Fail" Doctrine
If you can't beat them, join them. Right or wrong, the US government has effectively announced to the financial markets that they will not let the largest banks in this country fail. In times of distress, this does not necessarily mean that common shareholders are in the clear because of potential for forced dilution if the banks issue stock below intrinsic value. But with preferred equities and trust preferred securities, which are senior to common equity along the capital structure, these equities could be a good way for investors to profit from the "Too Big to Fail Doctrine." Of course, there are by no means guarantees, especially if there is another severe financial crisis. But under normal stock market draw downs and distress, preferred stock should offer some relative safety over the common.

JP Morgan Series J, 8.625% Non-Cumulative Preferred Stock (Prospectus)

  • CUSIP: 46625H621
  • Price (as of 5/27/2011): $27.44
  • Annual Coupon Rate: 8.63%
  • Liquidation Preference: $25.00
  • Effective Yield: 7.86%
  • Callable: 9/1/2013
  • Call Price: $25.00

JP Morgan is considered one of the safest of the money center banks and as a result their preferred equity has one of the lowest yields. The Series J preferred stock can be called in 2013. Financing rates are very low across Corporate America so it is very likely these securities will be called in 2013 at their call price of $25.00. While the effective yield is 7.86% on the current price, this does not account for the liklihood of capital gain losses as the stock drifts to the call price ahead of the call date. In general, the drift should be gradual. If there are sharp adjustments, it could present buying or selling opportunities.

Assuming JP Morgan calls the securities in Sept 2013, the yield-to-call is less than 4.5%. This yield is not attractive to everyone, but the yield-to-call is higher than the dividend yield on the stock and while the preferred stock does not offer the same potential upside as the common it is also less sensitive to downside risks.

Investors should be aware that the preferred stock can trade below liquidation preference. In addition, these stocks often have limited daily trading volume.

Disclosure: I am long BAC, C.