Trading Preferred Stocks: Opportunity for Generous Yield and Quality Capital Gains

Jun. 3.11 | About: Xcel Energy (XEL)

This post is a follow up to Preferred Stock ETFs: Beware the Heavy Concentration in Financials and 5 Preferred Stocks for High Income and Safety both of which are the latest in an ongoing series first introduced in the article Best Post-QE2 Opportunities Lie Beyond Stocks providing a detailed analysis on investment strategies outside of the stock market leading up to the end of QE2.

Trading opportunities are available in preferred stocks just like they are in regular common stocks. Sure, most invest in preferred stocks for their yield. But this doesn’t mean that you have to buy it today and hold it until it gets called away. One of the great things about preferred stocks is that, when selected at the right time, they can offer attractive high quality capital gains opportunities to go along with their generous yields.

When I focus on a preferred stock investment opportunity, I am looking first at the capital gain potential. The yield is also terrific, but this is typically secondary in my investment decision. What is attractive about preferred stocks from a trading perspective is the various levels of protection that come along with the investment. First, the par value for most preferred stocks is $25 per share. While most preferreds trade close to $25, it is not unusual to see prices deviate by 20% or more from this par value at any given point in time. Such price movement implies that worthwhile capital gains opportunities exist in these names. Second, the price volatility is sufficient but still fairly predictable in a tight range, which sets up attractive low risk trading opportunities. Also, you are one step higher above common stocks in the capital structure. So in the event the underlying company runs into solvency or liquidity troubles, you have more time to act in advance of any issues and a greater probability of recovering more of your principal investment.

In my post 5 Preferred Stocks for High Income and Safety, I introduced five preferred stocks that I am monitoring for such trading opportunities. The list was made up of non-financial preferreds that are investment grade rated and demonstrated relative price stability through recent market pullbacks including the financial crisis. They are also not callable until at least 2012. This list is shown below:

  • AT&T 6.375 (NYSE:ATT)
  • Alabama Power 5.875 (NYSE:ALM)
  • NextEra Energy 7.45 (FGE)
  • Xcel Energy 7.60 (XCJ)
  • Dominion Resources 8.375 (NYSE:DRU)

Before going any further, I thought it would be worthwhile to respond to a very good point that was raised in several of the comments from my previous post on the topic. All of these preferred stocks trade at a premium to par. In other words, the price is over $25 per share. As a result, if the preferred ended up getting called by the issuer at $25 per share, you would end up with a capital loss on your investment. It is for this reason that this strategy applies best to stocks that are not callable for at least six to nine months or more. For any preferred stock trading strategy, I would expect that I have sold out of the position well before it becomes callable. And in the unlikely event that I do end up holding a position to call, I will have at least been collecting the yield income along the way to help neutralize any downside. But the objective is to first realize a capital gain with the potential of capturing some generous yield on top along the way for a solid overall total return.

Xcel Energy 7.60 (XCJ) presented the first such trading opportunity following my previous post. After reaching an intraday high of $28.24 just four trading days earlier on May 23, XCJ corrected lower by -4% to $27.12 by May 30. This price hit right on the upward sloping trend and immediately bounced higher. As a result, I stepped with limit orders to purchase XCJ at $27.19 on May 31. Click to enlarge:

Click to enlarge

This new XCJ position sets up for a nice trading opportunity. First, the price remains in an upward sloping trend on a yield adjusted basis, and the potential for this upside continuing has support given that QE2 is soon ending on June 30. Second, XCJ has various levels of strong downside support including at the 50-day moving average at $27.36, the upward sloping trend line now around $27.20 and the 200-day moving average at $26.79. Third, if XCJ returns to its previous highs in the $28.20 to $28.30 range, this would provide a +4% capital gain, which is more than six months worth of dividends if I purchased XCJ with only the yield in mind. Finally, if XCJ hits this $28.20 to $28.30 range and is technically overbought with an RSI of 70 or above, that’s my signal to exit the position and lock in the capital gain. Otherwise, it may be worthwhile to hold the position and collect the next dividend scheduled for a few weeks on July 1, thus combining the capital gains power of the position along with the healthy yield.

In the two days after the XCJ purchase, the price already jumped by +3.2%. This highlights once again the trading opportunities available in preferred stocks, as 42% of the yield you expect to receive in an entire year from holding this preferred has been achieved through a capital gains trading strategy in just two days.

Two points are worth mentioning. First, this type of trading strategy is obviously better employed in a qualified account such as an IRA. But with that being said, it also has merit in a taxable account. After all, an investor would be paying ordinary income tax rates on the yield received from their preferred, so paying the same tax on short-term capital gains essentially makes this an opportunity to create additional synthetic income in taxable accounts. Second, employing such a strategy does require watching these types of positions on a daily basis and having the patience to implement and wait on limit orders to ensure the right price realization on both the buy side and the sell side.

I will check back if and when other trading opportunities present themselves in the five names listed above.

Disclosure: I am long XCJ.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management ((GWM)) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.