Watching for Contagion: The Preferred Stocks Most at Risk

by: Eric Parnell, CFA

Preferred stocks are worth watching as we endure the ongoing market volatility. As discussed in previous posts, preferred stocks provide a key indicator to determine whether the common stock market is simply going through a short correction or is instead deteriorating toward crisis. If preferred stocks hold steady, underlying conditions for the common stock market remain generally healthy. But if preferred stocks enter into a sustained correction, then it may be time to prepare for danger ahead.

Beginning on Thursday, the preferred stock market broke sharply to the downside. Since roughly 85% of the preferred stock universe is made up of financials including roughly 25% from European financials. This is a signal that the solvency of major global financial institutions may be coming into question. But given that both the United States and Europe face their share of challenges, it is worthwhile to dissect the preferred stock universe to determine exactly where the danger spots lie.

The following is a series of charts for more actively traded financial preferred stocks. It should be noted that these securities go by a variety of names and have various subtleties to their underlying characteristics. But the key to focus on here is that they act a lot like bonds with high yields. Also, the par value for all of the securities shown below is at $25 per share. Thus, if a security is trading above $25 per share, it is trading at a premium to its value at maturity, and if it is trading below $25, it is trading at a discount.

For illustration purposes, I’ll begin by showing a preferred that is “broken” in that the dividend distribution has been suspended. The following is the chart for the Royal Bank of Scotland 6.40% (RBS-PM). Although the dividend was suspended, the preferred still trades at a price that is currently around 55% of par value at $13.60. This is the type of outcome that a lower risk income investor would seek to avoid.

(Click charts to enlarge)

Now on to the review. I will begin by taking a look at the major United States financial institutions to see if we see any signs of stress. Representative preferred stocks from five U.S. institutions are shown below:

While some signs of stress are emerging among U.S. banks, we’re not seeing any extreme movements just yet. Examining the charts above, financial institutions that have been considered among the healthiest over the last several years such as JP Morgan Chase and US Bancorp have seen their preferred stocks hold steady in recent years. They may have pulled back some in recent days, but it is still within historical ranges of the past few years. Moving down the list, institutions such as Wells Fargo and Citigroup whose preferred stocks have climbed back in recent years are also solidly holding their ground. The only U.S. institution that is signaling issues more notably at present is Bank of America, whose preferred was sold off particularly sharply in recent days. While this overall solid condition could certainly change for U.S. institutions in the coming days, they are generally holding within range at the moment.

I will now move on to European financials to see if signs of stress are emanating from these institutions.

Preferred stocks suggest that signs of stress are much more pronounced from European institutions. What is particularly notable is that many of the banks shown above are among the healthier institutions in the region. As a result, if these institutions are showing meaningful stress in their recent price movement, this implies that conditions may be even more challenged among those banks not shown here that are closer to the epicenters of the crisis in Spain and Italy or more heavily exposed in France.

While it is still early in this phase of the sell off, preferred stocks are signaling that the most severe tests for the financial system are emanating from Europe. This could certainly change, so monitoring the price performance of financial preferred stocks such as those shown here is worthwhile to determine whether we see a shift in trend or if contagion effects are spreading across the Atlantic.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.