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Savvy preferred stock investors use a technique called "upgrading" to trade in their low dividend payers for higher payers, and have cash left over. This article explains how it's done and shows you the results from a real example.

Upgrading is one technique that preferred stock investors can use to help get more out of your invested funds plus add a layer of principal protection by keeping up with interest rate changes over time.

And upgrading is very easy to do, too. All you need is a list of high quality(1) preferred stocks sorted by the last trade price (highest to lowest).

Stable Or Increasing Interest Rates Favor Upgrades

Upgrade opportunities tend to present themselves during periods of stable or increasing interest rates. So the Federal Reserve's monetary policy of keeping interest rates at their current low levels for at least the next two years is a real gift to preferred stock investors looking to upgrade their holdings.

During the course of my preferred stock research I notice upgrade opportunities every day and have for many months now.

Please remember that upgrading, as I am about to explain, takes advantage of short-term inefficiencies in preferred stock market prices. The example shown here uses real high quality preferred stocks. Since market prices change continually, this upgrade example may not be available when you are reading this. It is the step-by-step technique explained here that is important, not this specific example.

Preferred stock investors should avoid purchasing shares for more than the security's "par value." The below explanation of upgrading assumes that you have followed this rule. The technique will still work if you paid more than par, but $25 is used in this example.

Step-By-Step: Upgrading A Low Dividend Preferred Stock

  1. Find your selling candidate:
    Look at your list of high quality preferred stocks, sorted by today's market price (highest to lowest). Draw a line at $25.00. If you own shares of a low paying preferred stock (say, less than 6.75%) that is listed above your line (i.e. low paying issues that are selling for more than $25) today is your lucky day. There were 62 such high quality preferred stocks when I pulled the list on November 11, 2011.
  2. Find your new purchase candidate:
    Look further down your sorted list for a high quality preferred stock that is available to purchase for a price less than $25 but has a higher dividend rate than the low payer you found in Step 1. You will be surprised at how many candidates you have to pick from (the list I pulled on November 11, 2011 shows 23). To the extent of your faith in Moody's ratings, you might want to limit your candidates to just those that have the same or higher rating as your low payer, hence your risk profile does not change (and might improve).

By following these two steps you can sell your low payer (from Step 1) for more than $25 per share and use the proceeds to buy the same number of shares of the higher payer (from Step 2) for less than $25. Your dividend income increases and you will have cash left over in your brokerage cash account when you are done. That's upgrading.

Here's a real example from my November 11, 2011 list:

Example:

Sell VNO.PG (NYSE:VNO) at $25.30; Buy CWH.PE (CWH) at $24.30.

This example uses real high quality preferred stocks to illustrate an upgrade opportunity that was available on November 11, 2011. To look up these preferred stocks yourself, click here to go to Seeking Alpha's Preferred Stock Trading Symbol Cross-Reference Table to see how your online service denotes preferred stock trading symbols.

Step 1:

Let's say you own shares of Vornado Realty's (VNO) series G high quality preferred stock (VNO.PG) that you originally purchased some time ago for $25.00 per share. VNO.PG has been paying you its 6.625% annual dividend ever since. But you are concerned that if interest rates go up and prices drop in the future you may get stuck with these low-paying shares and be unable to sell them without taking a loss. VNO.PG is your upgrade candidate.

The following data is taken from the Preferred Stock ListTM software tool available to those subscribing to the "CDx3 Notification Service" (my preferred stock email alert and research newsletter service). The Last Price column shows you that VNO.PG can be sold for $25.30.

Vornado Realty Series G Preferred Stock

Step 2:

Looking further down your sorted list of high quality preferred stocks that are currently available to purchase for a price below $25.00 per share, you find 23 candidates. You want to limit your choices to just those candidates that have the same investment grade Moody's rating as VNO.PG as to not change your risk profile (Baa3 or better).

CommonWealth REIT Series E Preferred Stock

CommonWealth REIT's (CWH) series E preferred stock (CWH.PE) pays a 7.250% annual dividend (0.625% higher than your old VNO.PG shares) and is available for a market price of $24.30 (November 11, 2011). That's $1.00 per share cheaper than you sold VNO.PG for at Step 1.

You upgrade (sell) your old shares of VNO.PG to the same number of shares of CWH.PE (buy).

Upgrade Results

Selling VNO.PG for $25.30 and using the proceeds to purchase CWH.PE at $24.30:

  • Increases your annual dividend income by 0.625%
  • Leaves $1.00 per share in cash left over sitting your brokerage cash account
  • Maintains your risk profile

And all you had to do was look over a sorted list of high quality preferred stocks.

Since the Federal Reserve has stated that interest rates will not be increasing for at least another two years, today's stable rate conditions are delivering a continuous stream of upgrade opportunities to preferred stock investors. And when rates do head back up, this technique can help add another layer of principal protection to your preferred stock portfolio.

Where To Find A List That Is Sortable By Current Market Price

For a list of high quality* preferred stocks that can be sorted by current market price see the "CDx3 Notification Service" on my site (my preferred stock email alert and research newsletter service). If you want to do the work yourself check out QuantumOnline (which relies on the honor system for your contribution but does not include sortable market price data in their tables). You may also have luck with a downloadable program called PreferredSearch from Virtuali-Tea (do a google search for current download mirrors).

Footnote: (1) High quality preferred stocks are those that meet the ten risk-lowering selection criteria from chapter 7 of my book, Preferred Stock Investing. For example, high quality preferred stocks (a) offer "cumulative" dividends (if the issuing company skips a dividend payment to you they still owe you the money; their obligation to you accumulates), (b) are rated as investment grade and (c) are issued by a company that has a perfect track record of never having suspended a preferred stock dividend. For more about how to select, buy and sell the highest quality preferred stock read my October 24, 2011 Seeking Alpha article titled "Preferred Stock Investing: A Simple Guide To 7% Yield".

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

Source: How To Upgrade A Low Dividend Preferred Stock To A Higher Payer And Have Cash Left Over