Profit From Fears Of Eurozone Financials With Banco Santander Preferreds

| About: Banco Santander (SAN)

Banco Santander (STD), with headquarters in Madrid, is one of the world’s biggest banks. It has over 6000 branches in Europe, but more important, over 5000 additional branches in Latin America, particularly Brazil and Chile.

The extensive South American operations provide a cushion which reduces the risk of its exposure to Eurozone banking contagion and deflation of its Spanish assets. Despite this advantage, the market is treating Santander's common stock with the same fear it has of Europe’s banks in general.

Click to enlarge:

STD vs. European Financial sector

Now, if the only option were the common equity shares, this still would offer little temptation. With the shares down 31% in the last 6 months, who knows where the bottom will be?

But there’s a better way to gain from the market’s distaste of European finance. Santander has several series of preferred shares, offering relative safety and great value. I’ll discuss the three most liquid versions, each having distinct characteristics.

The most straightforward investment is in series C (STD.PC). It has a 6.5% coupon, which by itself is a decent return for a fairly bulletproof investment. But that’s based on the $25 call price. Today, the shares are trading close to $20, boosting the yield to 7.8%. Better? And then, assuming that the bank’s credit risk is seen as being lower in 2017 than it is now, and it can borrow more cheaply, the shares will be called for $25. Including the capital appreciation, the annualized total return could be 12% over 6 years (or somewhat less, if the call is delayed).

A very popular alternative is the series E preferreds. These shares offer a coupon of 10.5%. Yet so great has the fear been, that even this hasn’t been enough return for the perceived risk: a couple of times since its 2009 IPO it has traded below par, providing great opportunities for both yield and appreciation. Yesterday it closed at $26.11, still yielding nearly 10%. That’s a better return, for the time being, than the C-shares. But, careful: this one is callable in September, 2014. If the bank can get cheaper financing by then, it will surely call these expensive shares at $25. Share price has already been trending down, anticipating the call at par. The annualized 3-year return in that scenario would be about 8.6%. This offering is VERY sensitive to variations in the purchase price, so be sure to buy on dips.

If you think that financing will remain expensive because interest rates must be going up in the next few years, then you want the floating rate issue, STD.PB. The yield is set each quarter at a modest 0.52% above LIBOR, with a minimum of 4%. With interest rates so low now, and other STD preferreds yielding in the area of 8%, why would anyone want a 4% coupon? And even back in 2007, before the central banks lowered interest rates to fight the financial crisis, LIBOR was never more than 5.5%.

Well, that’s why STD-B is trading at astonishing discounts. At a $15 purchase price, that 4% minimum yield has become 6.7%. Not so bad, but still not the real point. When interest rates rise, the yield can only go up, and the trading price will start approaching par. Even under adverse economic conditions, this security has the potential for 30-50% appreciation—again, with relatively little risk.

That's three distinct choices, none bad, which you can optimize for your timeframe and expectations of economic conditions.

Disclosure: I am short XLF, long STD.B and STD.E