By now, it’s common knowledge that benchmark yields in the United States are trading near all-time lows. But even so, would you buy a long-term junk-rated corporate bond, four notches or more below investment grade, if it were yielding just 79 basis points? When I think about buying the common stock of Bank of America (BAC), this is one of the first questions I ask myself.
While Bank of America’s senior unsecured debt is rated Baa1/A- by Moody’s and S&P respectively, its Trust preferred is rated Ba1/BB+, and its Preferred stock sports a solid junk rating of Ba3/BB+. Given that common stockholders are supposed to be wiped out before the rest of the capital structure, if Moody’s has the preferred stock rated three notches into junk territory, what does that say about the risk profile of the common stock? In addition, what has been and will be the opportunity cost of playing the waiting game with the common stock, versus collecting the 7.876% yield on the Baa2/BBB+ rated subordinated debt?
These aren’t the types of questions many of today’s long-standing money managers and most senior equity analysts who built their careers during the 1980s and 1990s are used to asking. However, we are now seemingly in an era of perpetual uncertainty, an era of more stringent capital standards for the large banks compared to years past, a deleveraging cycle that seems to have a long way to go, and a time in which the very foundations of the global financial system are being called into question. If you are going to invest your money in the giant banks, what are you hoping to get out of the common stock? Perhaps this is the opportunity of a lifetime for people to buy BAC or any of the other “too-big-to-fail” banks. I’m not questioning that possibility. I’m simply proposing that investors who are interested in investing in our nation’s largest banks take a moment to think about where on the capital structure their money is best suited to meet their long-term goals.
Among other things, it is important to think through whether an eventual rising yield on cost or unrealized capital gain over a period of many years is enough to offset the lost income from not having invested in the upper portions of the capital structure from the beginning. After all, if current shareholders will eventually see a healthy return on their investments, then the bonds of those banks will still be paying out. Therefore, understanding opportunity cost is important when investing in the common shares.
Furthermore, think about how your bank stock has traded over the past few years and how your principal investment has been affected. Moreover, do you understand the business and the balance sheet well enough to make an informed decision about future earnings prospects? At the end of the day, despite the high-frequency trading, computer-driven financial markets in which we operate, earnings and multiples are still quite important in determining the value of the common stock over a longer period of time. On the debt side, however, when it comes to an investment in the unsubordinated debt of a systemically important financial institution, should such a bank ever find itself struggling to survive, the political climate is likely to be the driving force behind whether or not investors see a return of their money.
Below, I provide the preferred securities ratings of the other seven American systemically important financial institutions. Two of the seven on the list, Citigroup (C) and Morgan Stanley (MS), also have preferred stock with junk ratings. One of the other things that caught my eye on this list is that Moody’s has Goldman Sachs’ (GS) preferred one notch above Wells Fargo’s (WFC). That is sure to cause some head scratching by industry participants, given how beloved Wells Fargo is by many.
JPMorgan Chase (JPM): Trust preferred rated A2/BBB+; Preferred stock rated Baa1/BBB+ by Moody’s/S&P
Citigroup (C): Preferred stock rated Ba2/BB+ by Moody’s/S&P
Goldman Sachs (GS): Preferred securities rated Baa2/BBB- by Moody’s/S&P
Wells Fargo (WFC): Preferred stock rated Baa3/A- by Moody’s/S&P
The Bank of New York Mellon (BK): Trust preferred securities rated A1/A- by Moody’s/S&P
State Street (STT): Capital securities rated A3/BBB+ by Moody’s/S&P
Morgan Stanley (MS): Trust preferred rated Baa2/BB+; Preferred stock rated Ba1/BB+ by Moody’s/S&P
Whether we should believe these ratings or not is certainly up for debate. When thinking this through, keep in mind that over the past few years, as the rating agencies have come under fire for their ratings of certain securities, it has almost always been because the securities were overrated. Whether or not the ratings of the aforementioned preferred securities are too high, given the hierarchy of the capital structure in the event of bankruptcy, think about what these ratings tell us about the risk level of the common stock.
It is true that big risks can lead to big rewards. But, big risks can also lead to severe losses. If you intend to invest some money in the equity of the giant American banks, at least spend some time thinking through the risk-reward of investing in the various parts of the capital structure as it pertains to your risk tolerance, time horizons, and financial goals. You might be surprised by the result.
As a final note, on November 29, 2011, S&P announced it was downgrading 37 global financial institutions. At the time this article was written, S&P had released its new ratings for unsubordinated and subordinated debt but had yet to announce the new ratings for preferred securities.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am long various CUSIPs assigned to JPM, BAC, GS, WFC, and C