Good News, Bad News: Public Storage Announces Preferred Stock Offering

| About: Public Storage (PSA)

If your broker makes a habit of calling you when a new investment-grade preferred stock is about to start trading, you might want to keep your phone handy. But there is good news and bad news here.

Public Storage, Inc. (NYSE:PSA) just filed a Free Writing Prospectus for a new preferred stock[1]. Once the New York Stock Exchange approves PSA's trading application (usually within a couple of weeks), the new issue will likely trade under the symbol PSA.PS[2]. In the meantime, the shares have just started trading on the Over-The-Counter stock exchange under the temporary symbol PSAY.

Before buying shares, though, preferred stock investors should understand that this particular issue from Public Storage is not as sweet as it might seem, especially once you consider the available alternatives. As I'll explain in a moment, there are currently several other high-quality preferred stocks that provide a much better return without the risk that this new issue from Public Storage represents.

Preferred stocks issued by Public Storage are very widely held. If you have been investing in preferred stocks for any length of time, it is highly likely that you own shares of at least one preferred stock series issued by Public Storage. Brokers love recommending them, and shareholders love the reliable dividends from this company.

And why shouldn't they? This is one of America's best-run companies and does extremely well in good times (when people are trading up and need temporary storage for their stuff) and in bad times (when people are downsizing and need temporary storage for their stuff).

With one exception, this new preferred stock from Public Storage meets my ten selection criteria for a "high quality" preferred stock.

For example, this new issue (1) carries an investment grade rating (Moody's Baa1), (2) offers cumulative dividends to shareholders (meaning that if the company ever skips a dividend to you, they still owe you the money) and (3) is issued by a company that has never suspended a preferred stock dividend.

But the one exception is extremely important for preferred stock investors: The historically low dividend rate offered by this new Series S preferred stock from Public Storage creates a unique risk that you should consider before investing.

PSA Series L To Be Called

Public Storage is using the proceeds from this new preferred stock to retire (call) all 8 million outstanding shares of its previously issued preferred stock PSA.PL.

PSA.PL became callable on October 20, 2011, and has been costing Public Storage 6.75% in annual dividend expense to shareholders since its October 2006 introduction.

If you own shares of PSA.PL, Public Storage is going to buy your shares back from you (for $25 per share plus the dividend amount for the partial last quarter) on February 9, 2012. Check your brokerage cash account on that day, and start thinking about what to do with your new windfall (see "The Good News" below).

Using the proceeds from the issuance of the new PSA.PS to call (buy back from shareholders) the outstanding shares of the older PSA.PL makes sense to Public Storage, since the new PSA.PS is offering a miserly dividend rate of only 5.90%. It is refinancing a security that costs it 6.75% by issuing a new security that only costs it 5.9%. Makes sense.

The Bad News

Because Public Storage is going to be calling PSA.PL, those shareholders are going to be in the chips when they receive the $25+ per share from the company. Congratulations. But those purchasing shares of the new PSA.PS are not likely to be so lucky when the new PSA.PS shares become callable five years from now.

Preferred stock investors should understand that Public Storage is unlikely to ever call PSA.PS shares.As with all new preferred stocks, the new shares will start trading later this month on the NYSE for a market price very close to the security's "par value," which in this case is $25 per share. If you purchase shares for anything close to this price, you are very likely to be holding them forever, unable to sell them without realizing a capital loss.

There are two reasons for this. On November 1, 2011, Moody's affirmed Public Storage's Baa1 investment grade preferred stock rating and revised its outlook on the company to positive saying "... the positive outlook reflects Moody's expectation that the REIT's excellent franchise and operating platform will continue to drive solid core earnings growth, improving upon its already strong credit metrics."

This glowing rating and outlook revision comes at a time when the Federal Reserve has implemented a low-to-no-interest-rate monetary policy. By issuing PSA.PS, Public Storage is taking advantage of the coincidental convergence of these two events.

The 5.9% dividend rate offered by PSA.PS shares is among the lowest paying cumulative, investment grade preferred stocks in history (my data goes back to 1926) not issued by a utility and is the lowest dividend rate ever offered by a Public Storage preferred stock since the company's founding in 1971.

The Fed announced in August 2011, and reaffirmed in December 2011, that it is not going to be raising interest rates for at least another two years. That's great news for preferred stock investors, since that implies stable market prices into 2014.

But once PSA.PS becomes callable five years from now, rates are likely to be higher than today.

That means that once PSA.PS becomes callable in 2017, Public Storage is not going to be able to use the same refinancing trick to call PSA.PS shares. Issuing a new preferred stock at a lower rate and using the proceeds to call an older, higher-rate issue only works if rates have fallen.

Rates are likely to be higher when PSA.PS becomes callable five years from now, not lower. So a future call of PSA.PS shares by Public Storage is very unlikely. Secondly, if Public Storage seeks to retire the shares of PSA.PS in the future, the company is more likely to simply buy the shares on the open market at that time rather than call them. Calling the shares costs the company $25 per share but the shares are likely to be selling for less than $25 five years from now, as higher-dividend-payers are introduced.

Public Storage is unlikely to ever issue a call for PSA.PS shares since (1) higher future rates will eliminate any opportunity to refinance using a new lower rate issue and (2) it is highly likely that they will be able to buy the outstanding shares on the open market for less than $25 per share when PSA.PS becomes callable in 2017 (assuming it has the cash to do so).

The Good News

The good news is that this risk is easy for preferred stock investors to avoid[3]. While the new cumulative Series S preferred stock from Public Storage sounds good at first, this security has a significant risk of "perpetual ownership" due to its miserly 5.9% dividend rate. It is for this reason that I recommend avoiding preferred stocks with dividend rates of less than 6.5%.

Rates go up and down over time. With very few exceptions, high-quality preferred stock dividend rates range from 6% to 9%. By giving yourself a 0.5% cushion at the bottom of the scale, you will have a chance to sell your shares for a gain once rates bounce off of 6% and start increasing again.

Of the 1,000+ preferred stocks currently trading on U.S. stock exchanges, there are 78 high-quality preferred stocks that do not leave the investor exposed to the perpetual ownership risk seen with PSA.PS. Of these 78, 14 are available for less than $25 per share right now (January 9, 2012 prices)[4], [5] and offer an average annual dividend yield of about 7%.

I don't see any good reason a preferred stock investor would take the risk of perpetual ownership in order to earn a 5.9% dividend when there are many much better preferred stock alternatives available without that risk earning 7%.


[1] A preliminary 424b5 was filed on Wednesday, January 4, 2012. The FWP was filed the following day, Thursday, January 5, 2012 (source: CDx3 Notification Service data, Disclosure: the CDx3 Notification Service is my preferred stock email alert and research newsletter service).

[2] See Seeking Alpha's Preferred Stock Trading Symbol Cross-Reference Table to see how your online service denotes preferred stock trading symbols.

[3] See "Protecting Your Principal," CDx3 Newsletter, December 2011. This article explains four ways for preferred stock investors to protect their principal when expecting increasing rates, including how to use the 6.5% limit described here.

[4] Source: Preferred Stock ListTM data, Note that the number of high quality preferred stocks available for less than $25 per share changes daily with market price fluctuations.

[5] Shareholders receive $25 per share if the company calls your shares. By paying less than $25.00 per share for the highest quality preferred stocks preferred stock investors position themselves for a nice capital gain while adding a layer of principal protection in the event of a call.

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