One Of These Preferreds Is Overpriced - Another Is A Bargain

| About: Wells Fargo (WFC)

Summary

The pricing of Wells Fargo preferred stock issues seems to contradict the theory that securities pricing is efficient.

One of the bank's preferreds appears substantially overvalued due to call risk.

A convertible preferred offers an attractive return.

Followers of the efficient market hypothesis believe stock prices represent all available information about a security, so there's no way to consistently outperform the market. That means investors could simply buy index funds rather than picking stocks or actively managed mutual funds.

Maybe. But even the most zealous indexer, like Vanguard's Jack Bogle, might have trouble explaining the pricing of preferred stock issued by Wells Fargo (NYSE:WFC), the nation's third largest bank by assets and the largest by market capitalization.

Unlike common stock, preferred stock pays a fixed dividend. These regular obligations must be paid before any common dividends. Preferreds became especially attractive to banks in the wake of the 2007-09 financial crisis as a way to shore up balance sheets, because they add to capital without diluting equity for common shareholders.

Let's look at a sampling of Wells Fargo's preferred issues, using Friday's closing prices.

At first glance, it might appear the best deal is WFC-J. It pays an 8% coupon - an outstanding rate for a BBB-rated security, up there with junk bonds from far less creditworthy companies. Since investors like high yields, the price has been bid up to $27.89 from par value of $25, but so what? The yield is still a juicy 7.17%.

Compare that with WFC-O. Its coupon is only 5.125%, and it's trading right around par.

All of these preferreds are on an equal footing, or pari passu - in the unlikely event Wells Fargo's stagecoach tips over into bankruptcy, both preferreds would have the same value in liquidation, behind the company's bonds but ahead of the common stock (hence the name "preferred"). So why would anybody buy the one that yields two whole percentage points less?

That's where the call date in the last column comes in. Wells Fargo can call WFC-J anytime after Dec. 15, 2017, give investors their $25 par value per share, plus accrued interest, and spirit away their stock.

By coincidence, vanilla option WFC-O has the same call date. The Excel spreadsheet below shows the cash flows you would receive if you had bought 1,000 shares of both issues at Friday's close (the negative numbers), collected the dividend payments until the call date, and then had them called.

The bottom line represents Excel's calculation of the annual internal rate of return for each investment. Note that the seemingly dull WFC-O has an IRR of 5.57%, higher than the coupon rate, mostly because the purchase price includes more than one month's accrued interest.

But look what happens to WFC-J. Far from returning more than 7%, the IRR is a measly 2.6%. How can that be? It's because the investor suffers a sizable capital loss when the stock bought at $27.70 is called away at $25.

If you believe markets are efficient, you do have one argument to defend the current pricing. You can say the market is predicting Wells Fargo won't call the stock at the earliest possible date, allowing investors more time to collect that luscious 8% coupon.

But that's not a reasonable position. Unless interest rates go up A LOT in the next two years, Wells Fargo's chief financial officer would be stupid to keep paying 8%. Based on the near-par price of WFC-O, the market is saying a Wells Fargo preferred should only be paying a little over 5%. If the bank doesn't promptly call WFC-J, it would be wasting the money of the common shareholders, who are the only ones who vote for the board of directors.

In reality, companies are zealous about calling overly generous preferreds, like this one from Wells Fargo, which paid 5.85%, far less than WFC-J.

So why are investors in WFC-J overpaying for something that in all probability will return them less than 3% per year?

It's because of the buyers. These $25-par securities are called "retail preferreds" because they're usually bought by small, individual investors.

Some of these folks either don't realize there is call risk or are just plain yield hogs who always go for the fattest dividend. They've bid the price too high. And there's not enough of an institutional market to arbitrage it back to where it should be.

Here's a challenge for efficient market hypothesis followers who ogle Bogle: Tell me why I'm wrong.

Now that we've seen a WFC preferred that's overvalued, can we find one that's a bargain? Let's look at the first chart again.

WFC-L has a coupon of 7.5% and a current yield of 6.4%, more than 130 basis points higher than the vanilla WFC-O. That's a mouth-watering return in this low-interest environment.

It's a different beast than the rest. For one thing, par value is much higher, $1,000.

For another, WFC-L can never be called. Instead, it is convertible into common stock. As this Quantum description shows, if Wells Fargo's common closed above 130 percent of $156.71 (that's $203.72) for 20 out of 30 consecutive trading days, the company could convert WFC-L into 6.2814 shares of WFC, which at that price would be worth $1,279.

WFC stock is currently selling around $49. For practical purposes, the chances of it getting to $203.72 in the next few years are nil. And even if it did, you could sell the common shares you received for more than you paid for the preferred.

Why does WFC-L have such a high yield? It appears to be more a function of reduced demand than an irrational market:

  • The $1,168 share price is a stumbling block for many individual investors, who have to come up with nearly $117,000 to buy a full lot. (I've been able to buy fewer shares fairly easily, however, using limit orders).
  • Some preferred shoppers may not see convertibles on their screens.
  • As we noted last week, liquidity issues tend to keep institutional buyers away from preferreds.

If you're looking for income with relative safety, the L could ring a bell. Just stay away from the J.

Disclosure: I am/we are long WFC, WFC-L.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.