Mispricing In Public Storage Preferreds

| About: Public Storage (PSA)

Summary

Preferred stock investors pay too much attention to yield-to-price and not enough to yield-to-call.

If your preferred is showing a negative YTC, then you should consider selling.

The preferred stock market is a good place to find mispricings.

Note: All prices are as of the close of May 17, 2016

Last week, I got an unexpected email from Seeking Alpha. Due to my workload, I haven't had time to check SA in the last few months and so I had no idea that someone had posted a question on an article I had written almost 2 years ago about how Public Storage (NYSE:PSA) preferred stocks were mispriced. These mispricings kept occurring over the next 12 months prompting me to write another article, and now this reader's question has pushed me to write a third article regarding these preferreds. This will most likely conclude what we can officially call a series on "The Mispricings of Preferred Stocks in the Market."

What was most interesting about these preferreds was that PSA has a history of calling their preferreds within one month of their call date, making it easy to calculate the gains or losses from them. In this regard, they are exactly like a bond; they have a "maturity" date with an exact cash flow and a par value. Yet despite all this, some PSA preferreds were priced to lose money if called on their call date, which PSA has a 100% historical rate of doing. In other words, some PSA preferreds were sporting a negative yield-to-call. This made me question how that could happen. What were investors looking at that made them unaware of this?

The answer was so simple that at first I had some trouble believing it. Could investors really be so naive? The answer of course is - yes, yes they can. In short, most investors of preferred stocks seem to look only at the yield-to-price and not at the yield-to-call (YTC). The reason for this is easy to understand; many preferreds aren't called on time. Of course, this doesn't mean that the investors weren't making a mistake here, just that we can understand why the mistake was made.

Fortunately, we were able to take advantage of this by doing one of the following:

  • Switching from a preferred with a negative yield-to-call to a preferred with a positive YTC. At the time of the first two articles, some of the PSA preferreds were showing YTC as high as 7.75% with a call date within 2 years, which was much higher than the preferred market in general (and, I think, higher than the high-yield bond market at the time). This was also interesting to me, since PSA shows a very strong "earnings to fixed-charges & preferred dividends" ratio. This was most appropriate for investors who need income (i.e. retirees) and for investors who are long only.
  • Short the negative YTC preferreds while going long one of the positive YTC preferreds. This allowed one to take advantage of the spreads and lower their risk exposure.

[As a side note, since writing those articles, the yields on the PSA preferreds have come down (I think the highest YTC you can get on these preferreds is only 4.2% and that is with a call date sometime in 2021… not worth it, in my honest opinion). This means investors wizened up to the high yields available (can I take credit for this?) and possibly some traders keeping prices in line by shorting the negative YTC preferreds, while going long the positive YTC preferreds.]

And now, two years later a reader asks:

"If you buy a preferred under par, but at some point its yield to call becomes negative, should you then sell it?"

I was happy I got this question. Firstly, it meant that this reader had taken my advice of switching to or buying a higher yielding preferred and that it has been profitable since the price was obviously higher than his purchase price, high enough that it was now showing a negative YTC. Secondly, (and more importantly) because I was dealing with a similar question myself.

In May 2014, I bought PSA Series U for $23.59 with a YTC of 7.7%. Currently, PSA-U is $26.38. With a quarterly dividend of $0.3516, a par value of $25, and one more year to its call date, I stand to gain only $0.37 over 12 months. Now this isn't a negative yield, but an extra 1.4% more doesn't seem worth it, in my opinion. However, unsure of my opinion, I went to a fund manager that is an acquaintance of mine and asked his advice.

He had only two words to say, "sell now." He went on to explain what I had already reasoned, namely, that the risk of the price falling or PSA deciding not to call the preferred wasn't worth the reward of 1.4%. By selling now, I locked in a CAGR of over 16%, as opposed to the 7.7% I would get if I waited the full 12 months. (The higher CAGR has to do with the fact that I get my money today as opposed to having to wait 12 months to collect that amount in dividends and redemptions. It's all about the time value of money.)

With a negative yield, the answer seems much easier. For example, the PSA Preferred Series R (PSA-R) is currently $25.55, with a call date of July 2016 and a quarterly dividend of $0.3969. That means that if you buy PSA-R today, you stand to lose $0.15 (and that is before transaction costs). Again, investors aren't paying attention!! They are essentially betting that PSA won't call the Series R in July and they are willing to lose 0.5%. This translates into an annualized loss of 3.65%! Now I'm not saying that PSA has to call the Series R, or even that they will call the Series R, only that history has proven that they are greatly inclined to call their preferreds and refinance it with another Series.

With all the above in mind, I responded to the question by writing:

"zgb952, good question. I think it all depends on what your goals where when you bought. However, it's probably a smarter move to sell.

I'm guessing that if you do the math, you will see that by selling now you will get more money than if you wait. If we are discussing PSA preferreds the only negative yield I see is PSA-R which is $25.62. If you wait till the call date you will get $25 along with 0.40 of dividend. that is 0.20 less than if you sold today. Your upside is extremely limited (close to 0, I'd say), while your downside is huge. What if they decide to go against all odds and not call the preferred - the price will probably drop really hard, really fast."

As shown in the answer to zgb952, and in this article, when investing in preferred stocks, investors should always see what will happen if the stock is called. If you take the possibilities and weigh it by the probabilities, you will make smarter investment decisions, and hopefully profit from it. Don't leave yourself open to loss, especially when it is easily calculable.

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

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.