Molycorp Preferreds: An 8% Yield, But Conversion Is Mandatory

| About: Molycorp, Inc. (MCPIQ)

Kenarnold left a comment on my last article on Molycorp (MCP) options, pointing out that the company also has a convertible preferrred series (MCP-PA) that currently yields about 8%. It's called Molycorp 5.50% Series A Mandatory Convertible Preferred,

This is an interesting security because it's a mandatory convertible preferred. According to Quantum Online (an excellent resource on income securities), there are less than two dozen mandatory convertible securities available now, but they usually follow kind of an odd payout structure.

This series of preferred shares pays a $5.50 dividend per year - until March 1 2014 when the stock will be called and converted into MCP common stock.

How many shares will you get? That depends:

  • If the common stock is at or below $50, you receive 2 shares of common stock
  • If the common stock is at or above $60, you receive 1.6667 shares of common stock
  • If the common stock is between $50 and $60, the number of shares you receive is 100 divided by the common stock price.

So if you were to plot that out, here's the value of 100 shares of Molycorp's preferred stock at the date of conversion vs. 200 shares of the common stock.

The purple line shows that for the preferreds, your gains are capped at $50 but gains resume at prices above $60. Option traders will recognize this as what it would be like to be long MCP, but short a call option at $50 and long a call option at $60 - essentially a call credit spread against a long stock position.

However, option traders don't give up gains without getting something in return - and that's usually the premium for selling the short call less the premium paid for a long call.

Well there is a premium here, sort of. Remember, these preferreds pay a dividend of $5.50 per year ($1.375 per quarter). So if you'd invested in these preferreds when issued about a year ago, the payout structure would look like this as of March 2014

There's a bit of downside cushion, but there's a big difference between this structure and an actual options trade.

Here's why: If you sell an actual credit call spread against shares of stock, you collect your premium in advance and can close your option and/or stock position anytime. But in this case, you're collecting your premium in smaller payments over time, and of course, subject to the risk that the company won't make those payments.

Remember, if you invest in these mandatory convertible preferreds today, you don't get all those dividend payments because some have already been distributed. But according to Quantum Online, the next dividend will be paid on June 1, so there are 7 (possibly 8) quarterly payments remaining (as much as $11.00 worth).

Also note that these dividends may not qualify for the 15% dividend tax rate, so it might be worth reviewing the prospectus.

If you're considering these preferreds, it might be good to have some idea of what the current market yield for MCP-PA has been over the past year or so.

And here's the market price for both stocks, along with a chart that shows the ratio between the two.

The relevance of the ratio changes over time given that as time goes by the "premium" (dividends actually) you can expect to receive declines over time. Nonetheless, it's helpful to see the relationship between MCP and MCP-A if you're choosing between the two.

Why issue mandatory convertibles?

You might be wondering why companies issue these strange "mandatory" convertible preferreds in the first place. Why not a simple convertible preferred?

I'm not certain, but this 2004 paper (PDF) by two Boston College professors, Thomas Chemmanur and An Yan (along with Ph.D. candidate Debarshi Nandy) explores this topic:

In particular, our model predicts that, when faced with a choice between ordinary and mandatory convertibles, firms facing a larger extent of asymmetric information, but a relatively smaller probability of financial distress will choose to issue ordinary convertibles, while those facing a smaller extent of asymmetric information, but a larger financial distress probability will issue mandatory convertibles.

Thus, a larger firm, which is already highly leveraged (or facing a financial downturn) will choose mandatory convertibles over ordinary convertibles, while a smaller firm, which is relatively debt free will make the reverse choice.

I have no opinion one way or the other whether Molycorp is under any financial distress or not, nor whether the model in this paper accurately predicts outcomes. However, I think we can all agree that the rare earth sector is a volatile one.

So if you want to invest in MCP, and would be just fine with essentially being short a 50/60 call spread that expires in March 2014 in exchange for a dividend that now provides a current market yield of almost 8%, MCP-PA could be a good choice. Especially if you think MCP is headed north of $60.

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