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Concerns about investment risk are never far from the mind of investors and preferred stock investors are no exception. Looking over the list of the 1,000+ preferred stocks currently trading on U.S. stock exchanges can be interesting, but evaluating risk can be difficult and time consuming.

Determining risk is, of course, a tricky business starting with the fact that what one investor may consider low risk another investor will see as unacceptably high. By its nature, measuring risk is an effort to quantify the unknown.

We are therefore left with analyzing the past and trying to determine, now that we know the outcome, if there was any indicator along the way that, had we known where to look, would have alerted us to trouble.

Is There An Indicator Of Future Risk?

There are three types of preferred stocks (traditional, trust and third-party trust) and these three types have a variety of characteristics. The type of dividends they pay (cumulative versus non-cumulative), their payment schedules (monthly, quarterly, semi-annually, annually), their ratings (investment grade, speculative grade) and whether or not they can be converted to the company's common stock are all characteristics of each preferred stock issue.

The fact that preferred stocks have these various characteristics allows a preferred stock investor to tailor their choices to more closely align with their individual risk tolerance - a huge benefit that many other types of investors do not enjoy. Since preferred stock investors can use these characteristics to help manage risk, the extent to which a relationship actually exists between these characteristics and investment risk is worth knowing.

Is there such a thing as a bellwether characteristic that, above all others, is an indicator of the future risk of a preferred stock investment?

Study Period - June 2007 To March 2009: The Global Credit Crisis

The Global Credit Crisis started for preferred stock investors in June 2007. During that month the average market price of the highest quality[1] preferred stocks fell below $25 (PAR) and continued to fall until March 2009. This period provides a very interesting study period since extreme conditions will often magnify behaviors of securities, and the marketplace that they trade within, beyond what can normally be measured.

Thinking back to the months prior to the crisis, before you knew how our Big Banks were going to weather the coming storm, could you have picked the survivors?

While all banks faced challenges during this period, there were eight publicly traded Big Banks that ultimately declared bankruptcy while four others facing bankruptcy were saved through acquisition. Of the twelve Big Banks that faced bankruptcy during the crisis, how could you have picked the ones that would ultimately be saved through acquisition from the others that would perish?

70 Out Of 70

Going into the crisis, these twelve troubled Big Banks had a total of 70 preferred stocks trading. Of these 70, the four troubled Big Banks that ended up being saved had 13 preferred stock trading; these 13 preferred stocks, and their holders, were saved while the other 57 preferred stocks, and their holders, were not[2].

At the time, it would have been very difficult to separate the winners and losers by looking at a list of 1,000+ issues that included these 70 preferred stocks. All 70 were issued by Big Banks that met all of the regulatory capital requirements at the time; they were all large, well known publicly traded institutions.

And they all offered investment grade ratings which, of course, became a point of controversy (and litigation) as the crisis unfolded.

But there were differences too. It was one of these differences that ended up being the most meaningful to preferred stock investors. Here are the results of the Global Credit Crisis with respect to the twelve Big Banks that were facing bankruptcy.

High Quality Big Bank Preferred Stock Performance

As indicated on the above table, Bank of America (BAC), PNC Financial (PNC) and Wells Fargo (WFC) acquired Countrywide, Merrill Lynch, National City and Wachovia. The eight others, along with their 57 preferred stocks, fell into bankruptcy. While these 70 preferred stocks shared a variety of characteristics, it was the "cumulative" dividend characteristic that saved preferred stock investors more so than any other single factor.

A preferred stock that has the "cumulative" characteristic is one where the issuing company still owes you the money in the event that they skip a dividend payment to you; their obligation to pay you accumulates[3].

No Single Factor

But that's not to say that companies that issue cumulative preferred stocks never fail. The Series F traditional preferred stock from Lehman Brothers Holdings, for example, was a cumulative investment grade preferred stock trading on the NYSE at the time of Lehman's bankruptcy[4].

And while these results speak to the strength of the cumulative dividend characteristic when applied to bank-issued preferred stocks, it is not necessarily the case that the same is true of preferred stocks issued by other types of businesses.

There is no single factor that allows a preferred stock investor to avoid investment risk. What this analysis does show is that the cumulative dividend requirement can be a critically important characteristic for preferred stock investors to consider, but as part of a larger risk-lowering approach. Many preferred stock investors who did not do so throughout the Global Credit Crisis purchased preferred stocks issued by financial institutions that ultimately failed.

Using the Global Credit Crisis (June 2007 through March 2009) as a study period allows us to see the relative importance of preferred stock characteristics and their contribution to investing risk. While all characteristics are important and should be considered by preferred stock investors, the cumulative dividend characteristic separated winners and losers more definitively than any other characteristic during those very extreme conditions.

Footnotes:

[1] "High quality" preferred stocks are those that meet the ten risk-lowering selection criteria from chapter 7 of my book, Preferred Stock Investing.

[2] There are currently 31 preferred stocks trading on U.S. stock exchanges that meet all ten of the "high quality" criteria from chapter 7 of Preferred Stock Investing (originally published in October 2006). When applied throughout the crisis (June 2007 through March 2009), these ten selection criteria filtered out the 57 preferred stocks from the Big Banks that failed while letting through the 13 preferred stocks from the Big Banks that would ultimately be saved (70 out of 70 cases). See summary chart at PreferredStockInvesting.com.

[3] While the issuing company of a cumulative preferred stock is obligated to ultimately pay any skipped dividends, the period of time that they have to do so can be lengthy. However, this arrangement is still substantially more advantageous to investors than a security that offers no such obligation whatsoever (e.g. common stocks, non-cumulative preferred stocks, ETFs, mutual funds).

[4] LEH-F failed one of the other selection criteria from chapter 7 of Preferred Stock Investing so would not have been held by those using those criteria at the time of the Lehman bankruptcy.

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

Source: Identifying The Lowest Risk Preferred Stocks