United Technologies Convertible Preferred: 7% Yield But Gains Are Capped.

| About: United Technologies (UTX)

Over the past few months, United Technologies (UTX) has generally lagged the overall market, but over the past 5 or 10 years has been a significant outperformer as you can see on these charts:

Plus the stock pays a respectable dividend yielding around 2.8%.

Now the company has a new series of preferred shares outstanding. They're called the United Technologies Corp., 7.50% Corporate Units (symbol UTX-PA on Yahoo! Finance), and they may appeal to investors looking for more income.

But unlike a lot of convertible preferreds, these are mandatory convertible preferreds. That means they're a bit of an odd duck.

They do provide a high yield (about 7% right now), and will be converted into common stock in 2015. But these shares embed sort of short-call option position into the payout structure that can limit your gains - especially if UTX soars past its all-time high of around $90 per share.

High yield, but caps potential gains

Here's how these shares work, per Quantum Online, a great source of information on income stocks.

Each share pays $3.75 per year (paid quarterly) until August 2015 when shares are converted into common stock. The number of shares you receive is variable, depending upon where the common stock trades in 2015:

  • If UTX is less than or equal to $74.35, you get 0.6725 shares of common stock per preferred share
  • If UTX is greater than or equal to $98.51, you get 0.5075 shares of common stock per preferred share
  • If UTX is between $74.35 and $98.51, you get $50 worth of common stock per preferred share

It gets confusing, so let's take a look at this in graph form. This compares the payout structure in 2015 for two hypothetical purchases on July 3 - 200 shares of UTX common stock at $75.75 per share vs. 286 shares of the convertible stock at $56.96 per share. Each transaction would have cost about $15,000.

With the preferred shares, your gains are limited unless the common stock trades higher than $98.51. However, by 2015 you will have collected about $3500 in distributions on the preferred shares. (And in fairness, probably about $1400 in dividends on the common stock).

So all told, including dividends, the payout structure would really look like this:

All other things being equal, if you think that UTX will be trading higher than $82 or so, you'd do better buying the common stock. One thing to keep in mind, however, is that per Quantum Online, distributions on the preferred shares do not qualify for the 15% dividend rate while dividends on the common stock presumably do (but check with your tax advisor for details).

Common and preferred: A hybrid approach?

The way these preferred shares are structured makes it tempting to buy them if you believe UTX will tend to stay in double-digit land - especially with a 7% yield. But if UTX soars past $100, the common stock looks more attractive on a total return basis.

What about combining the two?

Perhaps you might put half your investment into preferred shares and the other half into common shares.

Based on prices on July 3, your overall yield would be around 4.95%. If UTX does make new highs, you could sell higher-strike call options against your common stock. You'd earn some extra income and if some of your UTX shares are called away, you'd still have your preferred shares for eventual conversion.

These mandatory convertible preferreds are fairly complex because they essentially embed a short call spread position into the payout structure, so read the prospectus to make sure you understand how they work. You might also want to track the performance of some of the other mandatory convertible preferreds that currently trade.

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

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