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In an environment where a high-yield savings account offers savers a rate of 1% and a 5-year CD yields 1.75%, investors (particularly retirees) are forced to look elsewhere for decent returns while trying to minimize risk. A number of healthy financial institutions offer preferred stocks with mid-single digit returns and have an acceptable amount of risk associated with them. One advantage of preferred stocks over common stocks is the defined cash flow schedule and minimal impact of intra-day price movements (provided, of course, that you are purchasing the preferred stock with the assumption that it will be redeemed at par at some point in the future). This being said, there are risks associated with all stock purchases, whether they are preferred or common.

The below is a list of metrics that I have followed when investing in bank-preferred stocks in order to minimize risk, while searching for mid-single digit returns as a viable alternative to parking cash in a savings account or CD:

1. Current Yield

The current yield is a function of the current price, par price (issue price), and coupon rate:

Current Yield

=

Coupon Rate

x

Issue Price

Current Price

An example of how the current yield is different than the coupon rate is the Citigroup (C) Series AA (Google Ticker: C-P; Yahoo Ticker: C-PP; CNBC Ticker: C'P). The Series AA has a coupon rate of 8.125%, an issue price of $25, and is currently trading at $29.25. This results in a current yield of 6.944%. While still a solid return, this is far from the 8.125% that you may have thought you were going to receive at first glance.

My general guideline has been to only invest in preferred stocks that have a current yield greater than 5%.

2. Yield To Call

One of the most important dates to look at when evaluating a Bank Preferred is the call date - the date that the issuing entity has the right to redeem the position at the call price. While it is not guaranteed that an issuing entity will call a preferred security on the call date, the safe move is to make sure that if it is called, you are not going to lose money on the trade.

An example of the importance of yield to call can be seen by comparing two U.S. Bancorp (USB) preferreds - the Series D (Google Ticker: USB-L; Yahoo Ticker: USB-PL; CNBC Ticker: USB'L) and the Series F (Google Ticker: USB-M; Yahoo Ticker: USB-PM; CNBC Ticker: USB'M).

US Bancorp

Name:

Series D

Series F

Ticker:

USB-L

USB-M

Par Price:

25.00

25.00

Current Price:

26.60

29.50

Coupon Rate:

7.875%

6.500%

Call Date:

4/15/2013

1/15/2022

Yield to Call:

-2.685%

4.168%

At first pass an investor may be tempted by the higher coupon on the Series D, but given where it is currently trading and how soon the call date is, the coupon payments will not be enough to get your basis down to par if it is called.

My general guideline has been to only invest in preferred stocks that have a Yield To Call greater than 3%.

3. Premium Risk

The premium you pay on a preferred security is the amount above par you are paying. This goes slightly hand-in-hand with the Yield To Call mentioned above (if you pay too much of a premium and the call date is soon, you may have a negative Yield To Call). The difference with just looking at Premium Risk, though, is that you are accounting for uncertainty in the marketplace. Certain market events can trigger an early redemption by the issuer (e.g. the bank can call the security prior to the call date) - recently this has occurred with the treatment of Trust Preferreds (TRUPS) against a bank's Tier 1 Capital. The change in treatment (and even the discussion alone) triggered the Regulatory Capital Treatment Event clause in TRUPS. Given that the discussion is still ongoing, I would recommend minimizing Premium Risk as much as possible.

As an example of comparing Premium Risk, take the two First Republic Bank (FRC) preferreds that are currently trading on the NYSE - the Series A (Google Ticker: FRC-A; Yahoo Ticker: FRC-PA; CNBC Ticker: FRC'A) and the Series B (Google Ticker: FRC-B; Yahoo Ticker: FRC-PB; CNBC Ticker: FRC'B).

First Republic Bank

Name:

Series A

Series B

Ticker:

FRC-A

FRC-B

Par Price:

25.00

25.00

Current Price:

27.50

26.55

Premium:

2.50

1.55

Coupon Rate:

6.700%

6.200%

Annual Payment:

1.68

1.55

Quarters to Recapture Premium:

5.97

4.00

Current Yield:

6.091%

5.838%

With the Series A having both a higher coupon and current yield, an investor may be tempted to purchase the Series A instead of the Series B. However, the Series B only takes 1 year to recapture the premium whereas the Series A will take 1.5 years. With this in mind, I would argue that the Series B is the right investment and that the extra 25bps (0.25%) in yield isn't worth the additional 6 months of risk.

My general guideline has been to only invest in preferred stocks that recapture premium within 1 year.

4. 15% Tax Rate

While there may be a change in policy of the treatment of dividend income come 2013, it is important in the meantime to know if a preferred that you are purchasing is eligible for the 15% tax treatment. This is important because $100 received under the 15% tax treatment is worth more than $100 that is being taxed at 35% ($85 vs. $65 to be precise).

A good side-by-side comparison is the Bank of America (BAC) Series I (Google Ticker: BAC-I; Yahoo Ticker: BAC-PI; CNBC Ticker: BAC'I) and the Wachovia (now Wells Fargo) (WFC) Series A (Google Ticker: WNA-; Yahoo Ticker: WNA-P; CNBC Ticker: WNA').

Name:

Bank of America
Series I

Wachovia Series A
now Wells Fargo

Ticker:

BAC-I

WNA-

Par Price:

25.00

25.00

Current Price:

26.30

27.20

Coupon Rate:

6.625%

7.250%

Annual Payment:

1.65625

1.8125

Current Yield:

6.298%

6.664%

Tax Rate:

15%

35%

Post-Tax Income:

1.41

1.18

In the above example, you can see that while the Wachovia Series A may have a higher coupon, the Bank of America Series I will actually return you more income after taxes. It is important to note that should the dividend tax treatment expire, the tax rates will be the same on both securities and the Wachovia Series A will return a higher post-tax income.

My general guideline has been to invest in preferreds that qualify for the 15% tax treatment.

5. Ratings

I place less importance on the ratings of the issuing institution and preferred security than most people, but it is still something to consider when evaluating a preferred position. Moody's, S&P, and Fitch are all rating agencies that generally rate both preferred securities and other corporate debt. The breakdown of the ratings is:

Moody's

S&P

Fitch

Investment Grade

Aaa

AAA

AAA

Aa1

AA+

AA+

Aa2

AA

AA

Aa3

AA-

AA-

A1

A+

A+

A2

A

A

A3

A-

A-

Baa1

BBB+

BBB+

Baa2

BBB

BBB

Baa3

BBB-

BBB-

Non-Investment Grade

Ba1

BB+

BB+

Ba2

BB

BB

Ba3

BB-

BB-

B1

B+

B+

B2

B

B

B3

B-

B-

The lower the rating, the riskier the investment is.

My general guideline has been to invest in banks whose long-term rating is investment grade, although the individual preferred security may not fall into this category. This is something that each investor should consider before purchasing preferred securities.

6. Diversification

We've all heard it at least 1,000 times - don't put all of your eggs in one basket. The importance of diversification cannot be stressed enough, especially if you are of retirement age. If you are considering purchasing bank preferreds, it is imperative that you diversify by issuer (you do not want a one-off situation to hurt your entire portfolio, such as a rogue trader or a computer glitch). Similarly, investors should also diversify by strategy. If you like the idea of investing in bank preferreds, do not move all of your cash into the idea. Figure out what you are comfortable with and trade within that limit.

7. Liquidity

Many bank preferreds trade on the NYSE, which generally should provide investors with sufficient liquidity. That being said, it is still important to look up the average volume of the preferred shares and decide if this is enough liquidity for you.

Mid-Single-Digit Returns

The above list are key metrics that I look at when evaluating bank preferred stocks. The goal is to minimize risk while generating mid-single digit returns. There are a number of preferred securities out there that fit the above criteria and can generate returns in excess of what an investor would get by leaving cash in a savings account or CD.

Disclosure: I have no position in any of the preferreds mentioned in the article. I am long C. 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.

Source: Bank Preferreds - A Viable Alternative For Cash