Variable Rate Preferred Stock Shares Unlikely To Beat Fixed Rate Returns

by: Doug K. Le Du

Variable rate preferred stocks sound like a good idea, especially during a period of low rates. The idea is that preferred stock investors will be able to ride the wave up when rates start to rise in the future.

In addition to increasing income, this mechanism also offers a degree of principal protection since such securities would theoretically maintain their value as rates go higher.

It is for these reasons that the top four movers each traded more than 250,000 shares last Friday [1] - GS-A and GS-D from Goldman Sachs (NYSE:GS), USB-H from U.S. Bancorp (NYSE:USB) and MS-A from Morgan Stanley (NYSE:MS). And almost two-thirds of the variable rate preferreds now trading on U.S. stock exchanges traded more than 10,000 shares that day.

But the higher dividend payout that many are looking forward to from today's variable rate preferred stocks is unlikely to ever materialize.

Current Crop

There are currently 34 variable rate preferred stocks trading on U.S. stock exchanges [2]. These 34 securities were issued between May 1994 (HBA-D from HSBC (HBC)) and March 2007 (BML-L issued originally by Merrill Lynch now by Bank of America (NYSE:BAC)).

Most of these 34 issues are from banks and insurance companies (domestic and foreign), although Southern California Edison's (NYSE:EIX) SCEDN, issued in April 2005, is still trading.

18 of the 34 enjoy investment grade ratings from Moody's while 18 are rated as investment grade by S&P.

Determining the Dividend Rate

While it would be great for investors if variable rate preferred stocks used a standard method for determining the dividend payout, that is unfortunately not the case.

Variable rate preferreds generally offer a dividend rate that is pegged to an index such as the 1-month or 3-month LIBOR rate (currently at 0.30%) or a specific U.S. Treasury Bill rate. They also frequently (but not always) offer a minimum dividend rate (usually around 4%) and a maximum rate that is either a stated amount (such as 10%) or derived by a formula. The formula can also change for different periods of time.

If you have one of those jobs where you have to fly a lot, you've learned not to ever ask how your airfare is calculated. Doing so results in a dull, blank stare from the counter attendant since every passenger sitting on your plane has paid a different amount for their ticket. Same goes for the rate calculation of many variable rate preferreds.

Here are a couple of typical examples.

ZB-A from Zions Bancorporation (NASDAQ:ZION) puts it pretty plainly right on page 1 of its prospectus (see ZB-A prospectus): the dividend rate will be "...equal to the greater of (1) 0.520% above three-month LIBOR on the related LIBOR determination date or (2) 4.000%."

Compare that to the rate calculation specified in the prospectus of HBA-D from HSBC: "The dividend rate on the Preferred Stock for the dividend period ending on June 30, 1994 will be 6.05% per annum, which is equivalent to $0.16 per Depositary Share. Thereafter, the dividend rate on the Preferred Stock will be equal to 81% of the Effective Rate (as defined below) in effect from time to time, but in no event less than 4 1/2% or more than 10 1/2% per annum. The Effective Rate for each quarterly dividend period will be the highest of the Treasury Bill Rate, Ten Year Constant Maturity Rate and the Thirty Year Constant Maturity Rate determined in advance of such dividend period." (see HBA-D prospectus)

Depending on how thinly the issuing company is trying to limit their exposure to increasing rates, prospectus language that describes the rate calculation varies from the fairly straightforward to the exceedingly mind-bending.

No Glory

But figuring out the currently applicable dividend rate of a variable rate preferred stock is not the real problem facing today's buyers (of which there does not seem to be a shortage).

Once rates start heading up again (2015?), those holding shares of variable rate preferred stocks are going to be in the chips. That, of course, is what today's buyers are counting on. These buyers are passing up two years (if the Federal Reserve has their way) of 6+% dividend income currently available from today's fixed-rate preferreds in order to position themselves for the glory of a future run up in rates.

But it is unlikely that those purchasing shares of today's variable rate preferred stocks are ever going to see such glory.

The most recently issued variable rate preferred stock was Bank of America's BML-L introduced on March 16, 2007. These securities have a typical five-year call period after IPO. What it appears that today's buyers of variable rate preferred are missing is that all 34 of the variable rate preferred stocks trading on today's U.S. stock exchanges have already exceeded their respective call dates.

The issuing companies of today's variable rate preferreds are currently getting away with paying the minimum allowed by the prospectus. While many of these securities have a minimum rate of about 4% (such as the ZB-A and HBA-D examples provided earlier), several have no such minimum whatsoever.

Since all of these issues are now callable, what do you think the issuing companies of these securities are likely to do when rates start heading up some day?

While it is not possible to know the answer to that question in advance, it seems unlikely that if future rates were to increase to a level that would make today's miserly returns worth the wait that these companies would just pay up. It is much more likely that today's variable rate preferred stocks will be redeemed at the first sign of increased dividend expense to these companies, leaving today's buyers with little to show for their patience.

Most risk-averse preferred stock investors avoid variable rate preferred stocks since there is no way to know the likely return on your investment. In addition to an unknown return, today's variable rate preferred stocks are unlikely to deliver their primary benefit (an increasing dividend rate) that current buyers are banking on.


[1] Source for all preferred stock data in this article: CDx3 Notification Service database, Preferred Stock Investing, Fourth Edition ( Disclosure: The CDx3 Notification Service is my preferred stock email alert and research newsletter service and includes the database of all preferred stocks and exchange-traded debt securities traded on U.S. stock exchanges used for this article.

[2] Excludes: those with zero daily trading volume on Friday, January 18, 2013, GNE-A from Genie Energy that was issued as part of a common stock exchange offer and GLD-B which was issued pursuant to a closed-end ETF (NYSE:GDL). ABV from AMBEV (NYSE:ABV.C) and CTWSP from Connecticut Water Service were also excluded since they have no prospectus available.

Disclosure: I 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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Securities identified within this article are for illustration purposes only and are not to be taken as recommendations.