Variable-Rate Preferred Stocks Underperform Their Fixed-Rate Cousins

Nov. 12, 2013 7:13 AM ETMET15 Comments

Over the last ten years, variable-rate preferred stocks have offered consistently lower returns, delivering about half the dividend income as fixed-rate preferreds, at higher risk to investors.

Variable-rate preferred stocks offer the promise of keeping up with interest rates in the event that rates increase. If rates rise, the return paid by variable-rate shares presumably increases as well. Shareholders not only receive additional dividend income but also avoid the price erosion that can occur as higher paying alternatives become available.

There are several variable-rate preferreds trading today that have been around for a decade now, surviving through booms, busts, rising rates, falling rates - you name it. So how has the promise of variable-rate preferred stocks compared to actual performance?

How Rates are Set

There are four primary methods used by variable-rate preferred stocks to set the dividend rate paid to shareholders: (1) LIBOR-based, (2) CMT-based, which use the constant maturity bond rate of certain U.S. treasuries, (3) inflation-based, using the Consumer Price Index and (4) fixed-to-floating, which offer a fixed dividend rate until the security's call date, then a variable rate thereafter.

The LIBOR-based method is the most common (although fixed-to-floating has regained some of its prior popularity recently; more on this in a moment). Variable-rate preferred stocks that use the LIBOR-based method will usually reset the dividend rate each quarter by adding some amount to the three-month LIBOR published at the time (unless the LIBOR is exceptionally low, then a minimum rate kicks in).

Example: MET-A

MET-A was introduced by MetLife, Inc. (MET) in June 2005. MET-A is the most generous LIBOR-based variable-rate preferred stock that is still trading today.

As described in MET-A's prospectus, the dividend rate paid by MET-A is reset each quarter by adding one percent to the 3-month LIBOR rate published at that time, but

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Whether you are the kind of investor who sticks with preferred stocks with a CDx3 Compliance Score rated 10 out of 10, or whether your portfolio has room for 9-score-and-lower securities, stay tuned for future articles recapping new IPOs and interesting preferred stock activity that we notice here at the CDx3 Notification Service.

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