Bank Of America: 5% Yield And Approximately 25% Upside Potential

| About: Bank of (BAC)
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Bank of America's Series E preferred offers investors 5% current income.

Huge upside potential is possible due to the discount to par shares trade at currently.

Rising rates will benefit BAC-E as the dividend increases with short-term rates.

Bank of America's (NYSE:BAC) shareholders who abruptly lost their dividends during the financial crisis have yet to recover them more than a few years later. While that may begin to change with impending CCAR results coming up, for now, BAC shareholders are still holding on for capital appreciation only given the common stock dividend that is essentially zero. However, for those that want exposure to BAC while bringing in some income, there are myriad issues to choose from. In this article, we'll take a look at a unique preferred issue that offers not only a nice current yield but also upside from rising rates as a opposed to downside, like most fixed income securities.

The issue in question is the Floating Rate Non-Cumulative Preferred Stock, Series E (BAC-E, may differ depending on your broker). This is a traditional preferred stock in that it has no stated maturity date and has no debt issue backing it. It also pays out regular quarterly dividends, typical for a preferred, but it does have one important difference that sets it apart from the rest of the pack.

That difference is the issue's dividend. As you can see from the title of the security, it is floating rate instead of fixed. In this case, BAC-E pays the greater of three month LIBOR plus 35 basis points or 4% annually. With three month LIBOR near zero for the past few years, it has obviously been paying a 4% dividend rate for a while now. With the issue price at $25 that means BAC-E shares pay a $1 annualized dividend in quarterly installments. Now, you'd be forgiven for wondering why I'm writing about a preferred stock that only yields 4% but the reason is simple: upside potential.

Although BAC-E only pays $1 in dividends per year right now, at the current price of $20.19, that yields 5% instead of the 4% coupon rate. That is a much more palatable yield for a fixed income security and isn't too far off from BAC's other preferred issues. The upside potential is two-fold for BAC-E; capital appreciation and higher dividends via rising rates. We'll tackle each to fully understand what BAC-E offers.

With shares trading near $20 there is the potential for shares to trade back to the $25 issue price, meaning holders would be entitled to nearly $5 per share of capital gains should that happen. So what catalysts would cause that occur? With BAC-E it is two-fold; the issue being called and rising rates. Beginning in 2011, BAC has had the right to call BAC-E at any time for the full $25 issue price. It has chosen not to do so because the coupon is so cheap. However, we will look at the other reason why I think BAC-E has upside potential now as it ties all of this together.

As rates rise, particularly short-term rates, BAC-E's dividend likely will eventually eclipse where it is now. Thus, as we return to a more normal interest rate environment and three month rates move up, there is the potential that the dividend for BAC-E moves up as well. While it is impossible to tell when that may occur, the fact is that three month LIBOR has traded materially above 400 basis points in the past decade and is likely to again at some point in the future. When that happens, I believe the price of BAC-E will rise in anticipation of that event. This is what sets BAC-E apart from fixed coupon offerings; whereas those will fall in price when rates rise, BAC-E should increase in price as the dividend moves up. This is the full potential of BAC-E; you can potentially get capital appreciation and dividend increases simultaneously whereas those two generally move inversely for most fixed income issues.

BAC-E is also eligible for the preferential dividend tax treatment of a 15% maximum for most investors. This is a great feature as those holding BAC-E in a taxable account for current income get a nice after-tax yield boost in comparison to a similar issue that isn't eligible, such as a REIT preferred.

There is some additional risk in owning BAC-E due to the non-cumulative provision shares have. BAC is able to defer or simply not pay dividends on BAC-E as it wishes, opening up the risk that these preferreds will essentially become worthless in the event BAC has another funding crisis like it did in 2008-2009. While I don't think BAC would actually default on any of its preferred/debt issues until it was literally about to go out of business, it is something to keep in mind as non-cumulative preferreds scare many investors away. With BAC, I think the risk is tiny at best that it will actually stop paying on BAC-E but I thought I'd mention it as it is a risk, however small it may be.

Overall, BAC-E offers investors an interesting opportunity to get exposure to BAC while collecting decent current income. However, it also offers the chance to participate in interest rate upside whereas most fixed income issues will fall in price as rates rise. BAC-E, trading at a huge discount to its call price, gives investors the chance to diversify out of interest rate sensitive securities into one that will benefit from rising rates rather than the other way around. While it's not for everyone, it certainly is an interesting opportunity.

Disclosure: I am long BAC. 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.