An increase in interest rates has been two weeks away for the last two years. Tapering out of their Quantitative Easing program did not produce the rate increase that the Fed had hoped for and so far the Fed's use of their overnight reverse repurchase agreements has not pushed up the federal funds rate either (see "Preferred Stock Buyers - Be Sure You're Watching The Right Indicator", September 22, 2014).
Dramatically falling oil prices throughout the fourth quarter of last year have reduced inflation pressure, delaying, once again, any hope of a rate increase. On December 18, 2014 Fed Chair Janet Yellen stated that the Fed "…could continue to be patient," a comment that produced a 400+ point uptick of the DJIA.
For preferred stock investors, downward pressure on rates means upward pressure on prices. The average price of the highest quality preferred stocks (cumulative dividends, investment grade ratings, etc.) closed 2014 at $25.98, about a dollar above these securities' $25 par value, producing an average current yield of 6.61 percent on December 31.
(Source: preferred stock data, PreferredStockInvesting.com)
2014 results - how you would have done using the OTC
As I have written to you many times over the years (see "Preferred Stock Buyers: Time To Change Tactics For Sub-$25 Purchases", July 14, 2014), during periods of upward pressure on prices, such as what we have seen for some time and are likely to continue seeing for several more months, savvy preferred stock investors, armed with a web browser and an online trading account, can frequently purchase shares at wholesale (sub-$25) prices when new preferred stock issues are being distributed to the market.
83 percent of the non-convertible preferred stocks issued during 2014 (54 of 65) were introduced to the market by their underwriters using a temporary trading symbol on the wholesale Over-The-Counter (OTC) stock exchange.
So how did buying shares during OTC distribution work out for preferred stock buyers during 2014?
The black diamonds on this chart show the average OTC opening price for preferred stocks introduced during the indicated month. The gray diamonds indicate today's (December 31, 2014) average market price for the same securities. Notice that in all cases, the black diamond (average OTC open price) is lower than the gray diamond (average price today).
To isolate the price behavior of OTC purchases from geopolitical events, 13 preferred stocks issued by domestic upstream oil producers and Greek shipping companies have been excluded from this analysis (see note at the bottom of the graphic).
The table below the chart shows the data. Note that the average effective annual return (yellow arrow) for these 41 preferred stocks during 2014, when purchased at wholesale on the OTC exchange, was 13.79 percent.
(Source: OTC open prices, TDAmeritrade.com)
Principal protection case study: JP Morgan's JPM-B preferred stock
The reason that underwriters use the OTC to distribute new preferred stocks shares to the market is speed. They are out a bunch of cash and they want to get it back as quickly as possible; they are not going to wait days or weeks for the NYSE or other retail exchange to get around to assigning the permanent trading symbol.
Depending on a variety of factors, underwriters typically pay about $24.25 per share to the issuing company in exchange for the newly minted preferred stock shares. For example, the underwriters of JP Morgan's (NYSE: JPM) JPM-B, issued on January 27, 2014 offering a 6.7 percent dividend, paid $24.21 to JPM.
The underwriters, now out the cash ($823 million in the case of JPM-B), are very anxious to sell the new shares to dealer/brokers and use the OTC exchange for these trades. A temporary OTC trading symbol is set up for these wholesale orders (JMXXL in the case of JPM-B).
Dealer/brokers typically pay $24.50 to $24.75 per share and are just as anxious to sell the new shares quickly. Turnaround speed is what is important here. In the case of JMXXL, the OTC opening price was $24.75. Savvy preferred stock investors with an online trading account were able to purchase JMXXL shares for less than $25 per share until JMXXL was transferred to the NYSE retail exchange on February 7, 2014 as JPM-B (your broker makes the symbol change automatically in your brokerage account).
These are shares of the very same preferred stock that today's retail buyers are paying $26.42 per share for (December 31, 2014); that's a gain of $1.67 per share over the OTC opening wholesale price.
In the event of a future rate increase, the price of JPM-B will have to fall more than $1.67 before preferred stock investors who purchased their shares using the wholesale OTC exchange would start to lose principal. That gives those inclined to sell time to act in the event of a future price drop.
During a period of high prices, most of your preferred stock positions will be showing significant, but unrealized, capital gains. Preferred stock investors who are interested in cashing in those capital gains can sell their shares for retail, then use the proceeds to buy shares of a new, similar preferred stock while it is being introduced on the wholesale OTC exchange.
Sell for retail above par; buy back in for wholesale below par.
The OTC exchange provided a very powerful tool for savvy preferred stock investors throughout 2014 and is likely to continue doing so for many months to come.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.