Preferred Stocks Above Liquidation Value: Should You Ever Buy Them?

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Includes: BAC, HBAN, KEY, WFC
by: The Unhooded Falcon

Summary

Many investors categorically reject the idea of paying more than liquidation value for preferred stocks.

Frequently they are making a reasonable decision to avoid this risk of a call and sudden loss of principal.

There are some exceptions where paying above liquidation value could still be considered a reasonable action.

There are many rules investors in preferred stocks try to follow and among the most commonly followed is to never buy preferreds that trade above liquidation value. But while this is a wise move in many cases, especially among more risk-averse investors, there are some underappreciated exceptions where it can be reasonable to pay a premium to liquidation value.

Paying a premium

It's understandable why many investors would be against paying more than liquidation value for preferred stocks given that preferreds can be typically (but not always) called at liquidation value at a future date. This means that when the preferred is called an investor would lose the difference between the purchase price and the liquidation value. This loss would lower the yield to call effectively lowering an investor's total return, potentially into negative territory.

Other preferreds have already passed their call dates making them (usually) callable at liquidation value at any time. Investors paying a premium for these preferreds need to recognize that the company can call them for their liquidation value at any time potentially leaving the investor with a loss before they have received their first dividend payment.

Looking to avoid this loss of the premium, many investors instinctively move on when seeing that a preferred trades above liquidation value. However, there are some situations where investors should give these preferreds a second look.

Effectively non-callable preferreds

While many preferreds do have liquidation values and call dates not all can be called at liquidation value even on the call date. Convertible preferred stocks sometimes have this characteristic and it can be found in certain preferreds from Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC), KeyCorp (NYSE:KEY), and Huntington Bancshares (NASDAQ:HBAN).

In these cases of Bank of America Series L (BAC-L), Wells Fargo Series L (WFC-L), KeyCorp Series G (KEY-G), and Huntington Bancshares Series A (HBANP) the preferreds cannot be called at liquidation value but can only be converted into common stock. For this conversion to be made by the company the common stock trading price needs to exceed the conversion price (based on the liquidation value) by 30% for 20 of 30 consecutive trading days. The end result is that these preferreds can only be called by giving the holder 130% or more of the liquidation value in preferred stock.

The following table provides more information on these four preferreds.

Preferred Issue Current common stock price Common stock price for mandatory preferred conversion Necessary gain to convert Liquidation value Current preferred stock price Upside/ downside to conversion
Bank of America Series L $13.40 $65.00 385.1% $1,000 $1,196.99 +8.6%
Wells Fargo Series L $46.60 $203.72 337.2% $1,000 $1,261.01 +3.1%
KeyCorp Series G $11.62 $18.33 57.7% $100 $132.80 -2.1%
Huntington Bancshares Series A $9.30 $15.54 67.1% $1,000 $1,385.00 -6.1%

As shown in the table none of these preferreds would see returns anywhere close to that of the common stock should the conversion be triggered by a rise in the common share price. In fact, the preferreds from KeyCorp and Huntington could actually lose if the common stock soared as it would allow the company to convert the preferred to a lesser value of common stock than the preferred currently trades at in the market. At the same time, these preferreds seem unlikely to hit the price necessary for a mandatory conversion any time soon with the Bank of America and Wells Fargo ones even less likely.

But the most important factor in the conversion part of these preferreds is not upside from the common shares but the prevention of calls at liquidation value and the delay of any conversion barring a substantial common share price movement.

Seeing as these preferreds trade more like perpetual securities with no meaningful call or maturity date they are worth considering despite trading well above liquidation value. Those looking to hedge the premium losses on the KeyCorp and Huntington preferreds could do so by purchasing a small amount of common stock that would see substantial gains in the event that a mandatory conversion on the preferred is made.

Suspended cumulative dividends

When cumulative preferred stocks suspend their dividends the missed dividends accrue and would need to be paid out once the preferred dividend is reinstated. While suspending a preferred dividend can free up some cash in the near-term, it limits a company's ability to get additional capital on favorable terms and prevents the payment of dividends to common shareholders.

In cases where dividends have accrued and a company is looking likely to resume payment, the trading price can easily exceed the liquidation price since the expectation is that the accrued dividends will be paid and the regular dividend reinstated. But even if the company wanted to call the suspended divided preferreds it would have to pay the accrued dividends in addition to the liquidation value effectively raising the liquidation value until the accrued dividends are paid.

For each preferred stock investors will need to make the decision of whether they expect preferred dividends to resume. If this is the case with a cumulative preferred stock it can make sense to pay above liquidation value on the basis of getting the preferred and capturing the dividend.

Far away call dates

While paying a premium to liquidation could mean a loss of invested capital if the preferred is called in the near-term, it could still provide a positive total return if the call date is far away.

Since, all else being equal, preferreds with higher dividends typically trade with a larger premium, buying a preferred with a higher premium could provide more dividends until it's called. Depending on the preferreds being compared, some situations can arise where a preferred trading at a premium to liquidation actually provides a higher yield to call than one trading at or below liquidation.

Additionally, not all preferreds that trade above liquidation get called since calling outstanding preferred stock and issuing new preferred stock has its own costs for the company. Because of this, a preferred trading at only a slight premium to liquidation could be left outstanding well beyond its call date allowing an investor to collect a higher yield in the meantime. Looking at comments from management and assessing the company's financial situation could provide some clues as to whether a call is likely, however, calls often come unexpectedly so investors should make sure to plan for the worst.

In the event of bankruptcy...

It should be noted that liquidation value is usually the amount that preferred shareholders have a claim to in the event of bankruptcy and that premiums to liquidation value do not factor into the recovery amount. Thus paying a premium means investors are paying a higher amount than they have a claim to in equity.

However, preferred shareholders typically fare poorly in bankruptcy and are frequently wiped out along with the common shareholders. Given the sizeable losses preferred shareholders would likely face in the event of bankruptcy the premium for the preferred is relatively small by comparison. So while this is something to be aware of, I do not believe it should be a major factor for investors buying preferred shares of lower-risk companies.

Takeaway

Despite the reluctance of some investors to buy preferreds trading above liquidation value, there are some situations where making this move can make sense. Since the terms of some preferreds can be complicated it's well worthwhile to look at both the company's financial situation as well as the details from the prospectus of the preferred stock to see whether paying a premium is a smart move or a yield trap.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author does not guarantee the performance of any investments and potential investors should always do their own due diligence before making any investment decisions. Although the author believes that the information presented here is correct to the best of his knowledge, no warranties are made and potential investors should always conduct their own independent research before making any investment decisions. Investing carries risk of loss and is not suitable for all individuals.

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