New Preferred Stock IPOs, November 2016

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Includes: COF, HT, NS, RILY
by: Doug K. Le Du

Summary

Preferred stock buyers are being treated to a long-awaited return to more normal prices. Just like 2015, share prices are down and income is up for today’s preferred stock investors.

There are currently 81 high quality preferred stocks (investment grade, cumulative dividends) selling for an average price of $23.73 per share, providing an average yield-to-call of 8.78 percent.

There were four new preferred stocks introduced during November 2016 offering an average current yield of 7.2 percent.

Last month's update gave preferred stock buyers a heads-up, saying that "…it is time for preferred stock buyers to start paying attention." On cue, November delivered the best market for preferred stock buyers that we have seen since mid-February. If you haven't checked prices lately, now's the time to do so.

Since last February, high quality sub-$25 candidates have been hard to come by. By high quality I mean preferreds offering the characteristics that most risk-averse preferred stock investors favor such as investment grade ratings, cumulative dividends and call-protection.

There are currently 81 of these high quality preferred stocks selling for an average price of $23.73 (November 30), offering an average yield-to-call of 8.78 percent.

November's new issues

With upward pressure on rates, we typically see fewer new preferred stock issues and November was no exception. Only four new preferred stocks were introduced for the consideration of preferred stock investors during November. But with 81 high quality issues currently available for less than their $25 par value to pick from, the number of new preferred stock IPOs becomes much less relevant to today's buyers.

Issuers have brought 86 new preferred stocks to market this year. There are now 882 of these securities trading on U.S. stock exchanges.

Note that I am using IPO date here, rather than the date on which retail trading started. The IPO date is the date that the security's underwriters purchased the new shares from the issuing company. Anxious to sell the new shares, underwriters will generally sell to broker/dealers using a temporary trading symbol on the wholesale Over-The-Counter exchange (who, in turn, sell them to us at retail within a few days of the IPO date).

Buying New Shares for Wholesale

Note that the most recently introduced issue - CFFFP from Capital One (NYSE:COF) - is still trading on the Over-The-Counter exchange (as of November 30). This is a temporary OTC trading symbol until this security moves to the NYSE, at which time, it will receive its permanent symbol.

But there is no need to wait; during a period of relatively high prices, individual investors, armed with a web browser and an online trading account, can often purchase newly introduced preferred stock shares at wholesale prices just like the big guys (see "Preferred Stock Buyers Change Tactics For Double-Digit Returns" for an explanation of how the OTC can be used to purchase shares for discounted prices during a period of high preferred stock prices).

Those who have been following this strategy of using the wholesale OTC exchange to buy newly introduced shares for less than $25 are more able to avoid a capital loss as prices start to drop (if they choose to sell).

Your broker will automatically update the trading symbols of any shares you purchase on the OTC. CFFFP will become COF-H.

Diversification

While relatively few in number, November's four new issues are from surprisingly diversified issuers - one property REIT, two financial institutions and one energy limited partnership.

Hotel REITs have been very active throughout 2016 with new preferred stock offerings coming from this sector just about every month. Hersha Hospitality Trust (NYSE:HT) issued its Series E traditional preferred stock during November, raising about $100 million at 6.5 percent. HT-E is Hersha's second preferred stock offering within the last six months, its Series D issue being introduced last May, also at 6.5 percent.

B. Riley Financial (NASDAQ:RILY) is a small financial services firm founded in 1973 as Great American Group. The company provides financial and trading services to businesses and high net worth clients. RILY executed the acquisition of United Online, Inc. in July of this year. RILYL is actually an Exchange-Traded Debt Security (indicated by green font in the above table).

ETDS are very similar to preferred stocks and are frequently labeled as such on brokerage statements, but are actually bonds recorded on the company's books as debt rather than equity. BILYL is the company's only offering, raising about $25 million and offering a 7.5 percent coupon that matures in 2021.

NuStar Energy (NYSE:NS) is a petroleum pipeline, storage and fuel marketing limited partnership founded in 1999. Those purchasing shares of the company's new NS-A preferred stock should expect to receive a K-1, rather than a 1099, at tax-time. NS-A offers buyers an 8.5 percent coupon until the security's December 15, 2021 call date. At the time, the dividend rate offered by this security becomes a floating rate pegged to the 3-month LIBOR rate (currently at 0.92 percent), plus 6.766 percent.

Buyers should be cautious of this structure since, while sounding especially attractive during a period of increasing rates, issuers will frequently call the shares on the call date if not doing so means increasing their dividend expense to shareholders (see "Variable-Rate Preferred Stocks Underperform Their Fixed-Rate Cousins").

Capital One has issued two new traditional preferred stocks within the last four months, both of which are nearly identical in their terms and size. Interestingly, this is the same four-month period over which preferred stock prices have declined in anticipation of a Q4 rate increase by the Fed. You can see the magic of decreasing prices by comparing the coupon rates offered by these two COF preferreds: COF-G was issued on July 26 with a coupon of 5.2 percent while the company had to pony up 6.0 percent on the new CFFFP (soon to be COF-H) just four months later.

(Sources: Prospectuses HT-E, RILYL, NS-A, CFFFP/COF-H. CDx3 Notification Service database, PreferredStockInvesting.com)

Tax Treatment

Dividends paid by REIT preferred stocks are a pre-tax distribution of the company's earnings to shareholders. As a pre-tax distribution, it is the shareholder who pays the full tax so dividends received from REITS do not qualify for any type of favorable tax treatment (although portions of REIT dividends are frequently re-classified at tax-time as capital gains, hence lowering your tax burden in that manner).

On the other hand, dividends received from Capital One's CFFFP are a distribution of the bank's after-tax earnings and are therefore designated as being Qualified Dividend Income ("QDI" in the Status column of the above table), although there are exceptions and conditions (see prospectus).

In Context: The U.S. Preferred Stock Marketplace

So how do the new November issues stack up within the context of today's preferred stock marketplace?

Market prices for preferred stocks are finally returning to more normal levels. By "normal" I mean returning to a price that is closer to par and determined by market participants rather than being artificially propped up by the Fed's monetary policies.

Just like 2015 at this time, preferred stock market prices have been falling since early-August in anticipation of a Q4 rate increase by the Federal Reserve. Remember that interest rates and the market prices of fixed-return securities (bonds, preferreds) move in opposite directions (rates up, prices down). As prices fall, and yields rise, preferred stock buyers realize higher returns for lower prices.

As the following chart illustrates, we saw the same price drop in late-2015 in anticipation of a December 2015 rate increase, which the Fed did at their December 2015 meeting. Prices dropped before and after the December 2015 rate increase, but only for about six weeks as it became apparent that the Fed was unlikely to raise rates again in early-2016, as had been expected. After reaching a low of $23.35 per share on February 11, 2016, prices started going back up and peaked at $26.40 in early-August again.

The data being charted here is limited to call-protected issues in order to limit the price distorting effect of an anticipated redemption.

At their November 1-2 meeting, the Fed deferred raising rates as to not influence the U.S. election, but odds makers and Fed followers now put the likelihood of a December rate increase at a near certainty. The price drop that we have been seeing since early-August is typical when the market expects a rate increase.

The average market price of U.S.-traded preferred stocks is now at $24.68 per share, up an annualized 0.4 percent for the year. As prices trend back toward normal, there will be many more high quality preferreds available, for less than their $25 par value, for preferred stock buyers to pick from.

Will it last?

What is less clear is how long this return toward more normal pricing will last. Foreign investors have been moving record amounts of cash into U.S. income securities for many months (see "Here's why 10-year Treasury may still drop below 1%"), putting upward pressure on prices here, because of the zero-to-negative domestic rates set by their central banks. If anything, the U.S. income security market has become even more attractive to such foreign investors.

Further, remember that the federal funds rate is the rate that member banks are charged when they need to borrow some cash overnight to pump up their reserves in order to meet regulatory requirements. U.S. banks have over $2 trillion in excess reserve cash - that's above and beyond the elevated 2010 Dodd-Frank requirements (see "Fed Worries About Deflation But Pays Banks Billions Not To Lend QE Proceeds"). The demand by member banks for overnight loans from the Fed has been, and remains, minimal, so fiddling with the federal funds rate does not have anything like the lasting impact it used to.

With increasing foreign demand and a banking system awash with cash, it would not be surprising if the current fall in the market prices for U.S. income securities is short-lived (as it was after the December 2015 rate increase).

But many things affect the market prices of these securities such as the proximity to their call or maturity date, proximity to their next ex-dividend date, industry and/or overall health of the issuer (think upstream oil producers), perceived direction of interest rates, pending government regulatory or policy changes, cumulative versus non-cumulative dividends and tax treatment of dividend payments.

So what we really need to look at is current yield, which calculates the average annual dividend yield per dollar invested (without considering re-invested dividend return or any future capital gain or loss). Current yield is a "bang-for-your-buck" measure of value that normalizes differences in coupon rate and price to give us a single, comparable metric.

U.S.-traded preferred stocks are currently returning an average current yield of 6.8 percent, up from 6.4 percent in early-August.

For comparison, I have set the Yield column in the first table above to show the current yield of the four new November preferreds on November 30. It is into this marketplace that November's new issues were introduced.

Income versus Value Investing, Year-To-Date

With an average current yield of 6.8 percent, plus the 0.4 percent annualized value gain, those investing in U.S.-traded preferred stocks since the beginning of 2016 are currently on pace for a total annualized return of 7.2 percent (6.8 percent of which is realized in dividend cash).

Benefiting from the November election results, those investing in common stocks, as measured by the S&P 500, saw an uptick after declining returns throughout the summer months. Starting at 2013 at the beginning of the year, this common stock value index closed on November 30 at 2199, an unrealized annualized value gain of about 10.1 percent plus about two percent in average annualized dividend yield - a year-to-date annualized gain of about 12.1 percent for common stock investors.

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

Additional 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 used for this article.

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