New Preferred Stock IPOs, August 2018

|
Includes: CAI, GAIN, LTS, OAK, PRU, SAR, USB
by: Doug K. Le Du

Summary

Seven new preferred stocks were introduced during August, offering an average annual dividend of 6.6 percent.

There are currently 123 high quality preferred stocks selling for an average price of $25.14 per share (investment grade, cumulative dividends).

52 of these high quality issues are now selling below their $25 par value, offering an average current yield of 5.32 percent.

U.S.-traded preferred stocks are now returning an average current yield of 6.6 percent.

Preferred stock prices have fallen an average of $0.18 per share so far this year, delivering higher returns to today’s preferred stock buyers. Continuing upward pressure on interest rates is likely to put additional downward pressure on preferred stock prices. But demand for these securities remains high, keeping the average market price at $25.50, $0.50 per share above par.

August’s new issues

August’s seven new preferred stocks are offering an average annual dividend (coupon) of 6.6 percent for the consideration of preferred stock investors.

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.

A special note regarding preferred stock trading symbols: Annoyingly, unlike common stock trading symbols, the format used by exchanges, brokers and other online quoting services for preferred stock symbols is not standardized. For example, the Series A preferred stock from Public Storage (NYSE:PSA) is “PSA-A” at TD Ameritrade, Google Finance and several others, but this same security is “PSA.PR.A” at E*Trade. For a cross-reference table of how preferred stock symbols are denoted by sixteen popular brokers and other online quoting services, see “Preferred Stock Trading Symbol Cross-Reference Table.”

There are currently 123 high quality preferred stocks selling for an average price of $25.14 (August 31), offering an average current yield of 5.50 percent. And 52 of these high quality issues are selling below their $25 par value, offering an average current yield of 5.32 percent. By high quality I mean preferreds offering the characteristics that most risk-averse preferred stock investors favor such as investment grade ratings and cumulative dividends.

There are now a total of 900 of these securities trading on U.S. stock exchanges (including convertible preferred stocks).

About the new issues

OAK-B (OAK.PB) from Oaktree Capital Group, LLC (OAK) carries an investment grade BBB S&P rating and offers 6.550 percent non-cumulative dividends. OAK is a $6.2 billion investment management firm founded in 2007 and headquartered in Los Angeles. OAK-B is the company’s second new preferred stock issued within the last 90 days. Increasing risk tolerance has pushed up the price of the things that investment management firms invest in, sidelining the cash held by the less risk tolerant. Consequently, OAK’s revenue has shrunk dramatically over the last year (-33.7 percent), while it has been a net seller of its investment assets. Preferred stock investors should also consider this statement from page S-24 of OAK-B’s prospectus: “…holders of Series B Preferred units who are U.S. taxpayers should anticipate the need to file annually with the IRS (and certain states) a request for an extension past the applicable due date of their income tax return…”

CAI-B (NYSE:CAI.PB), issued by CAI International (CAI), offers a fixed-to-floating rate structure, with an 8.5 percent coupon that is fixed until the security’s August 15, 2023 call date. At that time, the dividend rate will vary based on the 3-month LIBOR rate (currently at 2.34825 percent) plus 5.687 percent. CAI-B is the company’s second preferred stock issued this year and is unrated, but offers cumulative dividends. The proceeds from this offering will go toward paying down 2020 debt. If you find yourself in need of a couple thousand railcars, CAI will be happy to either finance your purchase or sell you some of theirs. CAI is a $470 million transportation lending and logistics company (market cap) founded in 1989 and headquartered in San Francisco.

PRS from Prudential Financial, Inc. (PRU) is the company’s first income security introduction in over five years. PRU now has three such securities trading, all of which are nearly identical Exchange-Traded Debt Securities. ETDS are bonds recorded on the company’s books as debt (rather than as equity, as in the case of preferred stock). As debt, the obligation to pay the interest on these bonds is cumulative. As bonds, ETDS are often seen as having lower risk than the same company’s preferred stock shares. ETDS are very similar to preferred stocks and are often listed on brokerage statements as such. While the prospectus for PRS does not specifically say so, it would not be surprising if Prudential uses the $500 million in PRS proceeds to redeem its PJH (PJH is also a $500 million issue and became callable on December 4, 2017). With the new PRS costing the company 5.625 percent in annual interest expense, compared to 5.750 percent for PJH, using the proceeds from PRS to redeem PJH would not provide much in the way of an expense savings for the company but would extend the maturity of this debt by almost six years (to 2058 from 2052).

USB-P from U.S. Bancorp (USB) is the company’s first preferred stock issue in five years and offers a 5.5 percent fixed-rate, non-cumulative dividend. With double investment grade ratings (A3/BBB), USB-P has been trading above its $25 par value since its introduction. Operating in 25 states, USB was a beneficiary of the credit crisis ten years ago, snapping up over-leveraged, smaller banks for bargain prices. Last month, the bank announced plans to aggressively extend its mobile banking platform. Seventy-five percent of the bank’s service transactions to check a balance or make a deposit are done via its mobile app. Extending mobile banking allows USB to capture new customers without having to build and staff new branch offices (of which it currently has over 3,000). U.S. Bancorp is a $90 billion regional bank founded in 1863.

LTSK is an unrated ETDS offered by Ladenburg Thalmann Financial Services, Inc. (LTS) at 7.250 percent. LTS has a total of four income securities currently trading, one traditional preferred stock (LTS-A (NYSEMKT:LTS.PA), 8.0 percent) and three ETDS. LTS-A became callable on May 24 of this year. While redeeming the 4.6 million shares of LTS-A would generate a significant savings to the company, Ladenburg would need a bit over $100 million in cash to call LTS-A. Interestingly, the two most recent ETDS, LTSF (7.0 percent) and the new LTSK (7.25 percent), were issued less than 90 days apart, with LTSF raising $40 million last May and the new LTSK raising $60 million. While neither prospectus for LTSF or LTSK says so, issuing the new LTSK for $60 provides the remaining cash the company needs to redeem the 8.0 percent LTS-A. Using the proceeds from LTSF and LTSK to redeem the LTS-A preferred stock delivers a $2.05 million per year dividend expense savings to the company. But this maneuver also converts about $115 million in equity (in the form of LTS-A shares) into $100 million in debt, weakening the company’s debt-to-equity ratio. LTS is a highly diversified financial services firm established in 1876 and headquartered in Miami.

GAINL from Gladstone Investment Corporation (GAIN) raises $65 million in gross proceeds, all of which is being used to redeem all outstanding shares of GAINO (6.75 percent) and GAINN (6.50 percent). Offering a 6.25 percent cumulative dividend, GAINL is unrated. GAINL is a “term preferred stock,” meaning that it has a specific maturity date. Only about thirty percent of currently trading preferred stocks are structured this way. While the company can redeem GAINL shares on or after the security’s August 31, 2020 call date, they are required to do so on the August 31, 2025 maturity date. As a business development company, GAIN invests in small to mid-cap U.S. companies with both debt and equity investments.

SAF is an ETDS from Saratoga Investment Corporation (SAR) with 6.25 percent annual interest payments, maturing on August 31, 2025. SAF is unrated by either Moody’s or S&P, but has a BBB investment grade rating from independent rating agency Egan-Jones. Saratoga is a relatively small business development company with a market capitalization of only $185 million. The $35 million raised by the new SAF represents about twenty percent of the company’s market value. SAR has two income securities currently trading, both of which are ETDS with three-year call protection (its other ETDS, SAB, was issued in December 2016 at 6.75 percent with a call date of December 21, 2019, maturing in 2023). In general, the company’s financial stats (profitability, current ratio, revenue growth, cash flow) look strong, although the high debt ($200+ million) typically carried by such companies puts their debt-to-equity ratio at a whopping 142 (as of May 31, 2018). Liquidity, as measured by their current ratio (assets-to-liabilities), is over 4, meaning that if the company were to liquidate its assets, it could pay its liabilities four times over.

Sources: Preferred stock data - CDx3 Notification Service database, PreferredStockInvesting.com. Prospectuses OAK-B, CAI-B, PRS, USB-P, LTSK, GAINL, SAF

Tax treatment

The tax treatment of the income you receive from income securities can be a bit confusing, but it really boils down to one question – Has the company already paid tax on the cash that is being used to pay you or not? If not, the IRS is going to collect the full tax from you; if so, you still have to pay tax, but at the special 15 percent rate.

Traditional preferred stock dividends are typically paid out of pre-tax profits so are taxable as regular income; you pay the full tax since the company has not (OAK-B, GAINL). The same is true for dividends received from partnerships since each partner is responsible for their own tax obligations.

Companies incorporated as REITs are required to distribute at least 90 percent of their pre-tax profits to shareholders. Doing so in the form of non-voting preferred stock dividends is the most common method of complying and because these dividend payments are made from pre-tax dollars, dividends received from REITs are taxed as regular income (i.e., they do not qualify for the special 15 percent dividend tax rate).

Interest that a company pays to those loaning the company money is a business expense to the company (tax deductible), so the company does not pay tax on the interest payments it makes to its lenders (i.e., interest payments made to lenders are paid with pre-tax dollars). Since Exchange-Traded Debt Securities are debt (PRS, LTSK, SAF), ETDS shareholders are on the hook for the taxes. Income received from ETDS is taxed as regular income.

Lastly, if a company pays your preferred stock dividends out of its after-tax profits, the dividend income you receive is taxed at the special 15 percent tax rate. Such dividends are referred to as “Qualified Dividend Income” or QDI. QDI preferred stocks are often seen as favorable for holding in a non-retirement account due to the favorable 15 percent tax treatment. Looking at the Status column in the above table, two of August’s new issues pay QDI dividends (CAI-B and USB-P).

In Context: The U.S. preferred stock marketplace

With consumer spending up, household income up, high employment, GDP growth at an almost unheard of 4.3 percent and consumer confidence hitting historic highs last week, the Fed is certain to continue putting upward pressure on interest rates. Hopefully, their efforts to do so will soften at least some of the huge demand that pushed up the prices of U.S. preferred stocks during August.

Despite repeated increases in the federal funds rate, the average U.S.-traded preferred stock price has increased by $0.53 from its February 15 low of $24.97. By the end of August, the average price settled at $25.50 per share.

The following chart illustrates the average market price of U.S.-traded preferred stocks over the last twelve months.

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, 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.

Moving down the risk scale, the next chart compares the average current yield realized by today’s preferred stock buyers when compared to the yield earned by those investing in the 10-year Treasury note or 2-year bank Certificates of Deposit.

Even though it is a different buyer that purchases U.S. treasuries versus those putting their savings into bank CDs, I find it very interesting that the 10-year treasury and the 2-year bank CD reached parity on August 30. Tying up your money for an additional eight years now offers the same return with what many would argue to be the same risk due to the federal insurance of bank CDs.

U.S.-traded preferred stocks are currently returning an average current yield of 6.6 percent (blue line) while the annual return being offered to income investors by the 10-year treasury is 2.9 percent and that of the 2-year bank CD has recovered nicely to 2.8 percent.

For comparison, I have set the Yield column in the first table above to show the current yield of the new August preferreds on August 31. It is into this marketplace that August’s new issues were introduced.

Disclosure: I am/we are long PRS.

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.