Preferred Shares To Hold Forever: Crestwood And RLJ Lodging, Yields Up To 10.7%

Summary

• Some people collect rare art, I collect dividend streams.
• One elusive investment is preferred stocks that cannot be called.
• These unique investments allow us to hold the shares and collect dividends forever.
• The decision to sell is in our hands, not the hands of the company.
• Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Get started today »

Co-produced with Beyond Saving

Today, we highlight two preferred stocks that can never be called.

• Crestwood Equity Partners preferred shares CEQP- (CEQP.PR)
• RLJ Lodging preferred shares RLJ-A (NYSE:RLJ.PA).

While it's becoming harder to find big bargains in the preferred stock space, there always are good opportunities. Both CEQP- and RLJ-A are still undervalued and offer a nice yield. These are two preferreds to buy and hold forever.

The Income Method is all about building a large and stable income stream from our investment portfolios. We value our portfolios just like we value the businesses we invest in, by their cash flow.

We have discussed before how preferred stocks can provide a lot of stability in terms of cash flow. A company cannot pay a penny of common dividends until the preferred dividend is paid in full. Also, many preferred equity investments are cumulative, meaning that in the event that the dividend is suspended, the amount owed will accumulate and will have to be paid to preferred shareholders in full before common dividends can be paid.

This makes preferred share investments a cornerstone of our high-yield strategy. While there are sometimes opportunities for capital gains, the primary goal of a preferred equity investment is for the large and stable dividend, a job that our preferred equity portfolio performed admirably even through the COVID-19 pandemic.

Today we look at two exceptional preferred share options. Both have unique features which means that they are very unlikely to ever be called.

In general, one of the negatives of preferred equity investments is that most have a "call" date, after which the company has the option to redeem the preferred shares at par value. While this means a realized gain if you bought the shares below par value, a company is only going to issue a call when it's in their favor. This means that a company is only going to call if they can refinance at a cheaper rate. This usually happens when interest rates are very low, just like today. Many of the companies that issued their preferred stocks did so a few years back when interest rates were higher. Some are able to refinance at lower rates. This is why we are seeing many preferred stocks being called.

For the preferred investor, this means getting bought out of a good income stream at a time when redeploying at the same yield would mean taking on a higher risk.

The great news is that there are a handful of preferred investments that cannot be called. As income investors, this means you get to decide if and when you sell your investment. You can wait to sell only when the conditions are good for us, not when it's convenient for the company. Or you can opt to hold forever and collect the high dividends.

With interest rates very low, and likely to remain low for several years, it's important that we lock in high yields while they are still around. Preferred shares that cannot be called are very rare. Just last month, we highlighted the preferred stock of ANH-B (ANH.PB). ANH-B is a unique preferred that can never be called, and investors can buy and hold forever. Today, we highlight two more preferred stocks with no call options, these two high-yielding preferred shares are at the top of our fixed-income buy list.

Pick #1: RLJ Lodging Trust

RLJ Lodging Trust Cumulative Convertible Preferred Series A (RLJ.PA) is a preferred issue that was inherited by RLJ Lodging Trust (NYSE:RLJ) as part of their acquisition of Felcor Lodging Trust in 2017.

RLJ-A is a convertible preferred, meaning that the preferred share was designed to be converted into common equity. The conversion is at the option of the preferred shareholder and usually there's a provision for the company to force conversion only if the common share price rises to a premium of the initial conversion price.

The Conversion Option

As a result of the merger, RLJ-A is convertible into 0.2806 common shares in RLJ. This sets the conversion price at $89.09 per common share. RLJ cannot force conversion unless their common shares are trading at 130% of the conversion price, or at a price of $115.82. Today, RLJ price is at around $14.

Looking at the history of RLJ's common shares, we can see that it's very unlikely that RLJ gets to anywhere close to the conversion price of $115.82.

Data by YCharts

This is what we would call a "busted" convertible. Essentially, it's incredibly unlikely that the common shares ever get high enough for RLJ to force conversion. This means that the only way that RLJ can get rid of these shares is by buying them in the open market. RLJ cannot force you to give up your income, you can hold RLJ-A as long as you wish.

Strong Liquidity

Of course, we also want to make sure that the preferred shares are secure and that RLJ will be able to continue meeting its dividend obligation. RLJ entered into the COVID-19 crisis in a strong liquidity position. They have more than $1 billion in liquidity, putting them near the top of their peer group.

Source: RLJ December 2020 Presentation

They have low leverage relative to peers and no large debt maturities until 2023 – providing them plenty of time for hotels to recover.

Source: RLJ December 2020 Presentation

While hotels are not cash flow positive right now, RLJ has been able to minimize their cash burn. In fact, RLJ has continued paying a common dividend of $0.01/quarter even through the entire crisis.

Outlook

With a vaccine starting to be deployed any day now, RLJ should see improving results throughout 2021 and they have plenty of liquidity. RLJ is going to be more than a survivor. RLJ is going to be one of the REITs that's likely to buy out weaker peers due to its strong liquidity.

You can confidently lock in a yield of 7.7% in an investment that will pay you in perpetuity with RLJ-A.

Pick #2: Crestwood Equity Preferred Shares

Crestwood Equity Partners LP, 9.25% Cumulative Preferred Partnership Units, CEQP- (CEQP.PR) is a second option that cannot be called. A preferred equity of Crestwood Equity Partners LP (NYSE:CEQP), this preferred offering has only recently been listed for public trading. Note: CEQP- issues a K-1 tax form.

CEQP- was issued to preferred shareholders of Crestwood Midstream during the merger with CEQP in 2015 and were not publicly listed until 2018. CEQP- is a preferred share that was issued to institutional level investors. As such, there are a lot of provisions that we typically do not see in preferred issues that are available to retail investors.

For starters CEQP- does not have a "par" value. Instead, the preferred shareholders were promised a 9.25% yield. As a result, instead of the usual $25, $50 or $100 number we usually see with other preferred shares, CEQP- pays 9.25% at a price of $9.129/share.

Conversion Option

Like RLJ-A, these preferred shares are convertible to common shares. Preferred holders are free to convert at any time, receiving one common unit for 10 preferred units.

CEQP cannot force conversion unless the Volume-Weighted Average Price of the common exceeds $91.27 for 20 out of 30 days. CEQP's common unit price currently is around $19. Like RLJ-A, it's unlikely that CEQP is going to be able to exercise their conversion option for the foreseeable future, or probably never.

Penalties

Like RLJ-A, CEQP- is cumulative, with a beneficial twist for shareholders. If CEQP- misses even a single distribution, the distribution increases to $0.2567/quarter. On top of that, any accrued and unpaid distributions will increase at a rate of 2.8125% per quarter. This provides CEQP very strong motivation to pay the preferred dividend, even in adverse conditions.

Coverage

It's no secret that MLPs have been one of the harder hit sectors in 2021. Despite COVID-19, CEQP actually managed to increase their DCF (distributable cash flow) year over year.

Source: CEQP Q3 2020 Presentation

For both Q3 and the first nine months, CEQP's preferred shares enjoyed over 4.5x coverage by DCF. Higher than it was last year. This is why CEQP did not even have to reduce the common dividend and keeps us very secure at the preferred equity level.

Outlook

CEQP can thank the high exposure to gas and NGLs relative to oil for having a relatively smooth 2020. Additionally, 87% of their contracts are "take-or-pay" or fixed fee.

Source: CEQP Q3 2020 Presentation

It's hard to imagine a stiffer test than COVID-19, and CEQP proved to have the stability that we look for with a fixed-income investment. The preferred dividends continued with more than adequate coverage every quarter.

As vaccinations take place next year, demand for energy is going to continue to rebound. Investors are going to realize what a steal it is to get CEQP- at a 10.7% yield.

Conclusion

When it comes to preferred shares, our primary goal is to ensure that the dividends are sustainable. After all, these are "fixed-income" style investments where we primarily intend to realize our returns through the income stream. We always are on the lookout for high-yield preferred stocks that are trading at opportunistic valuations. If you like preferred stocks, our "preferred stock portfolio" is a great investment resource for which we provide weekly updates.

The year 2020 has provided an opportunity for preferred stock investors to see how these investments perform under extreme and completely unpredicted stress. History tells us that after a bear market, preferred stocks are among the first to rally and recover to their pre-crash levels. This year was no different. RLJ-A and CEQP- have both performed admirably since the market crash. Both continued to pay their dividends uninterrupted in the face of the most tumultuous business environment that either company has ever seen.

Now, with a vaccine around the corner, both of these preferreds are set to see a recovery to their pre COVID-19 prices and beyond. If you haven't already, it's time to take advantage of the current discount and lock in these high yields. The best part is that you are locking up these yields forever since they cannot be called. Buy RLJ-A (yield 7.7%) and CEQP- (yield 10.7%) for high income and capital gains potential. These two are set to be some of the biggest winners in your high yield portfolio.

Additional Considerations for CEQP-

This preferred is issued by CEQP and is listed on the NYSE as CEQP/P.

However – Each brokerage uses a different ticker, and even multiple variations, which causes much confusion. Generally, on your broker's quote page, enter "Crestwood" to search for this preferred. Examples on how this preferred is listed:

• Here at HDO we use CEQP- (note the dash at the end) which is the syntax used by Quantumonline, IEX, GoogleFinance and TD Ameritrade.

• On Interactive Brokers, this preferred is listed as CEQP PR (with a space)
• Seeking Alpha, Nasdaq and E-Trade use CEQP.PR
• MerrillEdge uses CEQPPR, CEQP.PR and CEQP PR (but only CEQP PR is accepted when buying online, and then only if you dismiss/ignore the incorrect warnings about an invalid symbol).
• Vanguard uses CEQP_p
• Yahoo Finance has it as CEQP-P
• Charles Schwab uses CEQP/PR (StreetSmart uses CEQPp)
• Fidelity uses CEQP/P (Active Trader uses CEQPPR)

Tax Considerations for Owning CEQP- in a Retirement Account

As is generally the case with partnerships, the preferred shares (units) also issue K-1 tax forms. Investors should be aware of the tax implications of becoming a limited partner when investing in these instruments. Of particular concern with CEQP- are potential UBTI consequences (Unrelated Business Taxable Income) if it's owned in a retirement account.

HDO cannot give advice for your specific tax situation, but the general recommendation is that partnerships which issue K-1s are best held in taxable accounts. Our July 20, 2020, report on CEQP- has more details and reader comments about these issues.

We also have noticed that for non-US investors (or international investors), the dividends are only subject to the lower tax, based on the U.S. tax treaty. For example, most European investors will get only a 15% tax withholding on the dividend. This tax withholding is usually deductible when you file your tax returns.

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Disclosure: I am/we are long CEQP.PR AND RLJ.PA. 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.