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sagitarius84 (36.19)

High Yielding Preferred Stocks Could Also Get the Dividend Axe

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March 11, 2009 – Comments (1) | RELATED TICKERS: PFF , PGF , FNMA

Preferred shares are typically equity with a higher ranking than ordinary shares. Preferred stock does not have voting rights but has a fixed dividend payment, just like a bond. In a bankruptcy or a liquidation of the corporation, preferred shareholders have a superior priority over common shareholders, but a lower priority in comparison to bond holders. Preferred stockholders are also first in line to receive dividend payments, which are typically fixed. They don’t typically get to share in the prosperity of the enterprise however as preferred stock dividends do not increase. In tough economic conditions however, preferred stock dividends are much less likely to be cut or suspended; as long as the company continues operating as a going concern preferred stock dividends continue getting paid.

There are several ETF’s, which enable investors to participate in a basket of preferred stocks. One of the most active ETFs is the iShares S&P U.S. Preferred Stock Index (PFF) and the other is Powershares Financial Preferred (PGF). PFF currently yields 10.77% and has an expense ratio of 0.48%. Financials account for over 81% of PFF’s  asset allocation, while materials and Health Care account for 8% and 7% respectively.

PGF currently yields 13.60% and has an annual management fee of 0.72%. PGF’s holdings consist only of financial preferred shares. The main difference with PFF is that PGF holds preferred stock in foreign banks such as Credit Suisse, HSBC, Royal Bank of Scotland and ING Group.

Preferred stocks have typically enjoyed above average dividend yields. In addition to that preferred shares have usually come from financial companies. Regulators require banks to have adequate capital to support their liabilities and require that they hold a certain minimum level of Tier 1 capital. Because preferred shares are normally less expensive to issue than common stock, banks issue preferred stocks quite often.

The financial crisis that started in 2007 has affected negatively the market for preferred shares, which have taken a beating. Investors who chased high yielding preferred stock ETFs got burned in the process as well. The iShares S&P U.S. Preferred Stock Index, which lost almost 24% in 2008 are down 45.70% year to date. The Powershares Financial Preferred ETF also lost 27.30% in 2008 and 55.7% so far in 2009.

Main reason why investors are fleeing preferred stocks is the high allocation of financial companies. The bailout of Freddie Mac (FRE) and Fannie Mae (FNM) by the US government resulted in elimination of dividends for preferred shareholders. Most recently Citigroup (C) announced that it would suspend dividends on some preferred shares, which could be a final blow to investors seeking fixed income. Investors are worried that the rest of financial stocks, which received TARP money, such as Bank of America (BAC), Wells Fargo (WFC) and US Bancorp (USB), could be next to cut the dividend payments on their preferred shares.

Because of the current uncertainty in preferred dividends, I do not view PFF and PGF as buys at these levels. Investors who learned the hard way not to chase yield should think twice before diworsifying into preferreds.

Relevant Articles:

- TARP is bad for dividend investors
- Can USB and WFC maintain their current dividends?
- Don’t chase High Yielding Stocks Blindly
- Which Bank will be next? Follow the dividend cuts

 

1 Comments – Post Your Own

#1) On March 12, 2009 at 5:50 PM, mannacio (< 20) wrote:

Obviously no math is behind this thinking.  The questions that need to be asked are: First, what is the probability that any major bank will either be allowed to fail or go into receivership, taking into account the Government support already provided, the statements to the contrary by major administration offcials, and the views of many economists that this would be a major hit to market confidence thereby worsening the credit crisis. The next question is, if the banks do stay in business but skip some dividends what is the probability of dividends being shipped for each of the quarters going out 10 years or so.  Once having assigned our own estimates to the proabability of failure in quarter x as f(x) and the probable dividend amount in quarter x as q(x) then the value of the preferred stock is calculated as the sum of the present value in quarter x for a desired rate of return for each quarter multiplied by f(x) multiplied by q(x) and, assuming it is sold in year ten, we add to that the year 10 price present valued. So let's do the math for Barclay's Bank, which hasn't even accepted any government bailout money.  On March 12 the closing price for Barclay's Preferred A was $6.97.  This would be a yeild of 25.25%.  Now, does anyone think Barclay's Bank will be nationalized or go bankrupt, please raise your hands.  Those with their hands up, please go for therapy for PTSD, you obviously have let fear take over your thinking.  Now the quarterly dividend is $.44 so let's assume that hard times forces Barclay's to entirely suspend all dividends including those on preferred stock for 2 years.  Keep in mind this would mean a credit downgrade since preferred stock is uncollaterlized debt so non-payment lowers your credit rating. Let's also assume that even after 10 years the going interest rate for banks which have regained their footing is 8.5% (still rather high).  This would put the price in year 10 at $20.71. So, using this hypothetical, what rate of interest is a present value of $6.97 equal to assuming two years of skipped divndends and 8.5% yeild in 10 years?  Well that is a reutrn of 23.19% annually.  Even if no preferred dividends are paid for 3 years but the other assumptions are held constant that is still a 20.67% return.  It should be obvious that the overwhelming fear of nationalization is driving preferred bank shares to their ridiculously low level.  Smart investors would be well advised to take advantage of this opportunity. Not with an index basket, but selectively, with the large banks (offered government support).   The author's uncertainty - born of fear not math - is your opportunity.  You can trust your gut or keep your head.  It's up to you.

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