Take as an example Wachovia Capital Trust "B" Preferred. These have a $25 par amount and a 6.375% coupon, and have traded today in the $14.50 area. At that price, the preferred has a yield of 10.99%. That's a nice juicy income number to be sure. And hey, you might reason that Wachovia is a large bank with access to liquidity from various sources, not the least of which is the Fed. Plus it has been mentioned as a takeover candidate several times, so if they really got into a liquidity crunch, they'd probably choose a low-ball merger offer over bankruptcy.
All that's probably right. But consider the risk/reward of preferred stock compared with other opportunities. First the upside. If you think market sentiment is overly negative and that a given bank will be able to earn their way out of capital problems, you should buy the common. Wachovia stock was trading in the $30/share area as recently as May, compared with less than $13 now. So the upside for a bank like Wachovia, if indeed conditions improve, is a multiple of its current price.
Compare that with the preferred trade. The "B" preferreds were initially sold on February 8, 2007, near the peak for the credit markets. In order for the preferred's price to get back to its $25 offering level, credit conditions would need to return to pre-sub prime levels. That's not going to happen any time in the next couple years. In fact, comparable J.P. Morgan preferreds trade in the $21 area. So logically, the best possible intermediate-term upside for the Wachovia preferreds is about 50%, versus maybe 300% for the common.
Now compare the downside for both trades. If Wachovia were to go bankrupt, both would be worth zero. At a retail bank, there are too many other stakeholders ahead of preferred holders, namely depositors and senior bond holders, for preferred shareholders to expect anything in bankruptcy.
Same downside but better upside with common stock. Seems like a no-brainer.
Now some argue that the income from preferred shares cushions your downside. Sure, given enough time. But the reality of this market is that any given bank are either going to survive this next year and thrive, or they aren't. Within the next year or so there will be "burnout" on the 2005-2007 vintage home loans. In other words, all the loans that are going to go bust will have gone bust. The unknown is how deep the losses will be and which banks will be hit the hardest.
So if a given bank survives the next year, odds are its share price is much higher, and its preferred price is mildly higher. If it doesn't make it, then you are wiped out either way.
If you are looking for income and want to limit downside, then senior bonds make much more sense. I am not a buyer of bank bonds here, but at least the risk/reward is better aligned. Senior bond holders should enjoy significant recovery if a bank is liquidated.
Finally, be especially careful with preferred shares of Fannie Mae and Freddie Mac. How preferred shareholders will be treated in the event of a full government takeover is a complete unknown. I'd guess preferred shareholders would be okay, but its not something any of us can asses objectively, and therefore you have to stay away.
(No position in Wachovia. My firm owns senior debt of Fannie Mae and Freddie Mac)