With Wells Fargo and J.P. Morgan sparking a big rally in banks, income hungry investors may be tempted to look to preferred stocks. Whatever you think of the future of financials, I think preferreds are a bad play.
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)
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)
I agree with your assessment of the bank straight pfds, but what do you think of the convertible pfds? Even with the huge downward moves in the equities, these pfds are still fairly high delta so you will get a lot of the upside if the stocks recover. In a "middle of the road" scenario where things get worse but not catastrophic, the common dividends will continue to be cut, but the pfd divs are probably safe (I know they are non-cumulative, but a deferral would effectively shut the pfd market as a source of further capital). Most of them also have protection in the event of a takeover; while Bear Stearns didn't have any convertible pfds, they would have done very well even while the equity got crushed.
ReplyDeleteOn the upside PAR is not the limit. Premium to par could be large as you effectively pv 6.375% less fair coupon over a long expected life of the pref. On the way down, even if common recovers 1% of current price, pref recovers 100% of par. It depends on where the value breaks and there are many scenarios where the line is drawn at an acceptable level. Not sure, but I think Bear pref holders did better than ok.
ReplyDeleteOne unfortunate thing for buyers of recently issued pfds is that most are callable in 3-5 years. The FNM S (8.25% that was issued in December) is callable in 2010. So even if everything turns out OK, you get a good yield but only for 2.5 years. The risk still seems to asymmetric to me.
ReplyDeleteI don't think the fact that pfd is senior to the common should provide much comfort if any of these guys run into trouble. I think the more relevant fulcrum is that even if the creditors get 99% back, pfds are worth zero.
PNL: I agree that the relevant question is Senior/Sub, not Pfd/Common.
ReplyDeleteMy view on coverts is always a question of valuing the individual pieces. So if you run the numbers and determine that a covert is a cheap way to get call exposure to a stock, then great.
I once played around with a long preferred, long put on the common idea. Most of the names where it was interesting had big vol premiums in the put, so without big leverage, you couldn't make much money on the trade.
Thanks for the great information. I was just thinking of writing on a similar topic at my blog. Some good concepts to look into here and to be aware of.
ReplyDeleteRelated and interesting situation with Legg Mason (LM) and its convertible preferred (LMI). The convertible preferred had its $56 floor broken almost immediately after its May issuance, so it's trading similarly to the common now -- except you also get the preferred's 7% coupon.
ReplyDeleteA potential trade: short the common and buy the convertible preferred to lock in the preferred's coupon net the common stock dividend (net to around 7.5%).
there may be pitfalls in my reasoning, but seems like a good trade.
GP: That is a typical convert arb setup. For this particular trade, I would say your biggest risk is the non-cumulative nature of the preferred. The payment is a dividend rather than a coupon; the company can suspend it if they are in a weak capital position. Certainly this would be a last resort for the company, but it is a possibility.
ReplyDeleteThe other pitfalls are generic to most convert arbs. The borrow on the common could become difficult or expensive, you have to monitor your hedge ratio, and you are not fully protected from default. You are also vulnerable to the technicals of the convert market which are not great right now.
a wonderful poem on this subject can be found at:
ReplyDeletehttp://preftrader.blogspot.com