Finally, It’s Time – Convertible Preferred

convertible preferred stockWith the S&P 500 recently hitting new highs and interest rates poised to increase, it sure doesn’t seem like the best of times to be buying dividend stocks if you care about valuations and preserving capital.  So, given the timing of where we are in the economic cycle, is there a decent alternative to just waiting for a pullback before buying those income stocks you’ve been eyeing?

Hidden Opportunities for Income Investors

Viable alternatives are out there, but you have to drill down to find them. Continuing with the “less risk, more yield” theme from my post on baby bonds, let’s take a look at equities.  To minimize interest rate risk, you want to be looking at the stocks of companies whose businesses will benefit from increasing rates.  As mentioned in earlier posts, an example of one sector where this is true is the Financial sector.  To further minimize the risk to dividend payments, we look for companies within those rising rate-friendly sectors that are on a solid growth trajectory.  Unfortunately, these higher-growth companies often have lower dividend yields than their low-growth cash cow brethren.  One thing, however, that many of these higher-growth companies can offer to income investors are preferred shares with attractive yields.

Now the problem with most preferred shares is that they provide a fixed income, and, therefore, trade like bonds, i.e., their prices fall as interest rates increase.  But what if you could get that attractive fixed income while minimizing the effects that interest rate increases would have on prices?  That would certainly be something worth exploring.

An Income Investment Strategy

If you want to put some money to work right now, one possible alternative to consider is to selectively add preferred stocks with a convertible option (so-called “convertible preferreds”) to your portfolio.  I’m not going to summarize the basics of this type of stock in this post (you can click here for a good overview), but the main feature that distinguishes convertibles from non-convertible preferred stocks is that convertibles trade like a bond only while the share price of the common stock of the company is below the specified “conversion price” (unlike regular preferreds that always trade like bonds).  Once the common stock price rises above the conversion price, the price of the convertible preferred rises and falls primarily in sympathy with the price of the common stock, not with changes in interest rates.  Therein lies the opportunity.  What if you could find a convertible preferred issued by a strong growth company in a rising-rate friendly sector with an associated common stock that is trading above the conversion price?  Not only would those dividends be more secure, but the interest rate risk that most preferreds are vulnerable to would largely be mitigated.

An Attractive Income Investment Now

So what looks good right now?  One convertible preferred that my research has uncovered is the KeyCorp Inc. convertible preferred stock Series A (ticker symbol: KEY-PG).  KeyCorp is a growing regional bank holding company that stands to do well as interest rates rise.  KEY-PG pays $7.75 annually per share.  At the current share price of $129.50, KEY-PG has a yield of 5.98%.  Since the conversion price is $14.10 and the common stock (ticker symbol: KEY) is trading at about $14.43, one can expect future price movements of the preferred stock to be more closely correlated with the price movements of the common stock.  Analyst consensus is that the price of KEY will continue to rise as interest rates rise and the general economy improves.

So the play here would be to buy KEY-PG at the current price and monitor the price of the common stock.  Keep collecting the $7.75 per share distribution annually until the price of the common stock reaches $18.33.  When the price of the common stock stays at $18.33 or higher for 20 days, KeyCorp will have the option to force preferred stock shareholders to convert their preferred shares into common shares.  You do not want to do that.  So when the common stock price reaches that level, consider selling KEY-PG for a capital gain and reinvesting that money in other income investments, which by that time should all have relatively higher yields.

If you can discover similar plays with other securities, I think those would be very smart investments for income.

 

(Disclosure: I recently bought KEY-PG.  Yields and prices mentioned are current as of March 19, 2015.)

 

 

 

Preferred Stocks Revisited – Select Income Opportunities

preferred stock investment incomeA while back, I posted something on the possible advantages of buying preferred stock ETFs versus individual preferred stock securities.  The tradeoff of receiving a slightly lesser yield in return for some personal time savings seemed worthwhile to me when interest rates were low and stable.  As we seem to have now entered a period when interest rates appear to be moving upward, I wanted to revisit my approach to preferred stocks to see if there might in fact be opportunities that may be better options than just holding ETFs.

Preferred stocks are fixed income vehicles that trade essentially like bonds.  There are different varieties of preferred stock, but in general they are similar to bonds in that they pay dividends at a fixed coupon rate.  Like bonds, the price movements of preferred stock are heavily correlated to changes in interest rates (not to the price of the common shares of an issuer).  Unlike a bond, a traditional preferred stock does not have a maturity date and is considered a perpetual security.  Preferred stock is also callable by the issuer after a certain date.  When preferred shares are called, the issuer buys back your shares at the par value of the security.  Some preferred stocks are “non-cumulative” in nature, meaning that if an issuer skips a dividend payment, there is no requirement to make up that payment later.  As you can see, there is significantly more risk with investing in preferred stocks than with bond investing, but the tradeoff is that the yields you get with preferred stocks are higher than what you can get with bonds.  On the risk/reward scale, preferred stock would rank higher up than bonds, but lower than dividend-paying common stocks, REITs, or MLPs.

Doing good research is especially important for investing in preferred stock.  If you intend to hold the stock for a long time, then you need to make sure the issuing company has a sustainable business and is in solid enough financial condition to continue paying dividends for that duration.  On the other hand, some investors just use preferred stocks as an alternative to bank CDs to park their cash in for a few years.  If you intend to eventually sell your preferred shares, then you also need to make sure that you purchase shares at a price where your expected returns are worth the risk and that a liquid market for the shares exists when it is time for you to sell.

In an environment in which interest rates are expected to rise, what is a good strategy for picking preferred stocks?  My first screen is always to look for preferred stocks that meet some basic criteria:

  1. Must be cumulative
  2. Must not be callable for at least 3 years
  3. Must offer relatively high yield
  4. Issuer must be in a strong financial condition with a good credit rating

To select individual securities that might outperform an index of preferreds, I then consider the current economic forecasts and how they would affect the securities that meet the above four criteria.  In general, when interest rates rise, they:

  1. Discourage companies from calling their preferred shares (so, I can probably consider securities with a shorter period before the call date than I otherwise would)
  2. Benefit bank and insurance businesses (strengthening their ability to sustain dividend payments)
  3. Favor real estate trusts that hold shorter-term leases (also making it more likely they will be able to sustain dividends)

 As I sifted through the various preferred securities using these guidelines, two securities caught my attention.

 From the insurance sector:

PRE-E:  PartnerRe Ltd, 7.25% Series E Cumulative Redeemable Preferred Shares (callable 6/1/16; current yield to call 4.9%)

 From the REIT sector:

PSA-OPublic Storage Inc., 6.875% Dep Shares Cumul Preferred Stock, Series O (callable 4/15/15; current yield to call 6.7%)

The yields for these securities compare to a current yield of 5.85% for PFF.  Both securities are still selling at a premium to their liquidation/call prices of $25, so they still seem a little pricey to me (especially PRE-E).  However, I am putting them on my watch list, and when interest rates move up enough that they start selling closer to par (or, better yet, at a discount), then I would seriously consider adding them to my income portfolio.   

 (Disclosure:  I do not currently own any of the securities mentioned, but may purchase them in the future. All yields are calculated based on closing prices on 7/12/13.  I am not recommending these securities as investments, only as potential securities for your own research.  Please read the prospectuses for anything prior to making your own investments.)