Prefered Stocks

A Look at Preferred Stocks By Jim Jubak
MSN Money Markets Editor - 02/05/2003 07:26 AM EST

The search for high yields--make that high, safe yields—is taking investors where many haven't gone before...such as into preferred stocks. That's unfamiliar territory to many investors.

What, for example, are Citigroup (C: NYSE-news-commentary- research-analysis) 6.21% Depositary Shares, Series G Preferred? And how are they different from Citigroup 6.23% Cumulative Redeemable Depositary Shares, Series H Preferred?

But with the 10-year T. Bond yielding just 4% & the two classes of Citigroup preferred I cited above yielding 6%, it seems like a good time to get to know this sector.

Let's start with some of the basics & end with 3 preferred stocks that offer an appealing combination of yield, potential appreciation & safety right now.

What Are Preferred Shares? They're called preferred because they have preference over common shares -- the class of stock that most investors own -- when it comes to the payment of dividends (if cash is running low at the company) & in that case the company has to liquidate. (In most -liquidations, investors who hold common stock get nothing.)

Preferred shares pay a dividend that is stipulated & usually fixed at IPO. Dividend payments do not rise if company profits do, unlike common shares that pay a dividend. Preferred shares generally do not carry voting rights like shareholders.

When do companies issue them? When they have the cash flow to pay the dividends but don't want to issue bonds because they either don't want to add debt to the books or because capital is cheaper in the equity markets. Typically, companies issue them instead of common shares when they want to prevent the dilution of voting rights & write very specific financial terms for the shares. Preferred stock comes in an almost infinite variety of flavors, each with slightly different financial characteristics.

Are all these differences really important? Not for investors taking a first cut at finding opportunities in the asset class -- although you should never buy a preferred without reading the prospectus to check on those niggling little details that can bite hard later on. Major distinctions to keep an eye on include: •Cumulative v. non-cumulative. If a company misses a dividend payment for any reason, owners of cumulative preferred shares are entitled to be paid all their accumulated arrears before common shareholders get any dividend payments. If a non - cumulative preferred misses a dividend payment, it's gone. Most preferred shares are cumulative.

• Participating v. nonparticipating. Owners of participating preferred get to share in profits above the stipulated dividend like common shares. Nonparticipating preferred is stuck at the original dividend level for the life of the issue.

• Adjustable v. nonadjustable. The dividend on an adjustable-rate preferred stock changes every quarter, on some set formula, usually based on the yield on T. bills or some other money-market rate. The yield on most preferred stocks are not adjustable.

• Convertible v. nonconvertible. Convertible preferred shares can be exchanged for common shares, on a stipulated formula & often within a specific time frame. Because this links the convertible preferred to the value of the underlying common shares, convertible preferred shares tend to be more volatile than nonconvertible preferred shares.

What kind of details should I make sure I understand in the fine print? The key details to watch include:

• When the company can redeem or buy back the stock, if it wants to, and what price it has to pay for the shares.

Most preferred is not redeemable until five years have passed from the issue date and most recent preferred is redeemable at its-issue price. Investors who own preferred trading far above the issue price take on the risk that the company will call the shares after the redemption date. A calculation, called yield to maturity, considers how much investors will be paid in dividends and how much they'll lose if the stock is redeemed at maturity at a price that's lower than the current market price.

• When the dividend is paid. Preferred dividends are usually issued quarterly, and if you buy after the ex-dividend data, you may find that you own the shares at the end of the quarter but aren't entitled to receive the dividend, which goes to the former owner. Watch for heavier-than-normal volumes around the ex-dividend data -- and rising prices -- as investors try to capture the dividend at the last moment.

What determines current price of a preferred stock? Preferred shares, except convertibles, which have a direct correlation to the value of common shares, trade like bonds, so two factors ultimately decide their price: interest rates & credit quality.

Because most preferred shares pay a set dividend, as interest rates go up & investors can find higher yields in new issues, the price of existing preferred shares tend to fall. Prices go up when interest rates fall. Prices also go up when the creditworthiness of the company that issued the shares improves, because that means that investors are more certain to receive their dividends & don't require as much of a risk premium to
hold the shares. Prices drop & yields rise if a company's credit drops.

OK, enough of the general principles. What sort of preferred stocks are best right now? I'd recommend preferred shares that are slightly out on the risk curve right now. In other words, the companies that issued these shares aren't rock-solid credits, so investors required a higher yield, a dividend premium for taking the risk that the dividend might not be paid,
before they purchased the shares. But I wouldn't go too far out on the curve. It doesn't pay to reach too hard for yield right now.
Here's my reasoning: The trouble with all income vehicles right now is that interest rates look like they're near a bottom for this cycle of the economy, assuming nothing goes unexpectedly wrong with the economy or on the world stage. I don't know when interest rates might start creeping upward. With the economy so weak, I'd be surprised if we got much of a jump this year. But if you look five years into the future, I think it's reasonable to assume that interest rates will be higher than they are now.



And that will put downward pressure on the price of all now- issued fixed-income vehicles. To keep up with the rising yields paid by new issues, the prices of existing issues will fall until their fixed payout is equal to the new & higher market interest rates.

Now, preferred stocks issued by companies with less than rock-solid credit ratings have a way to combat this. If the economy improves -- or at least stabilizes -- & companies can improve their credit ratings, the price of their preferred shares will rise as the credit-risk premium is removed from the stock. This pressure for an increased price from improved credit quality will at least partially offset any pressure for a drop in price caused by climbing interest rates.

Why not go as far out on the credit risk curve as you can? Because the current economic recovery is still very iffy. Gross domestic product grew at only 0.7% in the fourth quarter of 2002. If the economy stalls again, companies that are now major credit risks will become even greater risks, & that will lead to a drop in the price of their preferred shares.

To give you an idea of the relative kinds of volatility I'm talking about, look at the preferred issues from M. Lynch & JPM. I'd call Merrill a modest credit risk. The brokerage industry isn't exactly coining money, & Merrill's debt-to-equity ratio (at $3.38 in debt to every $1 in equity) is well above both its own & the industry average. So its’ preferred has more than average volatility for the sector. The Class D preferred that I'll talk about in a moment has a 52-week high of $26.40 & a low of $23.13. That's a 14% swing from low to high.

But it's nothing like the volatility in JPM’s preferred, thanks to the market's perception of a high degree of credit risk at the bank. The class A preferred hit a 52-week high of $87 on Jan. 21 after a low of $70.50 on Oct. 29, 2002. That's a 24% move from low to high. And the stock's volatility doesn't appear to be behind it, because it moved back down to $82.95 by Jan. 31.

Three preferreds that pique my interest.

•C. card issuer MBNA (KRB:NYSE-news - commentary - research - analysis) has issued preferred shares in a wide variety of flavors, so investors should be able to find one that matches the specific needs of any portfolio. U may want to check out MBNA Capital C 8.25% TOPrS Trust Original Preferred, now yielding 8% & recently trading at $25.80 but callable at $25, or the company's adjustable-rate preferred, recently trading at $24.75 on the NY Stock Exchange & yielding 5.51%. The adjustable yield is set at 99% of the T. bill rate but with a minimum yield of 5.5%.

• Trans Canada Pipe Lines Ltd. (TRP: NYSE - news - commentary - research - analysis) is selling assets to focus on its core gas transmission & power-generating businesses as a way to reduce the company's rather hefty ratio of $1.84 debt to $1 equity. Add in the fair degree of skepticism in the financial markets about the whole energy sector right now & that translates into a hefty yield on Trans Canada's 8.25% Preferred of 8%. The NYSE-traded issue is callable at $25 in 10/03 & currently trades at $25.66.

• Merrill Lynch, suffering through a horrible downturn with the rest of the brokerage industry, has issued a range of preferred shares with redemption dates that are further in the future. For a 12/06 call date, take a look at M. Lynch Preferred Capital Trust I 7.75% TOPrS Preferred. The shares recently traded at $26.71 with a yield of 7.2%. And you can also go a little further out to 3/08, with Merrill Lynch Preferred Capital Trust II 8% TOPrS Preferred. The shares recently
traded at $26.40 and yielded 6.7%.