Preferred Stocks: Better Than Bonds but Act Just Like Them

December 13th, 2013 by

businesswoman - apple vs orangeWith bond yields struggling, investors might be wondering if the bond market is no longer a place to put all their fixed income investment dollars.

Fortunately, there is an alternative that doesn’t get much coverage in the financial press that provides diversification with bond-like regular income along with the possibility of capital gains. These securities are known as preferred stocks, and are considered stock-bond hybrids, as they share characteristics of both types of vehicles.  Frankly, I think of them as bonds.

 

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The best way to demonstrate the traits of a preferred stock is to select one. Hotel REIT Ashford Hospitality Trust issued eight million shares of 8.45% Series D Cumulative Preferred Stock at $25 a share, callable in 2012. Translated, this means that the company issued eight million shares at $25, raising $20 million to deploy as underwriter Goldman Sachs disclosed in the prospectus.  They called it Series D simply to make the distinction between this particular preferred stock offering from others previously issued.

The $25 price can be thought of as the IPO price if it were a stock, but it’s really closer to the par value of a bond. In preferred stock terminology, it is called the “fixed liquidation value”. That’s because if Ashford were ever to get liquidated, holders of the preferred stock would receive $25 per share. Even better, preferred stockholders are ahead of common stockholders in a bankruptcy (bondholders always hold the senior liquidation position).

“Callable 2012″ means Ashford could, at any time starting back in 2012, call back in all the shares of this stock at $25 per share. Obviously, the only reason they would do this is if the stock were trading above $25 and/or Ashford believed they could save themselves more than $20 million in dividend payments going forward. This will also depend on the company’s liquidity position but preferred stock is rarely called because the company would rather hold onto the cash than reduce their liquidity position.

“Cumulative” means that if Ashford misses a dividend payment, they are still on the hook for it and all other missed payments if the dividend is ever reinstated. Interestingly, many hotel stocks suspended their preferred dividends during the financial crisis, but Ashford did not.

However, the most attractive thing about a preferred stock is that it comes with that fixed dividend payment, and it is usually stated as a percentage of the fixed liquidation value. Ashford’s preferred shares pay 8.45% of $25, or $2.11 a share per year.

So from the standpoint of income security, preferred stocks like Ashford’s can look mighty tasty. Even better, however, is that the investment itself is usually very stable. Preferred stocks often stay in a tight trading range because they are more like bonds than stocks, so don’t think about shorting them. The trading range will depend on two things: the company’s financial stability, and competition from other fixed income investments. Capital gain appreciation is not like it was a couple of years ago. When everyone was freaking out over the solvency of many companies, some preferreds were trading at a 70% discount to par, and that included Ashford. These days most of the stable preferred stocks are trading close to par.

You want to check for five things before buying a given preferred stock. First, are bond yields headed towards 5% or higher? Most preferreds pay 6% or more. Second, is the company in sound shape financially? You don’t want a preferred dividend cut surprise. Third, where is it trading relative to par and the call date? You don’t want to get call paying over par value and then suffer a capital loss if the company calls the stock. Fourth, is the series senior to other issuances? You don’t want to be subordinate to other preferred shares if the company gets liquidated. Finally, you want a cumulative preferred stock in the event the dividend gets suspended.

About Lawrence Meyers

lawrence meyers

Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at pdlcapital66@gmail.com.

 

 

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