Philip Van Dorn
In this market, investors can buy discounted preferred stock at a discount now for a decent income and potentially big gains later on
It’s going to be a brutal year for bank stocks. But a deeper look could highlight opportunities for income-seeking investors to make money from the bank’s preferred stock.
On August 17, we published this view on banks that are expected to enjoy the largest NIM expansion as the Fed hikes rates. A bank’s net interest margin is the difference between the average yield on its loans and investments and what it pays on deposits and borrowings. Expanding profit margins could mean higher profits.
But shares of the S&P 500 banking group fell 9% between Aug. 16 and Sept. 6, and are down 23% in 2022, excluding dividends, according to FactSet. Investor concerns over a slowdown in the capital markets business sector and a possible recession and resulting credit losses appeared to outweigh enthusiasm for widening spreads.
The unfavorable environment for the bank’s common stock underscores the opportunity for preferred shares, Odeon Capital analyst Dick Boff wrote in a Sept. 7 note to clients. He cites JP Morgan’s (JPM) preferred stock series JJ as an example.
“Investment banking is under tremendous pressure right now, while traditional banking is doing well,” Boff wrote in explaining his “hold” rating on JPMorgan’s common stock. But he thinks it “makes sense” to steer clear of the risks of large bank stocks and “buy bank preferred shares at a discount.”
Regarding the J.P. Morgan preferred stock series JJ discussed here, Bove wrote: “In almost any predictable economic environment, the dividend is very safe.
Preferred stock terms
Anyone can buy preferred stock if they have a brokerage account.
If you’re new to preferred stock, we should start with some definitions.
Preferred stock differs from common stock in that its owner does not have voting rights. Preferred stockholders also have priority over common stockholders in the event of a company liquidation. In bankruptcy and liquidation situations, a simplified order of preference is bondholders, then preferred stockholders, then common stockholders.
A company may have more than one preferred stock. Investors buy preferred stock for dividends, just as they buy bonds for interest income. Preferred stock dividends are usually paid quarterly.
More definitions – all important:
Par – This is the price at which the preferred stock is issued. Usually $25, but could be $100 or something. The face value is similar to the face value of a bond. Investors are paid if the issuing company redeems the preferred stock. Just as the market value of bonds fluctuates, preferred stock prices fluctuate, often in the opposite direction of interest rates in the economy. In the current environment, many preferred stocks are trading below par as interest rates rise.
Coupon – The stated rate of return on preferred stock based on par value.
Dividend Yield – The stated yield multiplied by the face value. JP Morgan’s preferred stock series JJ was issued on March 10, 2021, with a face value of $25 and a coupon rate of 4.55%. The annual dividend is $1.375.
Current Yield – The annual dividend rate divided by the current market price. JP Morgan’s preferred stock series JJ closed Sept. 6 at $19.65. The current yield is 5.79%.
Redemption Date – The date on which the issuer can decide whether to redeem the preferred stock. Issuers may redeem some or all of the Preferred Series at any time from that date. If the interest rate is significantly lower than the interest rate at the time of issuance of the preferred stock, the issuer may redeem it.
Expiration Date – The date on which the Preferred Series will be fully redeemed. Today, most preferred shares are “perpetual,” meaning there is no maturity date, although there is usually a redemption date. JP Morgan’s preferred stock series JJ is perpetual preferred stock with a redemption date of June 1, 2026.
Cumulative/Non-cumulative – If a preferred stock issuer gets into financial distress, it may be forced to suspend dividends on one or more preferred stock series. If the preferred stock is cumulative, the suspended dividend will be paid later (or if) when the dividend resumes. Banks issue non-cumulative preferred shares because regulators want them to have the flexibility to suspend dividends and never reissue them in the event of severe financial or economic distress. It is very rare for an investment-grade issuer to miss a preferred stock dividend payment.
The Ins and Outs of Preferred Stock
Preferred stock is for investors seeking income. They are not intended to be growth investments. The 4.55% coupon of J.P. Morgan’s preferred stock series JJ may not be very attractive when the stock is offered at $25 on March 10, 2021. Likewise, on that date, the yield on the 10-year Treasury note was 1.53%. On September 6, the yield on the 10-year Treasury note was 3.50%.
So the current 5.79% yield is attractive to investors who bought J.P. Morgan’s preferred stock series JJ at a discount of $19.65 on Sept. 8.
And that discount could mean a lot of gravy. After the June 1, 2026 redemption date, JPMorgan can redeem the shares at any time if the bank no longer needs the capital or at a coupon rate below 4.55% (plus underwriting fees).
So, if interest rates end up sharply lower from here, J.P. Morgan’s preferred stock series JJ could trade well above its Sept. 6 closing price of $19.65. Shares can be sold at any time.
If the preferred shares are redeemed on or after the redemption date, the bank will pay $25 per share, which means if you bought them for $19.65, your profit would be $5.35 per share, or 27%, plus your Dividends already earned are always received.
There are many other examples of preferred stocks trading at a discount, or for those with higher coupons, at a premium you might consider reasonable. Ask your investment advisor or call your broker for more information.
For income-seeking investors, preferred stocks are worth looking into.
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Hear Ray Dalio speak at MarketWatch’s Best New Creative Currency Festival, September 21-22 in New York. The hedge fund pioneer has strong views on where the economy is headed.
– Philip Van Dorn
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