Preferred Stocks Buoyed by Bank Earnings. Is it Time to Invest?

There have been recent developments in the Preferred Stock segment of the markets. This is the latest research report prepared by my firm LPL Financial.

Second quarter earnings season has included positive news from financial issuers, who on balance managed to increase key capital ratios.*
Higher capital ratios helped minimize near-term risks for preferred stock holders, as the risks of dividend deferral or suspension, or of exchanges into common stock are greatly reduced.
Despite the news, preferred stock performance has been muted following earnings announcements, while investors await greater clarity on the second half of 2009.
The lingering risks are one reason why we emphasize corporate bonds and high yield bonds; however, we continue to find preferred stocks attractive and think they should be a part of portfolios for income focused investors.

Since financial firms comprise roughly 80% of the preferred stock market, bank earnings are of key interest to investors in these equities. During the first quarter of 2009, the preferred market reached a historic low, because investors believed that rising losses on real estate loans would mean that financial firms would halt dividend or interest payments to preferred stock holders. As risk appetite increased and the equity market rebounded, preferred stocks bounced strongly as well. In early May, government mandated stress tests indicated certain banks needed to raise additional capital in order to be sufficiently capitalized. The stress tests were designed to indicate a minimum capital ratio that needed to be maintained such that large losses would not impair a bank’s ability to lend to worthy borrowers and not jeopardize savings of depositors.

Second Quarter Earnings

Second quarter earnings season showed that banks, on balance, were able to bolster these key capital ratios. Banks were able to accomplish this
improvement primarily by issuing additional common stock and via better operating results.The two ratios we illustrate are the Core Capital (or Tier 1) Ratio and the Tangible Common Equity (TCE) ratio; the latter is more closely scrutinized by government regulators. Higher capital ratios helped minimize near-term risks for preferred stock holders. Higher capital ratios mean the risk of dividend deferral or suspension, one of the greatest risks to preferred stock holders, is greatly reduced. Since preferred securities have extremely long maturities, or in some cases are perpetual (i.e., have no maturity date), interest income is the main driver of investment performance. The continuation of this income stream is of utmost important to preferred stock investors.

On a secondary level, higher capital ratios reduce the risk of a forced exchange from preferred stock into common stock. An exchange into common can be a negative for preferred stock investors as it also implies an end to the income stream. If a dividend is paid on common stock, it is typically much lower. It is worth noting that exchanges completed so far this year have come at relatively favorable terms for preferred stock holders. In most cases, total compensation offered was above the market value of the preferred stock that prevailed over 4Q08 and 1Q09. So future exchange offers, should they occur, may not necessarily be a negative for preferred holders.

Positive News Good News for Preferred Stock?

Despite this positive news, preferreds market performance has been muted while investors await greater clarity on the second half of 2009.
The preferred market did have a good run up prior to the start of earnings season, perhaps in anticipation, but focus has now shifted to the second half of 2009. And preferred stocks have rallied sharply off the March lows.

Specifically, investors are concerned over the potential for continued losses on banks’ holdings of consumer loans that might erode capital ratios. One negative across second quarter earnings reports was that of continued credit deterioration. Should capital ratios decline again, risks to preferreds holders would increase.

We believe the preferreds market has priced in much of this risk and remains attractively valued. The preferred stock market, as measured by the Merril Lynch Preferred Securities Index, offers an average yield of 7.9% (as of July 23) and has an average credit rating of A3 (Moody’s). The yield spread to Treasuries is a healthy 3.7%. We do not dismiss the risks, as the ultimate loss rate or recovery value from consumer loans is difficult to predict. For this reason, we continue to have a preference for Corporate Bonds and, to a lesser extent, High Yield Bonds in client portfolios. However, attractive valuations still make preferred stocks a good income vehicle, and we continue to employ them in our income focused portfolios.

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
Neither LPL Financial nor any of its affiliates make a market in the investment being discussed nor does LPL Financial or its affi liates or its offi cers have a financial interest in any securities of the issuer whose investment is being recommended neither LPL Financial nor its affi liates have managed or co-managed a public offering of any securities of the issuer in the past 12 months.
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