How to evaluate preferred stock

Investors invest in preferred stock primarily for the dividends, but dividends can be suspended by the board of directors. Therefore, it is important to understand the type of business the company is in and whether the company can earn enough cash to cover its dividend payments. When you find a company’s preferred stock you are interested in, read the preferred stock prospectus (usually a 423B prospectus filing).

Most preferred stock issues are rated by rating agencies such as Standard & Poor’s, Moody’s, Fitch, or Duff & Phelps. The rating categories are slightly different from those for bonds. Ratings above B are considered to be investment grade, with AAA being higher than AA and A. Below B are considered to be speculative or junk.

Before investing in preferred stock, compare the yield (dividend divided by the stock price) of the preferred stock with the yield of comparable bonds. The yield of the preferred stock should be higher than the yield of comparable bonds.

Most preferred stock issues do not benefit shareholders from the lower federal tax dividend treatment. Check that the issue you are interested in purchasing qualifies for the favorable tax rate on dividends. If the issue is a preferred trust stock or a derivative, it does not qualify for the lower tax rates on dividend income for investors.

TRUST PREFERRED STOCKS

There is very little difference (other than the tax treatment) for investors in whether they invest in a regular stock issue or a trust preferred stock issue, but for issuers, there is a considerable difference. Issuers of trust preferred stock issues gain the tax advantages of being able to deduct the interest payments on the subordinated debt, thereby negating the favorable tax treatment on dividends for preferred trust shareholders. Of the Citigroup preferred stock listed in Table 3–1, Citigroup’s preferred V series is a trust preferred stock. This is how preferred trust stocks work:
* A bank holding company forms a wholly owned trust which sells the trust preferred stock issue to investors. The proceeds from the sale of the trust preferred stock is used by the trust to purchase the subordinated debt issue of the bank holding company. The terms of the subordinated debt issue and trust preferred stock issue are identical.
* The bank holding company deducts the interest payments on the subordinated debt as well as the dividend payments from taxes. In order to qualify for the latter, the trust preferred issue must have a cumulative feature.
* When the financial statements are consolidated, the subordinated debt is eliminated, and the trust preferred stock is shown as “minority interest in equity accounts of consolidated subsidiaries” on the bank holding company balance sheet.

Trust Preferred Derivatives

There are different trust preferred issues with different names depending on the sponsor or investment bank, each with its own acronym: monthly income preferred shares (MIPS), trust-originated preferred shares (TOPrS), quarterly income debt securities (QUIDS), quarterly income preferred shares (QUIPS), and corporate-backed trust securities (Corts).

The common features of these securities are as follows:
* They have a par value of $25 instead of the traditional $1,000 par for a bond.
* They are listed on the stock exchanges as opposed to the bond exchanges or over-the-counter markets.
* They pay regular interest.
* Most have a maturity date. There are some issues that are perpetual, like common stock.
* Many of these issues have call provisions.

Generally, these are easier to buy than regular preferred stocks and bonds because they are listed on the stock exchanges, where prices are available, and they do not require as large a capital outlay as bonds with the lower par value. Table 3–2 lists some of these securities.

The first of the issues listed is JC Penney’s corporate-backed trust securities (Corts) with a coupon of 7.625 and maturity on March 1, 2097. The closing price of this issue as of July 2006 was $25.58, which is a slight premium to its par value. The rating of this trust preferred issue is the same as the JC Penney 7.5/8 percent bonds in the trust. There is a call provision for this issue that puts a ceiling on the appreciation of the issue when interest rates decline. If this issue is bought at $25.58 per share and held to maturity in the year 2097, the yield to maturity will be 7.5 percent.

JC Penney’s corporate asset–backed corporate (Cabco) securities also were issued with a 7.625 percent yield and trade under the ticker symbol PFH, pay a dividend of $1.91, and were trading at $25.26 per share. In the early years of 2000, JC Penney was not as financially sound as it is in 2006, and its Cabco securities were listed as junk bonds.

There are some caveats that investors should be aware of:
* Be cautious when paying a premium for an issue with a call provision. If the issue is called, you will receive the par value, $25, or the call price, which means that you can lose some of your capital.
* These companies can suspend their dividends during times of financial hardship.
* Companies with balance sheets that may be overleveraged might use this type of security to raise funds. Consequently, you should look for issues with strong credit ratings.

Preferred and trust preferred stock issues appeal to investors seeking income and sacrifice the potential for long-term growth through capital gains.

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