How to evaluate preferred stock
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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
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
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).Table 3-2
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
Trust Preferred Derivative Preferred Stocks
|Cort JC Penney
|Cabco JC Penney
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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