Preferred Stocks

[ericd1]

 

With the Citi deal the govt is requiring other preferred holders to convert their shares to common too. Although other large banks may not be in the same situation as Citi, it's possible some...perhaps many, would take the same path. Depending on the conversion terms, it could be good, or bad for pfd holders. If the conversion is at face value it could be a windfall, which is doubtful and if it's at some prior trading price of the common and pfd, then it is probably not good. Conversion at a current price would be close to a wash.

 

How many more Citi's are out there?

[dcollon]

Since I started this thread and Citi is forcing the conversion of some preferreds I thought I should make a quick comment.

 

I still think many of the preferreds (not necessarily Citi's) are interesting are current levels.  I also would point out that even though many of Citi's preferred securities will be forced to convert the trust preferred & enhanced trust preferred will continue to be paid (C.u and C.v). 

 

Unfortunately, the government doesn't seem to have a playbook.  They are reacting and sending mixed messages to investors i.e. suspending FRE & FNM preferreds outright and now splitting Citi's.  This is a horrible thing to do given the current environment.

 

It will be interesting to see which companies are hurt by the most recent move.  My guess is that anyone who owned the Citi preferreds should have already taken an impairment charge, but it might not have been enough.

 

[cman]

I agree that the lack of consistency is terrible. The government seems to be doing their best to manufacture a depression.

 

That said... Citi created the arb of a lifetime. You could buy the series AA and F for about 5-6 this am and short out 7.7 shares of citi common for 1.50-1.80. Basically you double your money on the capital put up for the long. By the end of the day the arb returned about 50-60%

 

I think this bodes well for preferred of strong banks as a worst case which isn't so bad. Makes me like my BAC position more

[oec2000]

Unfortunately, the government doesn't seem to have a playbook.  They are reacting and sending mixed messages to investors i.e. suspending FRE & FNM preferreds outright and now splitting Citi's.

 

I actually think the Citi plan is a smart plan. Firstly, it strengthens C's balance sheet without fresh govt capital infusion. Secondly, the preferred holders have been forced to take a haircut in a way that does not make them feel so bad (unlike the FNM/FRE situation). Thirdly, it sets the stage for C to raise funds in future by way of rights issues.

 

The thing is that they are learning from their mistakes as they go along and I think they are finally beginning to show signs of a more coherent policy with the Citi plan which, unlike the BS/LEH/FNM/AIG plans, does not seem to be a reactive last minute desperation plan.

 

The C plan, imo, clarifies three things:

 

1) The govt will continue to support the TBTFs (Too Big To Fail). By taking common equity, the govt has now aligned its interests with other common equity owners. When its support was purely in pfds, common equity owners could never be sure whether they would be wiped out.

 

2) Going forward, govt support will be on less onerous terms so as give the weakened institutions a chance to rebuild their equity. The earlier terms were too tough and self-defeating. The govt's goal is to save the financial system, not to maximise returns on its investment. The best way to do this is to pass on its low cost of borrowing to allow the institutions time to earn themselves back into health. The faster the financial system gets back into order, the faster the institutions can go back to raising private capital and the faster the govt can get its money back. Acceptance of zero-yield common equity shows that the govt realizes this now.

 

3) The govt will encourage/coerce private capital to share some of the burden of support. By assuring investors through its equity investment that C will not be allowed to fail, it will make it easier for C to raise capital in future by way of a govt underwritten deeply discounted rights issue which private investors will be motivated to take up so as not to be diluted; at the same time, they will not be deterred by the fear of C going under.

 

If my analysis is right, it makes the case for investing in pfds even stronger because every fresh addition to common equity enhances the position of the pfds, not to mention that pfd shareholders are now ahead of the govt. 

 

I hold the following basket of pfds:

 

C.PR.I (for the arb trade)

C.PR.U (18% yield on cost, 26% yield today)

WFC.PR.L (18%, 20%)

BML.PR.H (30%, 20%)

RBS.PR.P (36%, 48%)

HFC.PR.B (30%, 30%)

HBC.PR (20%, 20%) (Thanks, SJ!)

ORH.PR.A (12%, 12%)

 

My positions are somewhat aggressive but my exposure is less than 10% of overall portfolio. I am prepared to raise exposure to max of 20% if more compelling opportunities appear.

 

Please tell me if you think I'm crazy!

 

 

[netnet]

Hey,

 

OEC,

 

I noticed the commentary on the Citi arb Monday AM, and assumed that the profit had already been "arbed" away, so I did not go into the details.  What precisely are the ratios on the trade and how is it fairing with current volatility.

 

Also are you naked long on the other Citi preferred?  For me I like the Wells and the ORH preferred, those two look like shooting fish in a drained barrel! (At some point, I'll move down to the Wells common.)

 

Portfolio question: Don't you think that Odyssey Re looks money good; so that plus the Citi arb position really are conceptually different than the other positions.  From an analytical or risk management perspective, shouldn't you treat these preferreds entirely differently and not put them in together?

 

You were arbing those retractibles weren't you? How is that?

[Guest misterstockwell]

WRB-A is now at a very tasty level

 

WRB is an excellent insurer, well run.

[oec2000]

Netnet,

 

1) C arb - I missed the best part of the arb trade that was available on Fri am as pointed out by Cman because I am out on the West coast. Nevertheless, I was able to do the arb Fri pm as well as on Monday. (I had to improvise the arb by shorting the C 2010 2.50 call because TD would not let me short sell the common.)

 

Based on the original Citi announcement, I assumed that the M and P pfds would convert into 7.7 C shares ($25 par value divided by $3.25 conversion price). A few days later, C threw a curve ball by announcing that the conversion would be subject to exchange factors which effectively reduce the no of shares by 5% to 7.3. Last Friday, the common/pfd spread varied between 50-100%. Today that spread has narrowed to about 6-7%. So, if you had done the arb on Fri, you could unwind the positions now for a 40+% profit.

 

2) Yes, I'm naked long the C.PR.U which, I should point out, is a cumulative Trust Pfd. It is senior in ranking to the other pfds and even the TARP pfds. They are are effectively backed by junior debt securities isued by Citigroup and their dividends are funded by interest received on the debt. So, unless Citi is prepared to default on its debt payments, these pfd dividends shoudl be safe. (Citi does have a right to defer payment for a maximum of 40 quarters on the debt). Unless you think that the govt is prepared to let C go under (if they are prepared to throw almost $200b at AIG, I don't see why they would not do the same with Citi), these do look attractive at 30% yield today.

 

3) Agree that I should treat C arb and ORH separately.

 

4) Retractibles. In Q4 08, there was this ridiculous opportunity to buy BNA.PR.B at prices between $14-19 and then surrendering them at the end of each month for retraction at about $21.50. You had to take the risk of BAM going bust during the month. I considered the risk to be low but in any case I bought out of the money BAM puts for insurance. BNA.PR.B now trades at about $20.50 so you could still do the arb but for a much smaller gain. (Very low volume though.)

 

Right now, I am buying FBS.PR.B and BSD.PR.A - not so much for retraction (although the retraction rights offer a layer of protection - BSD retraction has been suspended for now though) but as a discounted and lower risk way to get exposure to Cdn banks and income trusts.

 

oec

[ericd1]

PGF is trading at a new low ~$5.50  yield ~25.5%

 

The market must believe many other banks are going to have to convert their pfds into common like C, and/or suspend pfd dividends.

 

Appreciate your comments.

 

Disclosure - I'm long PGF

[oec2000]

With the Citi deal the govt is requiring other preferred holders to convert their shares to common too. Although other large banks may not be in the same situation as Citi, it's possible some...perhaps many, would take the same path. Depending on the conversion terms, it could be good, or bad for pfd holders. If the conversion is at face value it could be a windfall, which is doubtful and if it's at some prior trading price of the common and pfd, then it is probably not good. Conversion at a current price would be close to a wash.

 

The market must believe many other banks are going to have to convert their pfds into common like C, and/or suspend pfd dividends.

 

Ericd,

 

As implied in my earlier post, I think the Citi model is likely to be followed in future by others. However, I do not see conversion to be a problem for current buyers of pfds at these distressed levels. (See how the C pfds performed after the conversion announcement.) The reason is that the conversion terms have to be set at a level that gives pfd holders an incentive to convert - otherwise, why would you convert and give up your seniority and liquidation preference of $25? Remember that conversion is optional and cannot be forced. So, there should be a premium on conversion at the time of announcement which pfd holders can lock in by shorting the common. That's why the arb trade on Citi was worth 50-100%.

 

Holding a basket rather than using an ETF gives you more control and that's why I prefer the basket route.

 

Firstly, you can buy only the Trust pfds if you want to minimise the conversion risk. (The banks can, of course, offer to convert the Trust pfds - but the terms would have to be much more attractive.)

 

Secondly, my strategy has not been to pick the pfds paying the highest yields but those trading at the largest discounts to par. Because the conversion price is the same for all pfd classes, the pfds at the biggest discount to par will have the greatest upside.

 

Thirdly, if I buy pfds at 10-15% of par (increasingly common these days), even if the dividends are suspended and no conversion is offered, as long as the bank survives, returns to health and resumes dividends after 10 years and the pfds revert to trading at par, my annualised return would still be between 21-26%.

 

To summarise, there are 4 possible outcomes"

 

a) C, BAC and WFC all fail - low probability outcome, imo. Loss would be 100% - but if this happened, even BRK would probably drop 50%!

 

b) Dividends suspended for 10 years, no conversion. 21-26% annualised return.

 

c) Conversion. Immediate gain.

 

d) Pfds continue to pay dividends. 20-30% annual return for a very long time! (WFC.PR.L is not callable by company - I could collect this 20% return in perpetuity - while sitting on a beach in the Caribbean. I may have to figure out how to survive into perpetuity though! ;))

 

 

 

 

 

[oec2000]

Stubble Jumper,

 

To get back to you on the WFC.PR.L, (sorry, so many opportunities to look into) you were correct about the conversion ratio - the Ls convert into about 6.5 WFC shares, i.e. $150 conversion price. Not much use unless we are planning to hold till 2030. Nevertheless, I like the converts because they are not callable - useful when collecting 20% p.a.

 

On HBC.PR, thanks for the recommendation. I was lucky enough to hold off buying until it went below $9 = 20% yield. Thought you might be comforted to know that Harris insiders bought these at significantly higher prices - not large quantities, to be fair. Skimmed through their 10-Q also and they appear to be in good shape.

 

oec

 

 

[ericd1]

I put together a spreadsheet with all the PDFs discussed in this thread along with a couple of others. It provides a rough calculation of possible returns if PFDs get back to some normalcy in three years. Huge uncertainty with PFDs...

 

http://spreadsheets.google.com/pub?key=pal75Wd8M5DN4QaPNLKc0IQ

 

1) Sears Acceptance - I couldn't find much in SHLD's 10K about Sears Acceptance, but it appears to hold SHLD's $4B revolver pledged against the general company's inventory and credit card receivables, etc. I'd like to think Eddie Lampert will continue to pay the PFD dividends. The 30% yield looks interesting.  Ba2/

 

2) Harris PFD Capital - Their portfolio backed by the govt and 22% yield. A1/A-

 

3) Royal Bank of Scotland - Non-payment risk, but govt plan does not wipe out PFDs ~ 10 bagger if return to par...A3/BB

 

4) Hilton Hotels QUIBS - 38% yield - NR/BB-  (owned by Blackstone Group)

 

5) Article on PFDs by Claymore regarding Citi exchange.

http://claymore.com/docs/cef/FFC/CAP%20Summary%20and%20Implications%20of%20Citigroup%20Exchange%20Offer%20(2-27-2009).pdf

 

Appreciate your commentary...

 

[oec2000]

Eric, could you please email me your spreadsheet at oec2000@shaw.ca? Thanks.

[oec2000]

Also, just wanted to point out that SGP Pfd is mandatorily convertible into common - just in case anyone is thinking of buying it.

[Guest misterstockwell]

The bell rings this morning for the SGP preferred as Merck is buying SGP

 

Finally some good news

[ericd1]

I found a useful feature at my Fidelity account. They offer a 'basket' trading application. You build the basket of securities you want to trade, indicate the dollar amount of each, or shares, etc...and trade the basket w/a reduced commission structure. I used the feature to pick up a basket of PDFs as suggested. It was alot easier and less expensive than making multiple trades. 

[Carvel46]

ericd1,

 

What's the commission structure? My understanding was that Fidelity baskets charge a commission per stock within the basket you create.

 

 

[ericd1]

The commission was $40.00 for the basket of five PDFs...That's a little less than my usual $9.95/per trade.

 

Wishful thinking, but I'd sure like to see the basket's 16.5% yield continue for a long, long time - That's more than double the yield I was expecting to receive in retirement 5 to 10 years down the road. Plus there's huge appreciation potential. There's risk, but if the five major banks in the basket stop paying then we'll be faced with bigger problems. With a conversion, I expect to at least b/e.

[cman]

http://www.bloomberg.com/apps/news?pid=20601213&sid=agPsi3R8BaWM&refer=home

 

I bought some more pfd's on Monday (USB).  Holdings are WFC L, PNC L, BAC E, USB L.  I may now sell the USB L for the USB H which is a floater (i see significant inflation on the horizon) as the yield differnetial is now lower and it trades at 40% of par.  USB is the most absurd to me.  There are few circumstances where USB common equity gets wiped out and the financial system/ economy survives.  They generate strong earnings (equivalent to 5% of the loan balances before taxes and loan loss provisions) of which 1/2 are fee driven and they have adequate capital such that the common is unlikely to be diluted by a stress test.  The preferred is in very strong shape despite being noncumulative.  I bought this at 50% of par and a 16% yield!  Using Obama tax rates of 20% divi and 39% marginal this is the equavalent of a 21% fully taxable yield.

 

[oec2000]

Cman, nice catch on USB L! I missed it myself - too many preferreds to monitor! ???

 

I have a question for you on taxation of pfds. Is 20% the highest tax rate on eligible pfd dividends for individuals? What rate do corporations have to pay, if any on these dividends? (Trying to figure out whether pfds would be a great tax advantaged investment for FFH/ORH.)

[dcollon]

OEC,

 

It depends on the structure of the preferred for tax treatment.  Trust preferreds and enchanced trust preferreds dividends are taxed at the ordinary income tax level (in taxable accounts). The reason is the dividend is deemed interest income since the trust owns debt securities. Straight preferreds qualify for the the reduced dividend tax level. 

 

The prospectus should have all the detail you need.

 

Hope that helps.

 

 

[cman]

trust preferred = interest income

preferred stock = dividend income

 

from a US corporations perspective...

 

interest income = taxed at corporate rate

dividend income = taxed at corporate rate after a "dividends received deduction" of 70%

so for example, on buffett's GS pfd's he gets 10% less a tax of 10% x (1-70%) x 35% =  1.05% tax / 10% dividend or a 10.5% effective tax rate

[oec2000]

Thanks, dcollon and cman! I've not bothered about reading the tax provisions on US pfds in the past because I'm resident in Canada and don't qualify for the preferential treatment unfortunately.

 

But, it is interesting that they could be highly tax-efficient for BRK and FFH. More after tax income for them and an indirect way for Canadians to benefit!

[cheapguy]

Posted this on FFH section also.

===============================

 

This is a basic question on preferred shares.

 

Can the companies start buying their own preferred shares from open market, without any announcement ?

 

Do they need any approval from common stock holders or regulatory bodies ?

 

With so much discount from the par value and such high yields, what could be stopping them from buying and retiring the debt ?

 

[dcollon]

I thought some of you might find the comments (below) from a sell-side firm interesting.  Some of what is mentioned has already been mentioned in this thread. 

 

A few people have asked me about going long C common and for my long-term shareholders and those that can trade the prefs I would take a look at the following...

 

You can buy the C P pfd = currently trades at $13.11

 

...each C P pfd will be exchanged for 7.30769 shares of C common - meaning you create C common at a price of $1.82 a share roughly - this at a time when the common is trading at $2.49 - a pretty meaningful pick-up.

 

Why is the spread this wide? because people can't get a borrow in C to set the arbitrage up and there is a finite amount of buyers in the pref market. We think the swap could take anywhere from 6 weeks to 3 months to complete.

 

For guys who already own C common when they took a flier on it down near $1.00 you can sell your common here and buy the pref and essentially get back in the stock at 60c discount and lock in the gain on the flier you took. This trade is for those more bullish on C long term that (1) have to own because it’s part of the index and (2) think that C survives and is worth $5.

[oec2000]

Why is the spread this wide? because people can't get a borrow in C to set the arbitrage up and there is a finite amount of buyers in the pref market. We think the swap could take anywhere from 6 weeks to 3 months to complete.

 

For guys who already own C common when they took a flier on it down near $1.00 you can sell your common here and buy the pref and essentially get back in the stock at 60c discount and lock in the gain on the flier you took. This trade is for those more bullish on C long term that (1) have to own because it’s part of the index and (2) think that C survives and is worth $5.

 

For those who missed it the first time round and are still interested, the spread is even better today! Pfds still at $1.80 equiv and C at $3.10. That's a 70+% return on the pfds! Too bad my broker won't let me short C. >:( 

 

There is a solution, though. You can create a synthetic short by simultaneously selling the calls and buying the puts - costs a bit and ties up some margin but well worth it still, imo.