Preferred Stocks

[Guest JackRiver]

Would you guys want to now buy some puts on the common?

 

Yours

 

Jack River

[ericd1]

Good question Jack...I previously considered puts on PGF (post above)...BAC and WFC are also candidates...But I decided not to hedge because of the Treasury statements regarding additional capital and news leading up to the stress test announcements.

 

That said, I was surprised the bank pfds didn't sell off today...

 

What do you think...Appreciate your comments...

[Kiltacular]

hey eric,

 

Wouldn't additional equity raises be good for the preferreds....or are you thinking that preferred holders may be forced to convert to common well below par a la the Citigroup deal.

[dcollon]

Shorting the common against the preferred has not worked as well to this point, but Jack it's a good question that I'm sure you have thought about a lot given your knowledge in this area (I have been reading your comments on the Ackman/Rose roundtable).  Eric, puts are an interesting idea, but the premiums are pretty steep.

 

The conversion on Citi is still floating around out there and it's going to be interesting to see how it's finally structured.  The outcome will help me understand how to play some of the more speculative securities going forward.

 

Kiltacular, I don't think any of the trouble banks would be able to issue equity at this point.  My feeling is that any equity raise will come from conversions of preferreds, whether or not that is the right approach is up for debate.

 

I guess you could argue that JPM, WFC, USB could raise common equity, but I don't think Mr. Dimon believes he needs to and I'm not sure that Mr. Stumpf and Mr. Davis do either. 

 

I have simply been trimming some of the preferreds and reducing the size of the bet.

[ericd1]

I read over the CAP program provisions and other than jr. pfds possibly having their dividend omitted I didn't see anything that troubled me. There are not any provisions for conversion of existing pfds like Citi, but I suppose conversion could be initiated on a case, by case basis. So far the pfd market doesn't seem to be negatively anticipating/reacting to the stress test info, which is good because if the pfds go in the dumpster, the ripple effect across the entire financial industry will be not be pretty.

 

Question - If a bank is seized by the Treasury and taken over by another bank don't the pfd's transfer to the new bank? (Merrill Lynch, Wachovia, Countrywide, etc)

 

[dcollon]

Eric,

 

I think one would have to evaluate the difference between "truly" seized vs. merged.  As you pointed out the examples you cite were distressed mergers.  I would take a look at WM and a few examples like that to get a broader view of what can happen.

 

 

[ericd1]

Good point DC...you are correct, in the mergers the pfds survived, would not happen in a 'seizure.'

[cman]

An update.  Many of the preferreds discussed on this board have proven to be very profitable investments thus far.  In particular, I have been a fan of the WFC L, PNC L, USB L and BAC E.  Those are all up a lot, but I will continue to hold to avoid taxes and because the weighted average yield on my preferred portfolio is still ~10% vs. the 1% in my Schwab checking account.  As for the BAC, I believe that the best thing that could happen is that the government forces BAC to convert preferreds to common in the manor required of C.  The C's are trading at 70 cents with an arb spread of an additional 18 cents (although there is an ongoing C short squeeze) vs. the BAC E at 38 cents. 

 

I have been adding to another holding recently: the USB H.  This is a fixed/floating issue that has just started moving up a bit.  It trades at $13.44 with a paltry 6.5% yield (I bought around $11.25 and would not add to the position unless it fell back to that range).  However, if you believe that rates will be materially higher in the future, this is a nice hedge as the floating yield is max 3.5%, L + 60.  USB will never call the security because of the low spread.  At 54 cents on the liquidation preference dollar with USB being a strong issuer, there is a hefty margin of safety here. 

[ericd1]

Cman - I would prefer the pdf's not be converted, as my average yield is well above my long-term market returns. But, sometimes when things are too good to be true, they indeed are too good to be true! Remember Bernie (That's in Madoff, and if you are old enough Cornfield too!)

 

If some pfds are converted as a result of taking additional CAP funds, the question is when and at what price/conversion ratio?

 

The new government pfds are very expensive (9%) and with the run up in most bank stocks, the conversion to common is currently very favorable to the govt., but that will likely change with the potential share dilution and future business results. Although it's unlikely needy banks will find additional private equity, they will likely exhaust all other funding avenues before accepting CAP monies.

 

CAP Provisions --

# Capital provided under the CAP will be in the form of a preferred security that is convertible into common equity at a 10 percent discount to the price prevailing prior to February 9th.

# CAP securities will carry a 9 percent dividend yield and would be convertible at the issuer's option (subject to the approval of their regulator).

# After 7 years, the security would automatically convert into common equity if not redeemed or converted before that date.

 

There is no verbiage in the CAP program about converting other pfds, even when the CAP pfds are converted...But as we know, that could change.

 

CD - Anything new on the C conversion?  Appreciate your comments

[ericd1]

Strategy question - The band and REIT PDFs have made a great run and I want to thank the board members for sharing their suggestions.

 

Let's say in March an investor purchased $100k basket of pfds yielding ~20%...in time they could trade close to par and the basket would be worth ~$285k and the yield would approach the average coupon of 7%. They are held in both taxable and tax advantaged accounts. The taxable dividends receive the QDI tax rate 15%.

 

Here's the question - How would you look at the basket when it is eventually actually yielding 7%. Do you take the profits and re-invest in equities anticipating 10-12% future returns, or let the dividends run under the premise they are generating 20% returns on the initial investment and then reinvest the dividends in equities?

 

 

 

 

 

 

[netnet]

Leaving the tax issue aside, your past decisions should not influence your present decisions.  Look at what your opportunity cost are today.  If you would buy that 7% security today then don't sell; if there is something better to buy don't hesitate, liquidate and move on.  Sunk costs are (or should be) totally irrelevant to your decision making.  Suppose for the sake of argument you had bought the pfd's at 3% rate and now they are yielding 7%.  Again it is irrelevant. If there are better thing to buy, then you should buy them. If there are not then keep them. (The only caveat is a portfolio management question of over exposure, i.e. the price move has concentrated your portfolio more than you wanted it to be, but that was not your question.) 

 

Part of your question "anticipating 10-12% future returns" is troubling.  Sounds like you are waving the wand of wishful thinking.  Are you saying that historically the returns on the market have been that or that you have generally beaten the market by that or is the before tax return...exactly what do you mean by this?

[Junto]

I think netnet is right on regarding opportunity cost and I believe that it should be the driving factor.

[ericd1]

...Sunk costs are (or should be) totally irrelevant to your decision making...If there are better thing to buy, then you should buy them. If there are not then keep them.

 

Part of your question "anticipating 10-12% future returns" is troubling.  Sounds like you are waving the wand of wishful thinking.  Are you saying that historically the returns on the market have been that or that you have generally beaten the market by that or is the before tax return...exactly what do you mean by this?

 

Net - Appreciate your comments about opportunity costs and agree with you 100% setting aside other factors like risk, etc.

 

However, my question wasn't totally clear...and perhaps it is still evolving...I was wondering about fixed income (pfds) calculations, which I'm not totally familiar with...and how to factor in risk to get a better understanding of portfolio risk-adjusted returns going forward.

 

For example on the fixed income return...Wouldn't the $20K dividend on an average investment of $192,500 (100+285 / 2) provide a yield of 10.4%? 

 

That's very close to my personal 40+ years investment average annual return of 10.2% (Quicken-IRR pre-tax calc) which is virtually all from equities. (not great, but I'm happy). While there's interest rate and issuer risk with the pfds, the risk-adjusted returns going forward appear to be very favorable to my experience and expectations of 10-12% future returns. If, so then I should hold them. If not, as you suggest move on.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

[valuecfa]

I'd like to thank this thread as well. I would have not thought to even look at the bank preferreds & TRUPs were it not for this thread. My only wish is that i had read it sooner.

 

Trying to do my part, I'll throw out a few others that are interesting (to me) HJA & DKR. These are SATURNS (Structured Asset Trust Unit Repackagings), The Hertz Corp. Debenture Backed, Series 2003-15, 7.00% Class A Callable Units, issued in $25 denominations. Underlying securities are the 7.625% Debentures due 6/1/2012 issued by The Hertz Corp. Distributions of 7.00% ($1.75) per annum are paid semi-annually on 6/1 & 12/1 to holders of record on the third business day prior to the payment date. The ex-dividend is coming up soon (and being a semi-annual payment is nothing to sneeze at). For further due diligence on Hertz, the Fairholme Fund's website has a great analysis of the company through their link to a recent OID interview. Bruce owns Hertz bonds as well as the common. Once caveat is that these are very illiquid exchange traded instruments, that have had a big move up recently (along with everything else). They do not qualify for the 15% tax treatment, and they have a $25 par maturity date of 6/01/2012.

 

Their is another illiquid pref, on a well known company that i am near finished in building a position in, that i will mention shortly.

 

As an aside, I am using for sorta money market purposes the MBNA TRUPs, symbol KRB-D (along with WFC-L), which have a current yield of 11.7%, and i perceive as very safe instruments. MBNA Capital D, 8.125% Trust Preferred Securities (TRUPS), Series D, liquidation amount $25 per share, guaranteed by MBNA Corp., now a part of Bank of America. This is hardly a money market, yet that is how i am using it with the 5 - 10% of portfolio parking place (combined with WFC-L, which is have been recently lightening up on).

 

Discussion is welcomed on the riskiness of the above issues.

 

Once again, this has been a very helpful thread. Thank you.

[dcollon]

More on Citi:

 

I wanted to come back to Citi and highlight an opportunity that I still think exists in the series "g" Citi pfd. 

 

Everyone can pull up the quote, but the Citi g's are roughly $20-21.  There has been and S-4 filed and the conversion process should start soon (historically speaking).  It would then be about 20 days for the transaction to take place.  Obviously, this is much different environment so you have to factor that into your risk tolerance.

 

The exchange is likely to be 95% of par with a $3.25 common exchange price.  The total return at current levels would be north of 20%.  I know it's not the 100%+ returns that some of us have seen in this space, but the annualized results are pretty nice.

 

Now the ideal situation would be to short common against the preferred, but that might be tough to do.

 

This isn't for everyone, but I thought I would bring it up just in case some might find it interesting.

 

[valuecfa]

The large spread still exists in the 'AA' preferred too (as well as the other prefs being converted), of which i will continue to hold. It is funny that the TRUPs are yielding more than the prefs in several of the banks, some b/c of conversions (Citi) and some just b/c of the current anomalies in the debt markets. Citi being one. Bank of America's MBNA notes being another where the current yield on the debt is higher (or the same) than the preferred despite having a higher capital structure position.

[ericd1]

DC - I read the C S-4 Amended and it appears there's decent upside potential for several of C's pfds even though they've up quite a bit recently.

 

For example C-U, the Cap XV 6.0% is trading for $17.70...it will convert into 7.3 shares (25.00x95%/3.25).

 

Based on today's C price of $3.75 that's a potential 55% gain ($3.75 x 7.3 = $27.41 vs $17.70)

 

Besides the risk of the stock trading down, am I missing something here?

 

Disclosure - I'm long C-U.

[dcollon]

Hi Eric,

 

I'm not completely up to speed on all the different series, but I would agree that some of them (not just Citi's) are still interesting.  You want to make sure that the series you are looking at will be converting.  I know that sounds obvious, but some people I have talked to have mistakenly bought trust preferreds or enhanced trust preferreds that aren't converting.

 

I have also heard rumblings today that Citi is going to follow BAC's lead and do a large common raise.  Just rumors.

 

Take care

[oec2000]

Besides the risk of the stock trading down, am I missing something here?

 

Eric, I haven't read the S-4 but from Citi's earlier releases about the Pfd exchanges, only $5.5b of trust pfds will be converted. C.PR.U ranks too low in the list of trust pfds to be converted. Even C.PR.O, which ranks ahead of the U's, will only be partially exchanged so I don't understand why the mkt is pricing it so high.

 

I have sold my U's because I think they are mispriced - they should be priced more in line with the E's and W's.

 

[ericd1]

DC - Thanks - understand about the different series...the Cap XV's are listed in the S-4.

 

Hopefully the dilution from a common raise would make the business stronger...

 

These are interesting times...

 

Best / E

 

[watsa_is_a_randian_hero]

anyone buying bac preferreds in anticipation of conversion offer? BML PRJ still trades @ 10 on 25 par.

[oec2000]

I wanted to come back to Citi and highlight an opportunity that I still think exists in the series "g" Citi pfd.

 

I discussed this arb trade on this thread when the exchange offer was first announced in early March and the spread was >50%. Bought the I's around 14-15 and sold Citi calls (because I was not able to short the common) which resulted in an effective cost per C share of $0.65.

 

Buying the pfds now would give you a much higher effective cost per C share of $3. Unless you can short the common to lock in the spread, I would advise caution in trying to do the arb today for a 20% return. A huge amount of Citi common (>>20b shares) will be issued through the exchange offers and it is difficult to tell what will happen to the price of C when all the "arbs" try to close out their positions.

 

To the extent that many arbs are "naked" arbs who did not actually short the common (this is likely because of the difficulty in borrowing stock to short), you can expect a rush to to sell when the exchange is completed. 20% does not provide an adequate margin of safety, imo.

 

 

[oec2000]

anyone buying bac preferreds in anticipation of conversion offer? BML PRJ still trades @ 10 on 25 par.

 

The problem with trying to do this is that the risk/reward ratio is not so attractive now that potential conversion is somewhat built into the pfd prices.

 

The other problem is trying to figure out which issues will be given priority in the event that only a partial conversion is done (as for the C trust pfds). Logically, the highest coupon pfds can be expected to be given priority. Unfortunately, you will see that these high coupon pfds already trade in the high teens.

 

My guess is that the BML J's will be low on priority because of the low coupon. You should only buy if you are happy owning it even if there is no conversion. Conversion will then just be icing. (I do hold the BML H's which are even lower coupon but I bought them when they were below $3.)

[ericd1]

Thanks OCE, you are correct - only Cap XIX (F), Cap XX (G) and Cap XXI (?) will not be pro-rated. And Cap XIV is ahead of XV...

 

Evidently Mr Market thinks they'll convert more shares, or as DC suggested some folks can't read (like me!)

[oec2000]

Thanks OCE, you are correct - only Cap XIX (F), Cap XX (G) and Cap XXI (?) will not be pro-rated. And Cap XIV is ahead of XV...

 

Imo, the most logical arb trade right now is to short the C-O and buy the C-S. If only my broker would let me do the short....... :'(