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Bank Preferred Stocks – A Good Alternative to Bonds: Bank of America Corp (BAC), Citigroup Inc. (C)

Preferred stocks issued by banks are a good alternative to bonds in a portfolio.  They provide a relatively high yield (5% to 8%) and will change little in value as the yield curve steepens.

Preferred stocks have characteristics of both stocks and bonds.  They are like stocks because they trade on equity exchanges.  They are like bonds because they pay a fixed dividend.  Investors in preferred shares get no voting rights with the company though.  Some preferred shares are callable which means that the company that issued them has the right to buy them back at a specific price whenever they want.  Most bank preferred shares that trade today are callable and this is what makes them a good investment now.

Bank of America Corp (NYSE:BAC)Here is a list of preferred shares that are currently trading.  All major banks, Bank of America Corp (NYSE:BAC), Citigroup Inc. (NYSE:C), Deutsche Bank AG (NYSE:DB), Goldman Sachs Group, Inc. (NYSE:GS), JPMorgan Chase & Co. (NYSE:JPM), etc. have issued preferred shares that are publically traded.

Due to details within Basel III, the new bank capital requirements, preferred shares aren’t as beneficial to banks as they were before.  In the past, banks issued many series of preferred shares to strengthen their balance sheets.  Since there is less weight put on preferred shares in new regulations, banks are slowly buying – or calling – back the preferred shares they have issued.  The call price on many of the instruments is $25.  The expectation is that banks will, over several years, call back all of their preferred shares.  The problem is that no one is exactly sure when they will be called.  As a result, most of the issuances of preferred shares are trading within a few percent of their call value.  Until the shares are called, the instruments will continue to receive the fixed dividends.  Though since all preferred shares are issued slightly differently, check the prospectus for the specific series you are interested in investing in to make sure you understand the terms.

Like bonds, if the company goes bankrupt, the entire investment in preferred shares can be wiped out.  I am confident that won’t happen to any of these large banks any time soon though because of the strenuous stress tests the banks are put through yearly.  I am much more concerned about these preferred shares being called back soon.

Many of the issuances of preferred shares are trading at a level where the holder loses no money as long as 1 quarterly dividend is paid before the shares are called.  This presents an opportunity because there are enough issuances of preferred shares outstanding for the banks that many of them won’t be called back for a year or more.  As recently as October, Bank of America called several series of preferred shares back.  I expect more announcements like this in the next few months because by April, banks should get their capital plans for the next year approved and several will probably want to buy back higher yielding preferred shares they have issued.  Having the shares called could happen at any time for the existing shares but until then, investors will collect the dividend (often 6% to 8% annually) but will lose 1 to 2% of the purchase price of the shares when they are called.  Since there is risk of the shares being called soon, the price won’t rise too far above the call value because investors are ready to sell these once the price is a couple percent above the call value.  Also, the shares won’t fall too far below the call value because buying these below the call value presents a good opportunity for investors to make some money with little risk.

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