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The Preferred Stock Puzzle

Banks that had big losses and were bailed out should, in theory, have suspended preferred-stock dividends. They didn’t, creating a value play — and confounding notions of capital structure.

Most observers expected big banks that survived the credit crisis to reflexively suspend preferred stock dividends to husband cash. Instead, virtually all banks — domestic and foreign — continued to pay dividends on their U.S.-traded preferreds.

“I surmise that banks kept on paying because to do otherwise would have been a confidence killer, and in today’s market environment, they simply couldn’t afford not to pay,” says Brian Gonick, a principal of Senvest International, a New York hedge fund.

The continued payments imply that “preferred stocks may offer greater returns with less dividend suspension risk than we had thought, especially given the severity of the crisis,” explains Barry McAlinden, a preferred securities analyst at UBS Wealth Management Research. “The results have been common equity–like returns from large-cap investment-grade bank preferreds.”

In fact, bank preferred stocks haven’t been behaving at all normally, considering their place in these institutions’ capital structure. “For the first time since the 1980s, when preferreds started to become a major source of bank capital financing, these shares got pummeled indiscriminately” in the financial crisis, observes Daniel Campbell, the former head of hybrid securities at both Merrill Lynch & Co. and Deutsche Bank. Although preferred shares are considered income securities whose prices move in response to interest rates, credit issues and yield spreads, many bank preferreds ended up tracking common shares, Campbell says, as fear of insolvency, reorganization or nationalization slashed their values to unprecedented lows.

For example, Deutsche Bank saw one of its $25-par trust preferreds, which are backed by subordinated debt and pay a coupon of 6.375 percent, collapse from $20 in mid-2008 to below $5 in early March 2009 — producing a yield at the time of nearly 32 percent. Investors who didn’t buy the end-of-the-world scenario could have made out like bandits: On January 14 these shares closed at $23.63.

Although such extreme opportunities are gone, there is still significant dislocation in the preferred market, making it one of the most attractive places to invest, according to William Scapell, head of fixed income at New York–based mutual and hedge fund firm Cohen & Steers. Until recently, he notes, preferreds were typically rated two notches below senior unsecured debt, reflecting their place in the corporate capital hierarchy. “Today,” says Scapell, “we are seeing much greater rating gaps, and that is putting further pressure on preferred prices.” For example, whereas Citi’s senior debt is rated A, its hybrid preferreds are rated eight notches lower, at B plus.

This differential is making for generous yield spreads on bank preferreds. In late December the BofA Merrill Lynch Core Fixed Rate Preferred Securities index of investment-grade securities was 400 basis points above ten-year Treasuries. Scapell acknowledges that investors view bank preferreds as risky and also anticipate rising Treasury yields. But, he says, he doesn’t foresee “a second wave to hit banks because the toughest news is already behind us.”

Perhaps the most intriguing opportunity in preferreds revolves around corporate actions: tendering cash, common stock or fresh preferred shares for existing preferreds or even warning of a dividend suspension. In February 2009, Citigroup said it was suspending dividends on certain perpetual preferreds. But investors were offered the chance to exchange each of these shares for 7.3 shares of common.

At about this time investors realized the government was committed to seeing Citi through the crisis without nationalizing it, which helped propel the bank’s common shares from less than a buck to $5. Thus those who converted and held the common for a month saw their investments peak at an equivalent of more than $36 per share. Before the conversion was announced, affected preferreds were trading below $5.

Even after this recent run-up, Senvest’s Gonick believes that preferreds whose dividends are threatened with suspension are attractive plays and likens them to zero-coupon bonds. If the dividends are reinstated in two years, investors could see these shares climb by a third or more. Announcement of an exchange offer could give a similar boost.

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