Portfolio Strategy: Will call window

With news of strong growth one day followed by signs of economic sluggishness the next, markets continue to seek direction. "It has led to a lack of differentiation between debt classes and between equity and corporate bond performance," observes Arthur Tetyevsky, a senior vice president and capital securities strategist at Lehman Brothers in New York. In the current environment Tetyevsky recommends subordinated securities like preferred stock that offer yields above those of comparably rated bonds with limited additional risk. Within the preferred stock sector, he says, "quality foreign issues are the most attractive shares around."

A once-obscure corner of the capital markets -- dollar-denominated preferred shares issued by non-U.S. companies -- is attracting more attention. This market sector, which got going only in the early 1990s, now boasts a total capitalization of about $100 billion. Spreads on foreign preferred shares can easily exceed 50 basis points above comparably rated U.S. securities. Notes Dan Campbell, who headed the global capital securities divisions at Merrill Lynch & Co. and Deutsche Bank in New York for 20 years and now works as a consultant in investment banking and capital markets, "These shares can boost yields of fixed-income portfolios and offer low-risk ballast to equity-heavy portfolios."

Among the leading issuers is Royal Bank of Scotland Group. Since 1991, when the bank started selling U.S. dollar preferreds, it has raised nearly $9 billion. The average current yield of its shares exceeds 7 percent. In contrast, various preferred series from Lehman Brothers yield less than 6.5 percent. Moody's Investors Service rates RBS A1 and Lehman A3; Standard & Poor's rates RBS A and Lehman BBB+.

Yield-hungry insurers, the dominant buyers of foreign preferreds, own about 40 percent of the sector's outstanding shares.

In explaining his appetite for foreign preferreds, Bernard Sussman, chief investment officer at Stamford, Connecticut­based Spectrum Asset Management, argues that he's achieving the best risk-return scenario by "trading down the capital structure in very good companies instead of investing in the senior paper of more troubled firms."

William Scapell, co-manager of New York­based Cohen & Steers Capital Management's $2 billion closed-end REIT and Preferred Income Fund, is pursuing a similar strategy. About one third of the fund's preferred holdings are foreign issues. Among them: Zurich Financial Services' 8.375 percent, Baa2/A­ rated capital trust preferreds, which have a current yield of 7.43 percent. "These are by no means guaranteed investments," Scapell says, "but they look like very good bets."

Foreign companies issue preferred shares in the U.S. for three reasons: to diversify their funding sources, to help fortify their balance sheets and, occasionally, to finance dollar-based acquisitions and assets.

The foreign preferreds that first came to market were retail issues, traded as American depositary receipts; they have a current market cap of about $25 billion. Then in 1996 the Federal Reserve Board determined that U.S. banks could issue preferred shares as tier-1 capital -- permanent equity capital that is set aside to offset risks. As a result, the market for preferred shares -- including a new variant, dollar-denominated institutional preferred shares issued by non-U.S. companies -- took off. Foreign institutional preferreds now have a market cap of nearly $75 billion.

Most foreign institutional preferreds carry synthetic maturities, meaning that they have provisions that make it likely that issuers will call the securities at the earliest possible date. Otherwise, as Merrill Lynch's preferred-stock specialist, Kevin Conery, explains it, the dividend will rise by a prearranged step-up, something most borrowers try to avoid.

The synthetic maturity remedies one of the sticking points of most retail preferreds -- their lack of maturity. An investor can calculate a yield to maturity for a bond to determine what he will walk away with, but a yield to call is a less meaningful metric because many preferred issuers are not obliged to call. When a company does call an issue under this arrangement, it's usually done when the cost of refinancing is less than the coupon on the outstanding issue. A yield to call for preferreds with synthetic maturities is like a yield to maturity. It thus mitigates a significant element of risk of investing in the preferred market.

A sampling of dollar-denominated preferreds issued by non-U.S. companies returned an average annual 7.01 percent from the end of 1997 through July 2004, reports Cohen & Steers's Scapell. In contrast, Merrill Lynch's global benchmark of preferred stock, its master preferred index of 292 issues, both foreign and domestic, returned an average annual 6.72 percent for the same period.

What accounts for the juicier payouts?

"It's not because they have inferior financials, less reliable accounting standards or questionable management," notes Mark Maloney, co-manager of the John Hancock Patriot Global Dividend Fund. "They're just foreign, and domestic investors have always demanded a premium yield for sinking their money into them." Patriot Global, a leveraged closed-end income fund that invests in preferreds and utility shares, keeps 5.1 percent of its $165 million in assets in foreign preferreds.

Foreign yields are also higher because the size of the issues tends to be smaller than those of U.S. corporate preferreds and the shares are more thinly traded. They attract only minimal research coverage. Like domestic preferreds, foreign issues yield more than comparably rated debt because they don't ensure dividend payment or capital redemption. Many are perpetual -- they don't mature -- and noncumulative, which means that if the issuer temporarily suspends the dividend, the shareholder may lose dividend payments even if the company regains its financial footing. Because many preferreds were issued when interest rates were higher than they are today, a number of foreign preferreds are trading above their call prices. Investors frequently demand a premium return when buying above the call price, because they are taking on additional risk that the shares could be called.

Spectrum's Sussman keeps about 30 percent of his firm's total assets of $11.5 billion in foreign preferreds. He predicts that demand for the securities will increase when new investment guidelines are issued -- which should happen this year -- by the National Association of Insurance Commissioners. Like the Financial Accounting Standards Board in the accounting profession, the NAIC recommends regulations that guide state insurance agencies, which in turn set policy.

Because preferreds are lower down the capital structure than bonds, the NAIC had required insurers to set aside a capital reserve of 1.1 percent on A- or higher-rated preferred investments, versus only 0.4 percent for bonds with equivalent ratings. Under pressure from insurers who want to buy more foreign preferreds, the NAIC is expected to change the rule so that preferreds and bonds have the same set-aside requirements. This will almost certainly encourage insurers to increase their exposure to preferreds. "This increase in demand," Merrill Lynch's Conery speculates, "should drive prices up and reduce the spread between preferreds and comparable bonds."

For tax purposes, U.S. institutional investors often opt for a particular segment of the market known as dividend-received-deduction preferreds. The dividends on these preferreds are 70 percent exempt from corporate taxation. Most are issued by U.S. corporations, but through mergers with American companies, some foreign names have acquired existing DRDs or issued new ones.

For example, after U.K.-based HSBC Holding took over Republic National Bank in 1999, the bank holding company issued a new DRD preferred. Currently trading at par on the New York Stock Exchange, rated A3 by Moody's and callable in October 2007, the security has a yield to call of 5.81 percent. For qualified corporations in the 35 percent tax bracket, the equivalent taxable yield is 8 percent.

The market for foreign preferreds expanded significantly with the introduction of eurodollar perpetual preferreds, also known as EurAsian preferreds. They were first issued in the third quarter of 2002 by European and Japanese investment-grade banks and insurers in their home markets and were simultaneously made available to U.S. institutional investors in the secondary market.

Since then the EurAsian market has grown from $650 million to $11.8 billion, according to Philip Jacoby, a portfolio manager at Spectrum Asset Management.

Although most investors look for call protection of no less than two years, Spectrum's Jacoby occasionally sees opportunities in preferreds with shorter call dates when the coupon makes it worthwhile. Three years before it was acquired by HSBC in 2003, Household International issued a 10 percent, $25 preferred. Currently trading well above par at $26.75, it's callable in June 2005, less than the two-year window most investors look for. But because HSBC will most likely call the security because of its very high coupon, Jacoby expects to pocket the current yield to call of 2.73 percent. Nothing spectacular. But he sees the play as a cash surrogate, generating 75 basis points more than what one-year Treasuries currently offer.