InvestmentNews; By Ilana Polyak - November 2007
While holders of Citigroup Inc. common shares weigh the possibility of a dividend cut, owners of the financial giant's preferred stock are sitting pretty.
Because preferred stocks take precedence in a company's capitalization structure, holders of these hybrid stock-and-bond securities have no fear since they'll collect their yield no matter what fate befalls holders of common stock.
"If a dividend payment is missed, cumulative preferred stocks, which most preferred issues are, must pay all accumulated dividends in arrears before common stock holders get theirs.
"If a company cuts its dividend or stops paying the dividend, that means that it's not wasting money on common shareholders and that means there's more money available to meet the preferred obligation," said Bernard Sussman, executive director and chief investment officer of Spectrum Asset Management of Stamford, Conn., which subadvises three closed-end funds from Chicago-based Nuveen Investments LLC that hold preferred stocks. "That's usually good news for our market."
In exchange for this relative security, preferred-stock investors accept less price appreciation than equity- stock shareholders might expect. In fact, the instruments perform more like bonds, though issuing preferred shares doesn't usually add to a firm's debt-to-capitalization ratio.
"In order for a company to stop payment on a preferred, it would first have to stop payment on common stock," explained Barry McAlinden, preferred-stock strategist with UBS Wealth Management Research in New York. "As long as they're paying something of the dividend of a common stock, they'll pay the dividend of a preferred."
Even if such a move doesn't affect preferred dividends, preferred stocks have also taken a hit because of the same grim news in the financial sector, where the majority of preferred stocks are issued. Prices have fallen drastically, leading to rising yields, since —as with bonds — prices and yields have an inverse relationship.
A dividend cut signals that cash is becoming scarce at a company, as occurred with Citigroup. And that eventually concerns holders of preferred stock, as well. "We certainly want [the companies] to make money because they're paying the preferred dividend with after-tax money," said Don Crumrine, chairman of the board of Flaherty & Crumrine Inc. of Pasadena, Calif., a money management firm with six preferred funds.
Last month, Citigroup announced a third-quarter profit decline of 57% as a result of losses related to mortgage-backed securities and leveraged-debt write-downs. Earlier, the company suspended a stock buyback program, citing a cash crunch.
On Nov. 1, Meredith Whitney and Carla Krawiec, New York-based analysts with CIBC World Markets Corp., raised the specter that Citigroup, whose common stock has been in free fall, might be forced to slash its $2.16 per-share dividend in order to "shore up its capital structure."
Preferred stocks have followed these price swings, too, though not to the same extent.
"They usually trade more like fixed-income instruments that are influenced by the level of long-term interest rates," said Mr. McAlinden of UBS. "What we've been seeing recently is [a closer] correlation with equity prices of [financial] stocks, which typically happens when a sector is under pressure."
Ordinarily, said Jeremy Jones, director of research with money manager Richard C. Young & Co. in Naples, Fla., preferred stocks should fetch between 0.5 and 2 percentage points more than the 10-year Treasury bond yield of 4.26%. Today, however, the stocks are yielding up to 3% more.
"Some of the preferreds we follow are trading as if they were junk," Mr. Jones said.
For example, Bank of America preferred stock with an A-minus rating from Standard & Poor's and Aa3 from Moody's Investors Service was recently fetching a 7.6% yield, while an issue from Minneapolis-based US Bancorp, with an A rating from both New York agencies, was yielding 7.4%.
"At these types of spreads, it's a phenomenal time to be buying," Mr. Sussman said.
Investors eyeing the preferred market are advised to think long-term. Because of the turmoil in the financial sector, yield rather than price appreciation should be the primary objective. In addition to purchasing individual issues, often sold in increments of $25, investors can also find diversified open-end and closed-end offerings. PowerShares Capital Management LLC of Wheaton, Ill., sponsors an exchange-traded fund of preferred financials called PowerShares Financial Preferred and a new, broader ETF called PowerShares Preferred Portfolio.
