As active conservative money managers, we at Portfolio Asset Management sought a way to capture appreciation from devastated financial stocks and yet have an increased chance of dependable high yields. With a focus on cash flow, an outgrowth of the demographics of our core retired investor, we began buying financial preferred stock this summer.
The common stock of large financial firms dropped dramatically in 2008. The environment of deleveraging and uncertain future earnings, not to mention the continuing risk of bank failure, tempers the allure of buying into this market plunge. Swapping common stock for debt that trades on an exchange with a daily quote versus the problematic bond pricing systems, makes financial preferred stocks a viable alternative-but not just any preferreds.
We consider the following three factors when investing in financial preferreds. First, understand the company. Research the firm and make sure it can continue to pay the preferred dividend! Second, don't chase yield for yield's sake. The yields on Lehman and Bear Stearns were extraordinary until they went belly up. Third, understand the security's structure. Is it at a big discount to the call value? If not you may give up capital appreciation if spreads tighten or the firm improves in the minds of investors. Is it liquid? What is the security backed by, the firm or an obscure subsidiary?
With these factors in mind, we recently added to our core portfolio Citigroup Inc., 8.125% Depositary Shares Series AA Non-cumulative Preferred Stock (NYSE: C-P, C-PP, C/PRP).
Issued early this year, the preferred had lost around half its value as confidence in Citigroup and the sector continued to erode. Early this year we decided against Citigroup as a potential preferred due to the uncertainty of its survival. However, since then, a few things have happened that caused us to reassess the situation. While the firm is too leveraged to invest in the straight equity, it also seems to exist in a gray area of too big to fail and too big to turn around any time soon.
Recently, the government decided to provide the banking giant with $40 billion in capital and cover losses on over $300 billion of illiquid assets beyond the first $29 billion. This insures the bank against a major catastrophe. You can hate the deal, love it, or blog to your heart's content about it, but it provides an opportunity to buy the preferred stock cheap when others are panicking about solvency.
The Fed made it clear that Citigroup would be one of the few banks to be backed up, while others could go down. Shareholders are getting a good deal while US taxpayers pick up the bill. Although the idea of a "bad bank" to wipe off the toxic debt remains interesting, the $300 billion of bad debt at Citigroup earmarked for government support will accomplish about the same. While it would be better for investor psychology to see the bad debt gone, the backstop has been placed.
Now we have a banking giant with some basic support, but that leaves the future earnings of the firm uncertain. We are not going to take a bet on whether or not Citibank will break up, change management, or just lumber along as a supergiant. Our only concern is that the firm continues to pay interest on time and stays solvent. While shareholders are waiting to see if the megabank model will work, we are clicking away at over 15% interest per year. Did we mention it qualifies for the 15% tax rate? Even if this rate goes to 20% or higher soon, it is better than the tax on earned interest.
So, in the end, the preferred stock route is one less traveled. The risk that the bank will fail or suspend the dividend remains, but we also get to see the story unfold without concern for how common shareholders are going to see appreciation anytime soon. If credit spreads ever tighten, we could see appreciation on the preferred stock. Remember, capital appreciation is what makes preferreds so interesting
