A Preference for Preferreds

THE MARKET FOR PREFERRED STOCKS has rallied sharply in the past two months in response to the government's investment of more than $150 billion in a wide range of banks and other financial institutions, in the form of preferred shares and equity warrants. Investors such as Bill Gross of Pimco have argued this heightens the appeal of both the bonds and preferred stock of these companies. "With Uncle Sam as your partner," Gross wrote in his November investment letter, "default seems remote."

While preferred stock isn't as secure as debt, both banks and the government seem intent on preserving preferred dividends. As part of the bailout ofCitigroup (ticker: C), for instance, the company's quarterly common dividend was cut to a penny per share. But preferred-stock dividends were maintained, as the government made a new $27 billion preferred-stock investment in the troubled bank. Preferred stock is senior to common but ranks below debt in corporate capital structures.

Government preferred usually ranks equally with investor-owned preferred issues, which means many financial companies would have to stiff Uncle Sam before omitting dividends on their publicly traded preferred. Economic conditions -- and credit losses -- would have to get far worse before banks omit preferred dividends.

Most preferred issues from financial companies now yield about 9% or more, and trade well below face value, typically $25 per share. Preferred purchased by the government through the Troubled Asset Relief Program, or TARP, yields just 5%.

The preferred market is down about 30% this year, dividends included, according to Merrill Lynch's preferred-stock index. One especially depressed -- and appealing -- sector is adjustable-rate preferred, which was sold by the likes of Merrill Lynch (MER), Goldman Sachs (GS), Bank of America(BAC) and HSBC Holdings (HCS). It was designed to trade near face value of $25 because dividend rates reset quarterly at a spread above three-month LIBOR, or the London interbank offered rate, the key short-term interest rate. Thus, investors would be protected with higher dividends if rates rise.

The adjustable-rate preferred market has tanked this year because of concerns about the health of financial companies and the sharp drop in short rates, which has reduced dividends. Some bulls argue that dividends can't go lower, and that payouts will rise if the government's massive financial bailout and fiscal stimulus results in a reacceleration of inflation and higher interest rates. That makes adjustable-rate preferreds similar to Treasury inflation-protected securities, but with much higher yields.

Ten- and 20-year TIPS now yield two percentage points above inflation, or 4% to 5%, assuming 2% to 3% long-term inflation. Investors are paying nothing for the inflation-protection feature of adjustable-rate preferreds, as fixed-rate "straight" preferreds currently sport similar yields.

Merrill Lynch has several adjustable-rate issues outstanding. The largest is Series L, which trades near $8.55 a share, or 34% of last year's original offering price of $25, for a current yield of 11.70%. The dividend resets quarterly at half a percentage point above three-month LIBOR, now about 2%. But the minimum annual dividend rate is 4% of face value of $25, or $1 a share.

Other Merrill preferreds with fixed rates carry similar or lower yields. The adjustable-rate issue arguably should yield less than straight preferreds, because its dividend can only go up.

ONE FAN OF THE ADJUSTABLE-RATE issue says it could double in the next year if the financial crisis abates. The issue traded in June at $15. Indeed, all Merrill preferreds could trade up once the company's scheduled merger with Bank of America goes forward. The deal has been approved by shareholders of both companies and could close by year end.

Bank of America has a large adjustable-rate preferred issue, series E, which trades around $8.82, for a current yield of 11.34%. It, too, is at its dividend-rate floor of 4%. The Bank of America adjustable-rate preferred yields more than some of the bank's fixed-rate preferreds.

Goldman Sachs has issued a series of adjustable-rate preferreds, including the series A, which trades around $10.31 for a 9.09% yield. HSBC also has several series of adjustable-rate preferreds with current yields of around 10%. MetLife 's (MET) series A adjustable-rate trades at $11.55, yields 8.66% and has a dividend floor of 4%.

With yields of around 9% or higher, adjustable-rate preferreds from financial companies offer ample income and increasingly secure dividends -- and a potential kicker in the event of inflation.