Preferred Stock Prices: Temporary Spike Or A New Normal?

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By Doug K. Le Du :

Today's high preferred stock prices and corresponding lower yields are likely to be a temporary spike more so than a "new normal" going forward[1].

The average market price for high quality[2] preferred stocks started this year at $25.32 per share and closed July at $26.00 - a full dollar above their $25 par value. While there is no way to determine in advance what future prices will do, there is a case to be made that today's high prices will probably come to an end sooner rather than later (months not years).

In fact, as discussed here, it is the short-term behavior of European investors, much more so than our Federal Reserve's monetary policy or any other factor, that will likely lead to lower preferred stock prices in the U.S.

No New Normal

It is tempting to think that today's high preferred stock prices are a direct result of the Federal Reserve's "Operation Twist" monetary policy, phase 1 of which ran from last October through June of this year (followed immediately by phase 2, now underway).

The objective of Operation Twist is to push down long-term interest rates by reducing the yield provided by long-term (six year to 30 year maturity) treasuries.

Under Operation Twist, the Fed has been selling shorter-term treasuries (with maturities of three years or less) and using the proceeds to purchase longer-term issues. By purchasing longer-term treasuries, the Fed is effectively reducing the supply available to other global investors, hence raising prices. Increasing prices, in turn, lowers yield thereby achieving the desired policy objective of lowering the longer-term cost of money in the economy.

The result is a flatting of the "yield curve" as illustrated here for September 2011 (before the launch of Operation Twist) and June 2012 (the last month of phase 1).

click to enlarge images

Operation Twist Results

The notion that Operation Twist would pull down the yield of preferred stocks has a certain amount of intuitive appeal, the tide affecting all boats the same way. Let's take a look. Here is the average monthly yield of high quality preferred stocks over the same period.

High Quality Preferred Stock Yield, 2012

Notice that while the overall result is a decrease, in five of the nine months since Operation Twist was launched last October, the yield provided by high quality preferred stocks was either flat or went up, not down.

The implication here is that while the Fed's Operation Twist probably does put upward pressure on preferred stock market prices (lowering yields), it is not clear from these data that today's extremely high prices are being caused by this policy.

Temporary Spike

The marketplace for preferred stocks is subject to the same laws of supply and demand as any other item that finds itself in a competitive market of buyers and sellers. As supply increases, giving buyers more choices, prices tend to drop.

We last saw this in dramatic fashion during 2008 when banks were continually introducing massive new preferred stock issues into the market. During the crisis all of our Big Banks - Citigroup ( C ), Bank of America ( BAC ), Wells Fargo ( WFC ), JP Morgan ( JPM ), Morgan Stanley ( MS ) - introduced multiple issues. Not to be outdone, our regional institutions got into the act as well with new issues from PNC Financial (PNC), BB&T (BBT), Fifth Third (FITB) and others.

While there were a multitude of risk-related issues for investors to deal with at the time, the market was flooded with new shares and prices dropped accordingly (all the way to an average of $16.14 per share at the end of October 2008).

Now consider this about today's preferred stock market: at this point last year the companies that issue preferred stocks had treated us to $5.7 billion in new issues to consider. So far this year, the supply of new preferred stocks available for preferred stock investors to pick from is at a whopping $17.1 billion[3].

But despite this tripling of supply, prices have not fallen; rather, they have climbed to an all-time high.

It appears that excess demand is causing today's high prices, much more so than the Fed's Operation Twist.

Four Key Events

So how long will these high preferred stock prices last? As mentioned earlier, it is impossible to know for sure. But once we understand what is causing the current spike in demand, that question becomes easier to answer.

While there are always of multitude of forces exerting pressure on market prices at all times, four key events, occurring nearly simultaneously, are significant contributors to the current spike in preferred stock market prices.

  1. Several months ago investors were very worried that the Fed was going to have to start increasing rates in order to hold off inflation. Such a rate increase could put downward pressure on preferred stock market prices (see the Seeking Alpha article titled " Preferred Stock Investors: How Afraid Should You Be Of Increasing Interest Rates? " for actual data on this mechanism) so the more nervous among us were staying away from fixed-income securities. That fear has subsided substantially, bringing such investors back in as buyers.
  2. The yields on the alternatives that many fixed-income investors favor (bank Certificates of Deposit and investment grade corporate bonds) are paying 1.1% and 3.6%, respectively. Since these earnings are completely wiped out by taxes and inflation, many have turned to the next step up the risk ladder - high quality exchange traded debt securities and high quality preferreds.
  3. The June 7 announcement by the Fed regarding Basel III compliance opened the 90-day premature call window, triggering redemption announcements for bank-issued trust preferred stocks (TRUPS - see the Seeking Alpha article titled " Preferred Stock Investors About To Be Cash-Rich Thanks To New Fed Action " for details). Tens of billions of cash started flowing into the cash accounts of preferred stock investors starting with shareholders of STI-Z from SunTrust on Wednesday, July 11, 2012.
  4. Eurozone investors are fleeing European assets and moving their funds to US fixed-income assets, especially investment grade preferreds and corporate bonds. In March, for example, net buying of U.S. financial assets including long-term equities, notes and bonds totaled $36.2 billion, up from $10.1 billion the month before[4].

If we can accept that today's high prices have been caused primarily by a spike in demand due mostly to these key events (more so than by the Fed's Operation Twist policy), then it follows that the upward pressure will ease as these events run their course.

In fact, some might even argue that preferred stock prices have already peaked. After having risen from $25.32 to start the year, the average high quality preferred stock market price at the end of July was $26.00 per share, down $0.01 from June.

Further, three of the four key events identified above have probably already played out.

Investors who fled fixed-income securities for fear of inflation's eroding effects have already returned. Whatever upward pressure this returning group's demand exerted on preferred stock market prices has likely already happened.

Bank CD rates and investment grade corporate bond rates leveled off at 1.1% and 3.6%, respectively, earlier in the year. Like those who had fled preferreds due to inflation fears but have since returned, most savers and bond investors who were considering jumping to high quality preferreds have likely already done so.

Redemptions of bank-issued TRUPS are just about to run their course as well. The call window opened by the Fed's June 7 announcement will close on September 7, 2012. Prior to the July 2010 signature of the Wall Street Reform Act there were over 30 high quality TRUPS trading on US stock exchanges; today there are only nine left[5], six of which have already exceeded their respective call dates and can be redeemed at any time. With the exception of a few holdouts, the majority of bank-issued TRUPS redemptions in response to new domestic and international regulations have already happened. While the Fed's June 7 announcement has pushed many of the remaining TRUPS shareholders into the market as buyers looking to replace their called TRUPS shares, that wave is just about spent.

That leaves us with Europe.

Europe Holds The Trigger For Lower Prices

European officials do not have to solve the eurozone problems before investors will return to European assets; they simply have to appear as if they are intent on doing so and are starting to take credible steps accordingly.

We have seen this on many occasions over the last couple of years, triggered by a single positive headline. With eurozone asset yields sky high, investors will jump back to those assets, seeking to beat the returning crowd, given the slightest indication that it may be time to do so. If European leaders continue to work through these issues and show progress, investors will return as quickly as they fled which could happen at any time.

The increase in demand from those getting over their inflation fears and those fleeing bank CDs and corporate bonds is likely to have already happened. And the newly cash-rich buyers who are seeking to replace their called TRUPS shares will wash through the system shortly.

For today's excess demand for U.S. preferred stocks to subside, former European asset investors who have currently parked their cash in U.S. preferred stocks have to see sufficient reason to return to eurozone investing. Probably more so than any other single factor, this is the event that will relieve the excess demand and high prices that we are currently seeing in the marketplace for high quality preferred stocks.

For preferred stock investors looking for ways to take advantage of today's high prices, the Seeking Alpha article titled " Preferred Stock Investors: Is It Time To Sell? " describes a technique that can allow you to do so while the opportunity exists.

Footnotes:

[1] Source for all preferred stock data in this article: CDx3 Notification Service database, Preferred Stock Investing, Fourth Edition, see PreferredStockInvesting.com. Disclaimer: The CDx3 Notification Service is my preferred stock email alert and research newsletter service including data for all preferred stocks and Exchange Traded Debt Securities traded on U.S. stock exchanges.

[2] "High quality" preferred stocks are those that meet the ten risk-lowering selection criteria from chapter 7 of my book, Preferred Stock Investing. For example, high quality preferred stocks have investment grade ratings and the cumulative dividend requirement.

[3] Source: 4-Traders.com (a Dow Jones Company), July 24, 2012, "GE Capital, BB&T Issue Preferreds as Yield Hunt Lowers Capital Costs" by Katy Burne.

[4] Source: Bloomberg research.

[5] There are actually thirteen high quality TRUPS still trading on U.S. stock exchanges but four have calls pending and have been excluded here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

See also Ceragon Networks Management Discusses Q2 2012 Results - Earnings Call Transcript on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Economy

Referenced Stocks: BAC , C , JPM , MS , WFC

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