K. Le Du
Variable rate preferred stocks sound like a good idea,
especially during a period of low rates. The idea is that preferred
stock investors will be able to ride the wave up when rates start
to rise in the future.
In addition to increasing income, this mechanism also offers a
degree of principal protection since such securities would
theoretically maintain their value as rates go higher.
It is for these reasons that the top four movers each traded
more than 250,000 shares last Friday  - GS-A and GS-D from
Goldman Sachs (
), USB-H from U.S. Bancorp (
) and MS-A from Morgan Stanley (
). And almost two-thirds of the variable rate preferreds now
trading on U.S. stock exchanges traded more than 10,000 shares that
But the higher dividend payout that many are looking forward to
from today's variable rate preferred stocks is unlikely to ever
There are currently 34 variable rate preferred stocks trading on
U.S. stock exchanges . These 34 securities were issued between
May 1994 (HBA-D from HSBC (
)) and March 2007 (BML-L issued originally by Merrill Lynch now by
Bank of America (
Most of these 34 issues are from banks and insurance companies
(domestic and foreign), although Southern California Edison's (EIX)
SCEDN, issued in April 2005, is still trading.
18 of the 34 enjoy investment grade ratings from Moody's while
18 are rated as investment grade by S&P.
Determining the Dividend Rate
While it would be great for investors if variable rate preferred
stocks used a standard method for determining the dividend payout,
that is unfortunately not the case.
Variable rate preferreds generally offer a dividend rate that is
pegged to an index such as the 1-month or 3-month LIBOR rate
(currently at 0.30%) or a specific U.S. Treasury Bill rate. They
also frequently (but not always) offer a minimum dividend rate
(usually around 4%) and a maximum rate that is either a stated
amount (such as 10%) or derived by a formula. The formula can also
change for different periods of time.
If you have one of those jobs where you have to fly a lot,
you've learned not to ever ask how your airfare is calculated.
Doing so results in a dull, blank stare from the counter attendant
since every passenger sitting on your plane has paid a different
amount for their ticket. Same goes for the rate calculation of many
variable rate preferreds.
Here are a couple of typical examples.
ZB-A from Zions Bancorporation (ZION) puts it pretty plainly
right on page 1 of its prospectus (
see ZB-A prospectus
): the dividend rate will be "
...equal to the greater of (1) 0.520% above three-month LIBOR
on the related LIBOR determination date or (2) 4.000%.
Compare that to the rate calculation specified in the prospectus
of HBA-D from HSBC: "
The dividend rate on the Preferred Stock for the dividend
period ending on June 30, 1994 will be 6.05% per annum, which is
equivalent to $0.16 per Depositary Share. Thereafter, the dividend
rate on the Preferred Stock will be equal to 81% of the Effective
Rate (as defined below) in effect from time to time, but in no
event less than 4 1/2% or more than 10 1/2% per annum. The
Effective Rate for each quarterly dividend period will be the
highest of the Treasury Bill Rate, Ten Year Constant Maturity Rate
and the Thirty Year Constant Maturity Rate determined in advance of
such dividend period.
see HBA-D prospectus
Depending on how thinly the issuing company is trying to limit
their exposure to increasing rates, prospectus language that
describes the rate calculation varies from the fairly
straightforward to the exceedingly mind-bending.
But figuring out the currently applicable dividend rate of a
variable rate preferred stock is not the real problem facing
today's buyers (of which there does not seem to be a shortage).
Once rates start heading up again (2015?), those holding shares
of variable rate preferred stocks are going to be in the chips.
That, of course, is what today's buyers are counting on. These
buyers are passing up two years (if the Federal Reserve has their
way) of 6+% dividend income currently available from today's
fixed-rate preferreds in order to position themselves for the glory
of a future run up in rates.
But it is unlikely that those purchasing shares of today's
variable rate preferred stocks are ever going to see such
The most recently issued variable rate preferred stock was Bank
of America's BML-L introduced on March 16, 2007. These securities
have a typical five-year call period after IPO. What it appears
that today's buyers of variable rate preferred are missing is that
all 34 of the variable rate preferred stocks trading on today's
U.S. stock exchanges have already exceeded their respective call
The issuing companies of today's variable rate preferreds are
currently getting away with paying the minimum allowed by the
prospectus. While many of these securities have a minimum rate of
about 4% (such as the ZB-A and HBA-D examples provided earlier),
several have no such minimum whatsoever.
Since all of these issues are now callable, what do you think
the issuing companies of these securities are likely to do when
rates start heading up some day?
While it is not possible to know the answer to that question in
advance, it seems unlikely that if future rates were to increase to
a level that would make today's miserly returns worth the wait that
these companies would just pay up. It is much more likely that
today's variable rate preferred stocks will be redeemed at the
first sign of increased dividend expense to these companies,
leaving today's buyers with little to show for their patience.
Most risk-averse preferred stock investors avoid variable rate
preferred stocks since there is no way to know the likely return on
your investment. In addition to an unknown return, today's variable
rate preferred stocks are unlikely to deliver their primary benefit
(an increasing dividend rate) that current buyers are banking
 Source for all preferred stock data in this article:
CDx3 Notification Service
Preferred Stock Investing, Fourth Edition
(PreferredStockInvesting.com). Disclosure: The CDx3
Notification Service is my preferred stock email alert and research
newsletter service and includes the database of all preferred
stocks and exchange-traded debt securities traded on U.S. stock
exchanges used for this article.
 Excludes: those with zero daily trading volume on Friday,
January 18, 2013, GNE-A from Genie Energy that was issued as part
of a common stock exchange offer and GLD-B which was issued
pursuant to a closed-end ETF (GDL). ABV from AMBEV (ABV.C) and
CTWSP from Connecticut Water Service were also excluded since
they have no prospectus available.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
Securities identified within this article are for illustration
purposes only and are not to be taken as recommendations.
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