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BENEFITS BEAT
Opportunities for Patient Money
Wall Street ponies up for new capital. Result: high yields on preferred stocks.
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Wall Street investment banks are in a bind because of the subprime mess. They need to raise additional capital to assure regulators, investors and counterparties that they are creditworthy. So they have gone to market to secure additional reserves. A few months ago, they cut private deals with "sovereign wealth funds" on highly favorable terms for those investors — they needed big amounts of money quickly to stanch the hemorrhage and avert a financial crisis. Now they have returned to the U.S. capital markets to raise additional funds through more conventional channels, including the issuance of common and preferred stock.
This latest round of recapitalization presents a unique opportunity for retirement investors, including large and small pension funds as well as individuals.
Although the remaining risk of recession makes purchase of common stock in the financial services industry a gamble that many investors would prefer to avoid, the preferred stock of some of these companies is certainly worth exploring. Some of the top names in the industry globally have issued high-coupon preferred stock that can now be tucked into portfolios with yields that coupon-clippers may not see again for many years. For example, Citigroup and Merrill Lynch both recently issued perpetual preferred stock with coupons of 8.5 percent or more. These securities are superior to common stock if there's a declaration of bankruptcy, albeit behind bonds.
But if we've learned anything from the financial services bailouts and forced liquidations of the past 30 years, the odds of one of these goliaths going under completely are very low. Regulators, shareholders and transaction counterparties will push hard to have the companies bought out by another titan, much like the announced absorption of Countrywide Financial by Bank of America and JPMorgan's shotgun purchase of Bear Stearns. In those scenarios, the common shareholders are mostly wiped out, but the preferred shareholders often end up keeping their preferred stock at parity with the new owner taking on the payments and thus upgrading the quality (although the current Countrywide scenario remains highly speculative). So unless the entire world collapses in a financial Armageddon, preferred stock in the largest solvent financial houses would seem to be a reasonable long-term investment. (Full disclosure: The author holds investment positions in several of the firms and/or securities mentioned above.)
Long-term U.S. Treasury bonds pay 4 percent these days, and investment-grade corporate bonds pay 5 to 6 percent. Common stocks historically have earned about 10 to 11 percent, so the current pricing of these particular preferred stocks offers an opportunity to meet or exceed a pension plan's actuarial return assumptions with lower risk than a common stock portfolio. Certainly the pension fund CIOs and CEOs will be wise to ask their money managers to take another look at special-situation preferreds these days.
For individual retirement investors, the beauty of these securities is that they are traded on the New York Stock Exchange and are easily accessible in an IRA account, or even in a defined contribution (401k, 401a, 403b or 457) account if it has a brokerage window for access to such securities. Ordinarily I am a critic of brokerage accounts in an employer-based retirement plan because employees tend to make dumb investments in them or trade too often for their own good. But the present opportunity to access such accounts to lock in attractive yields in high-quality names now paying junk-bond yields (and without paying an ongoing mutual fund management fee) is too good to pass up. Such accounts are especially well suited for "hybrid" preferred securities that are not tax-advantaged, as I will explain below.
An even better investment strategy for many individuals is to purchase preferred stocks in a taxable brokerage account. That's because current U.S. tax law favors dividends over bond interest. Even the highest-bracket investors pay only 15 percent federal income tax on qualified stock dividends. That's why it's important to verify if a preferred stock is eligible for qualified dividend income taxation. (Quantumonline is a helpful Web site for this information.) Several recent "preferred stock" issues are actually hybrid preferred securities that are actually more like bonds and thus subject to normal tax rates, and those are usually better held in an IRA or other tax-deferred account.
Of course, the next Congress could raise tax rates on dividend income. Also, investors (both institutional and individual) should be aware that many of these new preferred stocks are callable at par in 5 years, making it unwise to pay a big premium over their par value due to call risk. It's best to buy them at or below par, which is usually $25/share. As with any other investment strategy, it's wise to confer with experts before taking investment risks.
For example, I see less relative value in the recent and upcoming preferred stock issues of Fannie Mae and Freddie Mac, the federalized mortgage companies, which offer lower rates yet continue to carry undiversifiable risk if the mortgage market continues to weaken. These huge, one-industry issuers in particular may be worth watch-listing for a while to see where the dust settles in the housing and mortgage securities marketplace — even though they are both government-sponsored enterprises. The worst-case (preferred stock) takeover scenario I described above is less likely to apply in their situation. Given the magnitude of their underwater mortgage portfolios, who would be big enough to buy them out — except the U.S. taxpayers?
Public pension funds that deploy their long-term, patient money wisely should have a good year as buyers in 2008. Other patient-money rewards will soon arise in the mortgage securities market, in venture capital (think: economic development) and even infrastructure. Next month, I will write more about how these opportunities might best be captured by public pension funds in a diversified multi-state strategy. Meanwhile, plan administrators, chief investment officers and even individual employees investing for their own retirement should take a look at today's potential bargains in the recently issued preferred stock market.
Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net. His general market observations and institutional investment strategies are his own and should not be construed as investment advice or recommendations concerning specific securities. Retirement professionals and individuals should consult qualified investment and tax advisers, and/or conduct extensive personal research, before making investments in securities including preferred stocks. Nothing herein is to be construed as a recommendation to purchase or sell a specific security. More biographical information.