Conditions Right For Preferred Stock Calls

For the first time since early-2007, conditions within the preferred stock market favor calls of preferred stock issues that were introduced more than five years ago (early-2005 and earlier). If you have preferred stocks in your portfolio that were issued prior to early-2005 and have a declared dividend rate (coupon rate) greater than the low-seven percent range, your shares are in the cross-hairs.

When a company “calls” a preferred stock issue (which they regain the right to do five years after the issue is first introduced), they buy your shares back from you and the issue stops trading. Generally, you will receive $25.00 per share from the issuing company. As my book, Preferred Stock Investing, puts it, the issuing company, in the event of a call, becomes your “built-in buyer.”

As long as you purchase preferred stock shares for less than $25.00 per share, having a built-in buyer lowers your investment risk in that, in the event of a call, you stand to make a capital gain on top of the dividend income that you have been earning in the meantime.

Since high quality preferred stocks pay fixed dividends in the range of 6.5% to 9% per year, it does not take too much of a capital gain to consistently push your total effective annual return over the 10% mark. I define high quality preferred stocks as those that meet the ten selection criteria presented in chapter 7 of Preferred Stock Investing (cumulative dividends, issued by a company that has never suspended dividends, rated investment grade, etc.).

But conditions have to be right for calls to start happening. The issuing company has to be able to save money by calling the preferred stock shares. Plus they have to have a slug of cash sitting around in order to pay off all of the current shareholders.

A common method for generating such cash is to issue a new, lower dividend paying preferred stock and use the proceeds generated by the new issue to buy back the shares of the older issue being called. Preferred Stock Investing refers to this as “refinancing” since that’s exactly what it is. Just like a home mortgage, refinancing is something that happens when rates go down low enough to make it worthwhile. And the recovery from the Global Credit Crisis has done just that - pushed preferred stock dividend rates down to a point where this refinancing of older, more expensive preferred stock issues now makes sense for the first time since early-2007.

Public Storage (NYSE: PSA) issued a new preferred stock in early April that generated about $135 million in cash. The new preferred stock is going to cost Public Storage 6.875% per year in dividend expense to its shareholders.

Then on May 6 PS Business Parks (NYSE: PSB) announced that it is calling the outstanding shares of its preferred stock PSB-K, issued on June 25, 2004. PSB-K is costing PS Business Parks 7.95% per year in dividend expense. If you own shares of PSB-K you will see $25.00 per share show up in your brokerage cash account on June 7 and your shares of PSB-K will disappear from your holdings. Calling the outstanding shares of PSB-K is going to cost PS Business Parks $54 million.

Public Storage owns PS Business Parks. By issuing a new 6.875% preferred stock and using the proceeds to buy back the outstanding shares of a 7.95% preferred stock, Public Storage realizes an annual savings of over 1% on $54 million. And all they had to do was fill out a couple of forms.

Within the last 60 days, dividend rates for new high quality preferred stock issues have fallen below 7%, making calls attractive for the first time in years.

But with many analysts predicting an increase in rates within the next six to twelve months, companies are now motivated to issue new preferred stocks at today's sub-7% rates before rates start inching back up.

For preferred stock investors holding shares that were (a) issued prior to early-2005 (more than five years ago) and (b) have a dividend rate in the low-seven percent range or higher, you may soon be the proud recipient of a nice capital gain courtesy of your built-in buyer.

For the next six to twelve months preferred stock investors who hold such shares should keep an eye on their brokerage cash accounts for the proceeds from called preferred stock issues.

Subscribers to the CDx3 Notification Service (my preferred stock email alert and research newsletter service) should check the Beyond Call Date catalog on the subscriber's website. The catalog is sorted by IPO date. See if you own any of the issues listed prior to early-2005 that have a dividend rate greater than the low-seven percent range.

Many Happy Returns.