Hidden opportunities in preferred stock - includes related article - CEO Finance

Chief Executive, The, June, 1994 by Paul Maloney

The complex preferred stock market is difficult to gauge--which provides calculating investors with outstanding returns.

Investors are scrambling to maximize returns in today's low-interest-rate environment. However, these income-oriented investors may be missing an opportunity right under their noses: the preferred stock market, which offers equities issued by America's largest corporations, insurance companies, and utilities.

One of the preferred market's biggest attractions is that so few people understand it. Imperfect investor knowledge creates an inefficient market--and therefore, overall returns that can exceed those of either bonds or common stocks. Tax benefits also are a big attraction of preferred stocks. A little research can create a lucrative opportunity for rounding out a well-balanced portfolio.

The U.S. has the only developed market for preferred stocks, and traditionally, utilities were the largest issuers. (Preferred stock allows utilities to raise capital for construction without hurting their debt-equity ratios and, therefore, their debt costs. Utilities that issue preferred stock also receive a number of tax benefits, which vary from state to state.) In the last three years, however, banks and other financial institutions have become the biggest issuers of preferred stocks, mainly because of new federal primary capital requirements. Banks now are allowed to count preferred stock as core (Tier I) capital--which helps improve their capital ratios. Most recently, Bank of America, Citicorp, Chemical Bank, and Chase Manhattan have been major issuers of preferred stocks.

Corporations jumped on the bandwagon during the acquisition sprees of the 1980s--for instance, RJR Nabisco created a substantial issue of preferred stock during its merger and is moving to issue more, partly to compile a war chest to finance future acquisitions. Issuing preferred stock rather than debt allows companies to improve their debt-capital ratio and possibly improve their debt rating the next time they issue bonds.

While corporate issues have dwindled since the 1980s, preferred stock now appears to be undergoing something of a resurgence among corporations. Since the end of 1991, GM, Ford Motor Co., and IBM each has issued 44 million or more shares of preferred stock--creating the three largest issues of corporate preferred stock on the market. This trend may continue, as blue-chip companies seeking greater appreciation than offered by their common stock turn to less traditional financing in the preferred market. In addition, corporations without income-tax liability have an incentive to issue preferred stocks--while improving their capital structure, there's no disadvantage to paying preferred stock dividends (which are paid after taxes) versus bond payments (a pre-tax expense).

SHOULD YOU BUY?

Compared to bonds, preferred stocks offer tax advantages to certain investors that make them worthwhile.

Under the current tax law, dividend income to any incorporated investor is 70 percent tax-exempt. Therefore, a corporation with a 34 percent tax rate pays only $10.20 on every $100 in preferred stock dividends--versus $34 in tax on every $100 in bond coupon payments.

Because of this tax advantage, bonds generally have higher yields than preferred stocks. The exceptions are offered by equity issuers with weaker credit ratings, which must offer an additional risk premium to entice investors. (Bonds have priority over preferred stock if the issuer is forced to liquidate.) For example, Public Service of New Mexico's preferred stock has nominal yields of 10.25 percent to 10.5 percent, which is 25 to 50 basis points more than offered by Public Service's long bonds.

The majority of preferred stock purchasers are institutions, including large corporations that need to shelter excess cash against taxes. Insurance companies are the biggest institutional buyers of preferred stocks, largely because of special accounting rules that allow these issues to be carried at cost, rather than at market value. Individual investors may purchase single issues or make their investment through preferred stock mutual funds. Most corporations and smaller insurance companies work with money managers and brokerages that specialize in preferred stock issues.

Preferred stocks can make a valuable contribution to an institution's investment portfolio. For example, a medium-sized insurance company established a preferred stock "dividend-capture program," under which it purchased issues near their ex-dividend date and sold issues that were ex-dividend and had been held for 45 days. As a result, the company could receive a maximum of seven or eight dividends per year--rather than the usual four dividends paid by an individual preferred stock. From January 1, 1992, to December 15, 1993, this company realized an annual return on investment of 11.4 percent on an average investment of $37.2 million. This is obviously a respectable return in a low-interest-rate environment.

Pension funds and individual investors have been less enthusiastic about buying preferred stock. Neither investor is eligible for the tax benefits of preferred stock ownership versus bonds--so any investment in this type of stock must stand on its own risk-return merits. Individuals pay taxes on all the dividend income from a preferred stock, while institutions pay taxes on only 30 percent.