Cumulative Income: Investing in Preferred Shares
During times of market stress, the preferred share can be a fantastic tool. The relatively-illiquid market allows for retail participants to capitalize on price inefficiencies / dislocations. While the downside is the share price goes to zero, just like with common shares, there is a par value that allows upside to be modeled on more than just pure speculation. It is this contractual upside that makes preferreds opportunistic.
Contents
Basics
Preferred shares are a form of equity a company may issue, similar to common shares. Unlike equity however, preferred shares also possess characteristics of bonds such as fixed distribution payments, call provisions and defined durations. They are essentially a hybrid instrument.
While it’s true this blend of features has the potential to give preferred shares the worst of both worlds without any of the upsides such as:
- no dividend growth
- interest rate sensitivity
- caps on capital appreciation
- junior to bonds in the capital structure
- possibility of dividend suspensions
- proxy for price and volatility of common shares
- low liquidity
- shares can be called away or converted to common shares
There are scenarios where preferred shares make sense:
- defined upside potential
- improved income safety and stability over common shares
- dividend accruals in the event the dividend is suspended
- accumulated dividends must be paid before common share dividends are reinstated
- lower volatility of share price
- senior to common shares in the capital structure
- dividends can be based on prevailing interest rate, mitigating interest rate risk
Here are the common attributes and provisions of preferred shares:
Capital Structure
If we look at the capital structure of preferreds, they sit between bonds and common stock.
In a typical bankruptcy scenario bondholders get paid first and, should any funds remain after making all bondholders whole, the remaining funds are then distributed to common shareholders.
Should a company have outstanding preferred shares, bondholders are again paid first; any remaining funds are then distributed to holders of preferred shares. If funds remain after all preferred shareholders are made whole, common shareholders receive a distribution of whatever is left.
Takeaway: should a company with outstanding preferred shares file for bankruptcy, liquidation proceeds will flow accordingly:
- Bondholders
- Preferred Shareholders*
- Common Shareholders
* Some prospectuses contain verbiage that may enable the restructuring of preferreds during an ownership change – i.e. if bondholders become the new owners due to bankruptcy. Such restructuring may modify this hierarchy or force a conversion to common stock.
Voting Rights
The majority of preferred shares have limited or no voting rights as it relates to corporate governance. In the respect, preferred shareholders are similar to bondholders in that they do not participate in corporate events.
Takeaway: investing in preferred shares will not efficiently facilitate participation in shareholder matters.
Cumulative vs Non-Cumulative Distributions
Preferred shares issue dividends. Similar to the capital structure, preferred share dividends take priority over common share dividends but are lower priority to bond payments.
Consider fictitious company XYZ. It has bonds, preferred stock and common stock. One day XYZ experiences challenges and decides to suspend all discretionary investor payments in order to preserve liquidity. One year later business conditions have improved and dividends are restored. Here are the two ways this can play out:
Cumulative
- Bondholders
- Receive the regular coupon payment as usual.
- While a XYZ can suspend dividends it cannot suspend bond payments without becoming “in default.”
- Preferred shareholders
- Receive no dividends for a year.
- Unpaid dividends accrue.
- The dividend per share remains the same during the suspension.
- When dividend payments are resumed all accrued dividends are paid out.
- If dividends are never resumed all accumulated payments will be paid out when then the shares are called or mature (see next section on call provisions).
- The resumed dividend per share will be the same amount as before the suspension.
- All accrued dividends must be paid before dividends can resume on common shares.
- Common shareholders
- Receive no dividends for a year.
- Unpaid dividends is income forever lost.
- If dividends are never resumed, that’s the end of the dividend income.
- The resumed dividend per share may be more, less, or equal to the pre-suspension dividend amount.
Non-Cumulative
- Bondholders
- Receive the regular coupon payment as usual.
- While a XYZ can suspend dividends it cannot suspend bond payments without becoming “in default.”
- Preferred shareholders
- Receive no dividends for a year.
- Unpaid dividends is income forever lost.
- When dividend payments are resumed there will be no back pay for the “missed” income.
- If dividends are never resumed that’s the end of the dividend income.
- The resumed dividend per share will be the same amount as before the suspension.
- Dividends must be paid on preferred shares before dividends can resume on common shares.
- Common shareholders
- Receive no dividends for a year.
- Unpaid dividends is income forever lost.
- If dividends are never resumed, that’s the end of the dividend income.
- The resumed dividend per share may be more, less, or equal to the pre-suspension dividend amount.
Takeaway: preferred shares may experience dividend suspensions just like common shares. Unlike common shares, dividends on preferred shares are contractually set and must be paid before dividends on common shares. Some preferred shares have a clause that requires any and all unpaid dividends to accrue.
Fixed vs Floating Rate
Dividends on preferred shares usually have either a fixed dividend per share for the life of the instrument, for example 7%, or have a fixed-to-floating rate of, say 6.125% for 5 years then 4.697% + 3-month LIBOR thereafter.
Takeaway: preferred shares that have fixed-to-floating structures are less interest rate sensitive than fixed-rate shares.
Callability
Preferred shares are often issued with a value of $25 and have a liquidation/call price that equals the IPO value.
Issuers are often permitted to redeem (call) preferred shares after a minimum specified amount of time – usually 5 years from the date of issuance. Unless called, preferred shares will typically exist in perpetuity unless there’s also a conversion clause.
Takeaway: income from preferred shares should not be depended upon beyond the call date as the issuer can redeem the shares with little notice.
Duration
Some preferred shares have a conditional or mandatory conversion to common stock provision that, conditionally or forcefully converts preferred shares into common shares.
Takeaway: mandatory convertible shares cause the preferred share price to act as a price and volatility proxy for the common stock.
Ownership
The majority of preferred shares are owned by institutions. This is because corporations get to exclude 70-100% of the dividend income from their taxable income due to the IRS dividend received deduction (DRD).
Takeaway: entities taxed as a C corp including small businesses may be able to take advantage of the DRD if holding preferred shares.
Strategy
Now that we have an understanding of the common features and provisions of preferred shares, let’s talk strategy.
Why Do Companies Issue Preferreds?
Why would a company issue preferred shares? Interest rates are lower on debt and issuing bonds doesn’t dilute equity shareholders (bond interest expense is an operating expense whereas preferred dividends are funded from retained earnings). In general there are four main reasons: regulation, cashflow control, limited balance sheet strength, and business model.
Regulation
The majority of preferred shares are issued by banks. Federal regulation requires banks to continuously satisfy certain capital and debt requirements. Insurance companies are also a large issuer of preferreds and are subject to similar regulation. Issuing $250M in preferred shares has different balance sheet implications vs issuing $250M in bonds.
Cashflow Control
By issuing preferred shares, should a company determine it needs to preserve cash flow at a future date it can suspend dividends while avoiding going in default. The higher interest rate that preferreds have over bonds is, in part, the cost associated with having this flexibility. Whether the issuance of preferred shares should be interpreted as lack of confidence in future cash flows or wise flexibility of management is up to the investor to discern.
Limited Balance Sheet Strength
Organizations that have weak balance sheets may benefit from preferred shares. Suppose company XYZ wants to raise capital but any debt issued will have a “junk” rating (or by issuing more debt it’s credit rating will be downgraded). Issuing preferreds may have a nominal interest premium vs junk bonds (or nominal cost consequences vs a credit downgrade event) while granting the ability to suspend payments if needed. This usually requires a bit of homework by the investor to discern whether avoiding a credit downgrade is the reason for issuance of preferreds.
Business Model
Finally, there are business models where preferred share issuance and dilution activities are common practice. Consider equity and mortgage real estate trusts (eREITs and mREITs). These are businesses that, by law, must payout 90% of profits as dividends to shareholders in order to avoid double taxation of dividends. The organizations utilize leverage in the purchase of properties or mortgages on properties and thus it’s generally more accretive to shareholder value to raise capital via dilution than by issuing straight debt. There is where the quality of management teams come into play – poor execution of this activity can and does destroy shareholder value.
Guiding Principles
My approach to investing in preferred shares includes the following guiding principles:
Price
Never pay more than the par/liquidation preference for a preferred share. If/when the share is called, purchasing above the par/liquidation price will result in an immediate loss of capital and reduction of total return.
Conversion Rights
Never invest in convertible shares. Preferred shares that convert to common shares at a particular ratio based on the underlying common-stock price is a play on the underlying stock. If an investor wants exposure to the underlying security it’s optimal to invest in it directly and skip the complexity, risk and cost of investing through a proxy instrument.
Dividend Payouts
Only invest in cumulative preferred shares. This helps eliminate the risk of investing in companies that are issuing preferred shares due to having a balance sheet too weak to issue investment-grade debt; they will typically opt for non-cumulative provisions to limit liabilities. Similarly, an investor will want to be compensated for the risk they’re taking. If dividends aren’t indirectly “guaranteed” through an accumulation provision they’re better off investing in the common share which also has the upside of both dividend growth and capital appreciation – two opportunities not present with preferred shares.
Indexing
Don’t index.
- The universe of preferred shares is small. Applying the above filters yields a manageable list of prospects to research.
- The overwhelming majority of preferred shares are from the financial sector. Indexing mirrors this reality and fails to offer diversification.
- The expense ratios of PFF and PGX, two popular preferred share ETFs, are .46% and .52% respectively. Assuming an average yield of 5%, roughly 10% of returns are lost to fund fees.
- PFF and PGX hold roughly 66% of their portfolio in preferred shares (the rest is in baby bonds and convertibles). These ETFs aren’t a pure preferreds play and are subject to the risks of baby bonds and convertibles.
- Investing in preferred ETFs prevents an investor from:
- ensuring they never pay more than redemption value for a position
- avoiding convertible preferreds
- ensuring all dividends are cumulative
Tactics
At this point an investor is ready to begin identifying and researching opportunities.
The guiding principles brought me to mortgage REITs as the vehicle of choice for implementation. Virtually all preferred shares in this sector are cumulative and have fixed-to-floating interest rates. At a high level the business model for companies in this space is a glorified arbitrage play: borrow using short term funds, invest in longer duration assets and earn the spread between the two interest rates. Then, use leverage to juice returns.
With regard to dividend safety and consistency, since REITs are obligated to distribute a minimum of 90% of their annual taxable income, the likelihood that preferred dividends are suspended for a year or more (which implies the common share also had its dividend suspended and thus no income is being distributed) is virtually nonexistent barring the company going under.
mREITs generally have no retained earnings due to the material amounts of leverage necessary to support the business model the 90% income payout requirement to maintain tax status. Thus, suspension of preferred dividends for more than a year would imply:
- if the suspension is voluntary in order to preserve capital / meet long-term obligations, the REIT tax classification will be lost which will break the business model
- if the suspension is involuntary because they don’t have the funds to satisfy dividend liabilities, the leverage and lack of retained earnings will bankrupt the company if conditions haven’t improved over this timeframe
While it’s possible to operate on life support in each scenario, it is likely there will be consolidation or ownership transfer before there is recovery from such circumstances. In other words, an investor is unlikely to experience a “bad year” with a company in this sector. Either it works all the time or the company goes bust.
Speaking of going bust, there are 6 mREITs that already experienced margin calls in March:
- NLY (satisfied calls)
- TWO (satisfied calls)
- NYMT (does not expect to meet future calls; seeking forebanance)
- IVR (does not expect to meet future calls; seeking forebanance)
- MITT (does not expect to meet future calls; seeking forebanance)
- MFA (does not expect to meet future calls; seeking forebanance)
Did I mention preferred shares can be risky, especially in the mortgage REIT space?
mREIT Basics
Mortgage REITS are companies that purchase and/or originate mortgages / mortgage-backed securities (MBS) using leverage. For example, they may:
- buy $10M worth of 30yr mortgages paying 4%
- using $2M of their own capital and
- borrowing $8M via short-term funding at 2%
- for a total leverage ratio of 4:1
- the $10M in mortgage-backed securities is used as collateral to facilitate the borrowing
The $10M portfolio generates $400,000 in interest income ( $10M * .04 ), minus $160,000 in interest expense ( $8M * .02 ), for a net income of $240,000.
This is an oversimplified example but is the gist of how the business model works.
Key attributes that describe the risk profile of a mortgage REITs are their investment portfolio composition, ratio of market cap to preferred liquidation value, payout ratio on preferred shares, and competence of the management team.
Investment Portfolio Composition
Portfolios of assets consist of mortgage backed securities (MBS) that are classified as either agency, non-agency. Some mREITs focus on only one type of MBS while others hold a blend of both types.
Agency MBS are issued by Fannie Mae, Freddie Mac, or Ginnie Mae. These are government-supported agencies that guarantee the principal amount of the loan will be repaid. Since the loans are guaranteed, mREITs that focus on these assets tend to use more leverage – typically between 8:1 to 11:1.
Historically, the Fed has offered liquidity to agency MBS during times of market stress. This potentially makes mREITs that focus their portfolio on agency assets less likely to fail than those that are a mix or exclusively non-agency.
Non-Agency MBS are loans whose principal amount is not guaranteed and are more commonly found in commercial lending scenarios. Yields on these assets are typically higher than on agency MBS and as such lower levels of leverage are used – typically between 3:1 to 5:1.
Takeaway: agency assets are federally guaranteed and tend to have higher liquidity and lower interest rates than non-agency assets which are not federally guaranteed. mREITs that focus on agency assets tend to use more leverage than those that focus on non-agency assets.
Ratio of Market Cap to Preferred Liquidation Value
Suppose hypothetical mREIT “A” has 5M common shares with a market cap of $50M ($10/share) and 500,000 preferred shares with a preferred liquidation value of $12.5M ($25/share). This would imply a market cap-to-liquidation ratio of 4.0 (50 / 12.5). In other words, the total value of all common shares is 4x the liquidation value of all preferred shares. The majority of the company’s value [at risk] is in common shares.
Now, suppose hypothetical mREIT “B” has 1M common shares with a market cap of $10M ($10/share) and 500,000 preferred shares with a preferred liquidation value of $12.5M ($25/share). This would imply a market cap-to-liquidation ratio of 0.8 (10 / 12.5). In other words, the total value of all common shares is 80% of the liquidation value of all preferred shares. The majority of the company’s value at risk is in the preferred shares.
Should both mREITs fall on hard times and need to liquidate, preferred shareholders of company “A” have a better chance of being made whole than those of company “B.”
Takeaway: a higher market cap-to-liquidation ratio is better for preferred shares.
Payout Ratio
Similar to common share dividends, preferred share dividends are funded by retained earnings. An investor can add up the total dividend payments for all preferred shares and divide it by the company’s taxable income to identify the preferred share payout ratio.
Suppose company XYZ:
- has 100,000 preferred shares outstanding and each share pays a $1.75 dividend for a total dividend liability of $175,000 per year
- had taxable income of $2M over the last year
Using the 90% distribution requirement of mREITS, that means no less than $1.8M must be distributed via dividends. The payout ratio for the preferred shares is 9.72% (175,000 / 1,800,000).
In this scenario the company can experience more than a 90% drop in revenue before dividends on preferred shares are at risk for being suspended (baring management discretion to proactively suspend all dividends in order to retain capital in extreme scenarios).
Takeaway: a lower payout ratio suggests a greater dividend safety.
Management Competence
This is the only differentiator that is not 100% objective.
Management has the ability to control portfolio composition including leverage, the ratio of market cap to preferred share liquidation value, the payout ratio for preferred shares and many other aspects to the business.
Possibly the single more important duty of management is to raise capital to grow the portfolio. Done properly, shareholder value is preserved or improved and risks are successfully managed. Done poorly and all of the key attributes that define mREIT risk characteristics can get crushed, along with shareholder value.
Unfortunately there is not a hard and fast checklist to filter great management teams from good (or terrible). This will come down to investor research and homework.
Takeaway: having a strong management team will help ensure the success of the company. An investor will need to research management’s decision making process to sort the wheat from the chaff.
Implementation
The entire premise of investing in preferred shares is for their bond-like return structure as a diversifier to broad-market equities and to help mitigate sequence of returns risk. They can also serve as a low-beta, higher-yielding alternative to treasuries and cash for use as margin collateral for trading options.
The callable nature of mREITs limits meaningful sharpe ratio evaluations since most positions in the mREIT sector are redeemed after the customary 5-year call protection window. Thus, similar to a bond, yield (or cash)-to-worst is the metric of choice for evaluating return opportunities and performance.
Takeaway: use yield (or cash)-to-worst as the performance metric to determine evaluate the performance of an mREIT preferred share.
Liquidity
The first observation is the lack of liquidity in the mREIT preferred share space. Using limit orders is an absolute must. Purchasing 1000 shares can and does move markets if a market order is placed.
This also means day trading and scalping is a non-starter. Swing trading may be possible during times of high volatility but historic NAV data suggests there is little movement in prices.
Takeaway: buy with high conviction and with the intent to hold.
Market Inefficiencies
Markets tend to keep inefficiencies virtually nonexistent, or at least out of reach, for the retail investor. However, recent events have caused prices to come completely unhinged from asset values. For this we can thank UBS for liquidating nearly their entire portfolio of leveraged ETNs as listed below (UBS press releases):
- ETRACS Monthly Pay 2xLeveraged U.S. High Dividend Low Volatility ETN (HDLV)
- ETRACS Monthly Pay 2xLeveraged US Small Cap High Dividend ETN (SMHD)
- ETRACS Monthly Pay 2xLeveraged Diversified High Income ETN (DVHL)
- ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (CEFL)
- ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (CEFZ)
- ETRACS 2xLeveraged Long Wells Fargo Business Development Company Index ETN (BDCL)
- ETRACS 2xLeveraged Long Wells Fargo Business Development Company ETN (LBDC)
- ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (MORL)
- ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (MRRL)
- ETRACS Monthly Pay 2xLeveraged MSCI US REIT INDEX ETN (LRET)
- ETRACS 2x Monthly Leveraged Alerian MLP Infrastructure Index ETN (MLPQ)
- ETRACS Monthly Reset 2xLeveraged ISE Exclusively Homebuilders ETN (HOML)
- ETRACS 2xMonthly Leveraged S&P MLP Index ETN Series B (MLPZ)
- ETRACS Monthly Pay 2xLeveraged Wells Fargo MLP Ex-Energy ETN (LMLP)
- ETRACS ProShares Daily 3x Inverse Crude ETN linked to the Bloomberg WTI Crude Oil Subindex (WTID)
Several of these ETNs held mREIT common and preferred shares. The liquidation event occurred over 1-2 trading days in an illiquid market and prices crashed to levels that would lead one believe these companies had filed for bankruptcy protection. For those that were at their screens and understood what was happening, lots of deals were had as prices have since recovered.
Takeaway: Market inefficiencies that retail investors can exploit may exist. Also, don’t invest in ETNs.
Relative Value
Between the low liquidity and forced liquidation of shares, not to mention all the broad-market issues currently at hand, relative bargains were abounding between different preferred shares of the same company.
For example, one day NLY-I was trading at a premium to NLY-F. By selling NLY-I then buying NLY-F I was able to obtain both more shares and a greater dividend per share without altering the risk profile of owning a preferred share issued by NLY.
Takeaway: keep an eye on all preferred shares issued by a company and periodically evaluate for relative opportunities.
Have experience trading preferred shares? Let me know in the comments below.
