Outlook 2017: Market veteran sees benefits, opportunities in convertible preferred stock

By Stephanie N. Rotondo

Seattle, Dec. 30 – The convertible preferred market is a space that is underutilized by issuers but possibly attractive to some investors, one industry veteran says.

“The convertible market in recent years and decades has shown a huge preference for bonds,” the source said. “Retail buyers who might prefer preferreds are rarely in the convertible market, of course.

“Arbitrageurs and all traders and speculators who are driven by models also prefer the superior credit characteristics of bonds,” the source, a retired portfolio manager, noted. “So individual convertible preferreds often are exceptionally attractive.”

“They don’t get anywhere near the terms a bond can get away with,” said another New York-based sellside source. “Then comes the issue of duration. Mandatory or perpetual? These perpetuals can stay around forever.”

While the former portfolio manager sees opportunities in that space, he is not blind to the risks associated with such issuance.

“With preferreds, credit worthiness is always in question,” he said. In addition to that, dividends can be deferred, or even noncumulative. There also tends to be a higher level of volatility.

“Nowadays in the convertibles market, it is Neanderthal to trade converts without a model,” the source acknowledged. Modeling preferreds, however, can “become discombobulated. Anything can happen to credit spreads on a preferred. They are completely bottomless.”

As such, issuers who opt to sell convertible preferreds – most typically banks – have to offer “much more attractive terms to get anyone interested in buying these things.”

But the risks aside, the source maintained that the benefits were worth it.

“It is a market that allows retail to invest directly,” the source said – a boon to a group of investors that tends to go untapped more often than not.

Preferred deals, the source explained, are “almost always registered,” versus traditional convertibles, which tend to go the Rule 144A route. Preferreds are often listed on an exchange, making it easier for retail investors and individuals to access them.

And while credit risks are there, yields tend to be higher on preferreds than on convertible bonds.

Better yet, preferreds often qualify as qualified dividend income; bonds do not.

In a market that can be relatively stagnant for long periods of time, the volatility in convertible preferreds “does create opportunities,” the source said.

“Buyers could do well if the underlying stock goes up,” the source remarked. But investors “need to believe that there are growth opportunities.”

The source noted that “we haven’t seen any business euphoria for a long time. If we had a reason [to be euphoric, such as growth] then maybe [convertible preferred] issuance would go up.”

For those investors interested in the convertible preferred space, the industry veteran offers a few examples of strong issues to consider.

New York Community Bancorp

New York Community Bancorp Inc.’s 6% Bonuses due Nov. 8, 2051 offer the following:

• $275 million issue priced Oct. 28, 2002 via Citigroup Global Markets Inc. ($35 million greenshoe);

• $50-par;

• Convertible at $35.624 per share, up 27%;

• Current yield: 6.1%;

• Callable beginning in 2007, subject to a 125% price hurdle; and

• NYSE: NYCBPU.

“This was trading around par for months and then traded down to $48 after the election,” the source said. But the common stock went up, on the hopes that a “Trump-driven” economy would be good for the bank.

“What if the stock really does well?” the source contemplated. “The preferred has to follow and suddenly, this is a good deal.”

The source added that the deal is non-callable, but did point out that holders have to pay income tax on the full dividend.

Wells Fargo

Wells Fargo & Co.’s 7.5% class A series L noncumulative convertible perpetual preferred stock (originally issued by Wachovia Corp.) offer the following:

• $4,025,000,000 priced April 14, 2008 via Goldman Sachs & Co. and Wachovia;

• $1,000-par;

• Convertible at $31.20 per share, up 30%;

• Current yield: 6.28%;

• Forced conversion after March 15, 2013, subject to a 130% price hurdle; and

• NYSE: WFCPL.

“This is interesting from an income perspective,” the source said, noting that the paper qualifies as qualified dividend income.

“It’s effectively the equivalent of a traditional preferred that is trading at a discount to its call price,” the source said.

Because of the soft call protection, Wells Fargo will likely have to repurchase or tender for the preferreds if they want to take them off the balance sheet, the source pointed out.

And, “recent scandal aside, this is a very strong credit,” the source said.

Bank of America

Bank of America Corp.’s 7.25% series L noncumulative convertible perpetual preferred stock offers the following:

• $6.9 billion priced Jan. 24, 2008 via BofA Merrill Lynch;

• $1,000-par;

• Convertible at $50.00 per share, up 33.8%;

• Current yield: 6.2%;

• Callable after Jan. 30, 2013, subject to a 130% price hurdle; and

• NYSE: BACPL.

This issue came “around the same time as the [Wells 7.5%] issue,” the source said. It also is QDI paper.

The likelihood of a soft call is also quite low.

“The stock isn’t going to go up that much for many, many years,” the source opined. “So it’s a nice way to get some nice preferred income from a good credit.”

The source noted that the issue has had a “wild history.”

At the bottom of the financial crisis, the preferred had plummeted to $162.57 – while paying a $72.50 dividend, placing yields in the 40% range. Three months later, the issue had surged to around $890.

“It went up more than four-fold,” the source said. “That’s a fantastic recovery.”

The source also remarked that the paper has “outperformed the common stock, then and now – without ever missing a dividend payment.”

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