Capital Markets | The Preferred Way

Marilyn Cohen, Forbes Magazine, 03.24.08

When the market hands you lemons, make lemon chiffon. That's what I'm doing for my clients. In my last column ( Jan. 7) I cautioned investors to wait until later in the first quarter to buy either preferred shares or exchange-traded funds that track preferreds. I predicted that by then financial firms would come clean regarding their losses. Sure enough, this winter's red ink and writedowns proved to be momentous. Tin cups in hand, several of their chief executives had to beg for alms from the Asian and Mideastern sovereign wealth funds to shore up eroding capital.

Foreign bailouts haven't been enough, though, and these financial giants have also had to issue bonds and preferreds. The equation is simple: More writedowns equal additional capital needed. For you individual investors, let their pain be your gain. It seems every week another needy bank or broker floats new preferreds, which are easier to trade and more transparent than bonds. The issuers are household names: Citigroup (nyse: C - news - people ), Bank of America (nyse: BAC - news - people ), Lehman Brothers (nyse: LEH - news - people ), Deutsche Bank (nyse: DB - news - people ) and Wachovia (nyse: WB - news - people ).

Fortunately for the needy firms, a huge appetite exists for the new preferreds. Citi may have its troubles, yet no one believes it will default on payouts. Don't bother buying regional banks or brokers. Go for big, liquid issues. Many of the latest preferreds are listed on the New York Stock Exchange.

The bad news is that the securities offerings have attracted crowds of institutional investors, leaving just small portions for individual buyers. To give yourself a fighting chance, make sure your broker has you on a priority list for all the newly issued preferreds, which automatically puts you in the bidding. All you have to do is ask; anyone with an account is eligible. Then you can bid a specific yield. Another way to lay your hands on the shares is to place a "when-issued order," the equivalent of a market order for common. This means you bid within a range of yields--say from 8% to 8.25%--and accept what the market gives you. This boosts your chances of getting an order filled.

Even if your order is unfilled, you will at least see the market yields of the winning bids. That will help if you try to find the shares in the secondary market. Thus far many of these new preferreds' dividends qualify for the 15% maximum tax rate. (The favorable rate disappears in 2010.) Bond interest is taxable at regular rates up to 35%.

The financial firms' preferred yields nowadays are superior to those of their bonds, which are higher in the credit pecking order and hence less risky. Example: In January Citigroup issued 148.6 million preferred shares at $25 to raise a quick $3.7 billion. The Citigroup ( c 8.125% Series AA Pfd) shares now trade on the NYSE at a slight premium ($25.40) and still offer a decent yield, 7.99%. They are callable Feb. 15, 2018 at $25 for a 7.95% yield to call. Compare the Citigroup preferred with its closest bond equivalent: the ten-year $1 billion Citigroup bond issue, 6.95% due Nov. 1, 2018. The bond yields 6% to maturity.

Even the firms that haven't been slammed in the credit crunch are joining the preferred party. Perhaps they're figuring that today's yields, while generous, are still lower than they'll be amid the likely higher rates of an economic recovery. Lehman Brothers and Deutsche Bank had less exposure to the subprime-fueled deals of now suffering rivals. They have recently issued preferreds that are worth looking at.

Their yields are slightly lower than the likes of Citi, because these firms aren't as desperate to raise extra capital. Yet the payouts are still pretty decent. Lehman Brothers (LEH 7.95% Pfd) trades at $24.94 and is callable Feb. 15, 2013. At its $25 par is Deutsche Bank (DB 7.6% Pfd), callable Feb. 20, 2018, trading at $25.50 for a 7.35% yield to call. Both are large, and therefore easily tradable, issues: 75.9 million and 78 million shares.

My suggestion is to buy a variety of preferreds with different dividend payment dates and varying call features. As we did with Citi above, be sure to compare the preferred yield with the issuer's bond yield. Lehman does not have any bonds maturing in 2013, but you can look at 2012, which is close enough. There is a $1.5 billion 6.625% bond issue maturing Jan. 18 of that year, and it yields 5%. That 7.95% Lehmann preferred, although riskier, is the better buy.

Please do not think you have missed out on these preferred opportunities. Writedowns and losses in the financial realm, already around $150 billion, are far from over. Some analysts calculate that additional writedowns may total another $200 billion amid subprime and collateralized debt obligation carnage. UBS just reported an $11 billion fourth-quarter loss and warned of more to come. Watch it for a preferred issue.

Marilyn Cohen is president of Envision Capital Management, Inc., a Los Angeles fixed-income money manager. Visit her home page at www.forbes.com/cohen.

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