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"A Value Opportunity in Preferred Stocks"


Liberty
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Interesting read by the anonymous author known as @Jesse_Livermore on Twitter:

 

http://www.philosophicaleconomics.com/2017/03/a-value-opportunity-in-preferred-stocks/

 

(It's not because I post it that I necessarily would do it myself or would do everything this author does -- he's smarter than I am, and looks more with Macro than with single businesses -- but it's still thought provoking)

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Very good article thanks for sharing. Convinced me that they are undervalued on a relative basis at least. Personally the relative tax advantage does not apply to me however. Will consider buying a small position in one or both, but I definitely learned something reading this article. Thanks!

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My only concern with these is that the yield is fixed.  If interest rates go up, would 6.15% be a good yield for a bank preferred? I can recall government bonds yielding 6% or higher.  They have no end date to them so if inflation kicks in then all you have is the stock price and conversion scenario to save you. It would have to go up by quite a bit with either stock for that to make sense.  I am not sure if bank stocks would do well in an inflationary environment so you could get trapped in these.

 

If you think inflation will stay low they seem like good options.  I agree that you might as well buy both if you buy any.

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... the shares carry the same risk that any long-term fixed income security carries, which is the risk that long-term interest rates will meaningfully rise, forcing prices to adjust downward to create competitive yields.  But these securities, at their current prices, offer three features that can help mitigate that risk, at least partially.

 

First, at 6.15% (tax-equivalent: 7.26%, 8.28%), their yields and YTWs are already very high, higher than essentially any other similarly rated fixed income security in the market.  Conceivably, in a rising rate environment, their prices won’t need to fall by as much in order for their yields to get in line with other opportunities.

 

Second, if their prices do end up falling over time, they’ll be accumulating a healthy 6.15% yield during the process, helping to offset the losses.  That’s much more than the 2.5% to 3% that long-term treasuries will be accumulating.

 

Third, as discussed earlier, increases in long-term interest rates will tend to increase the profitability of Wells Fargo and Bank of America.  The realization of interest rate risk in the shares will therefore have the counterbalancing effect of reducing their credit risk. 

 

Granted, the market might not see the shares as carrying any meaningful credit risk right now, and therefore the credit risk “relief” that comes with improved profitability might not help prices very much.  But if the shares do not carry any meaningful credit risk, then why are they trading at a yield of 6.15% (tax-equivalent: 7.26%, 8.28%)? Is that the kind of yield that risk-free securities normally trade at in this market? Obviously not.

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  • 4 weeks later...

Thank you Liberty for the link/info.

Will definitely look into this. Spent some time in 2008-2009 looking into US bank capitalization and potential opportunities.

Will come back on this forum in a few weeks/months with hopefully helpful insights.

By the way, your post helped me discover the philosophical economics site.

The last article though (see link below), the one that followed your link on potential preferred security opportunities, tells me how out of step and not attuned I am versus our evolved and efficient Market.

http://www.philosophicaleconomics.com/

"To summarize: over time, markets have developed an improved understanding of the nature of long-term equity returns.  They’ve evolved increasingly efficient mechanisms and methodologies through which to manage the inherent risks in equities.  These improvements provide a basis for average equity valuations to increase, which is something that has clearly been happening."

It's all about evolution and progress. Isn't it?

A permanently elevated plateau of some sort?

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From Bogleheads:

 

1. Wells Fargo 30 year bonds yield 4.6%

2. 30 year treasuries yield 3.06%

3. Thus, Wells Fargo spread to treasuries is 1.5%

4. Recovery rates on corporate debt are about 50%. What this means is that on the average, if a company goes bankrupt and you are a bond holder, you receive approximately 50 cents on the dollar. Lehman bondholders only received 30% so perhaps we can look on that as a worst case.

5. Preferred shareholders will get nothing in bankruptcy. They are below bondholders in the capital structure and it is rare for bondholders to recover 100%.

6. Twice the capital at risk roughly means twice the spread, so I'd look to get 6.14% on a 30 year preferred.

 

Does anyone know what historical recovery rates have been for subordinate bonds in the financial sector?

 

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From his latest post -Diversification, Adaptation, and Stock Market Valuation-

 

"Panics are less likely to be seen as reasons to panic, and more likely to be seen as opportunities to be taken advantage of. Obviously, panics will still occur, as they must, but there’s a basis for them to be less chaotic, less extreme, less destructive than they were in market antiquity."

 

Why have there been two major panics (biggest draw downs) since the Great Depression if "there are less likely reason to panic?"

 

He's also making a big assumption here: "Consequently, they’re more willing to actively step in to prevent dislocations from happening, or at least craft their policy decisions and their communications so as to avoid causing dislocations."

 

They have so far - but that doesn't mean that'll continue to happen. Look at the rise of populism around the world.

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From Bogleheads:

 

1. Wells Fargo 30 year bonds yield 4.6%

2. 30 year treasuries yield 3.06%

3. Thus, Wells Fargo spread to treasuries is 1.5%

4. Recovery rates on corporate debt are about 50%. What this means is that on the average, if a company goes bankrupt and you are a bond holder, you receive approximately 50 cents on the dollar. Lehman bondholders only received 30% so perhaps we can look on that as a worst case.

5. Preferred shareholders will get nothing in bankruptcy. They are below bondholders in the capital structure and it is rare for bondholders to recover 100%.

6. Twice the capital at risk roughly means twice the spread, so I'd look to get 6.14% on a 30 year preferred.

 

Does anyone know what historical recovery rates have been for subordinate bonds in the financial sector?

 

Also, that logic seems to ignore the tax advantage of qualified dividends vs coupon payments

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  • 9 months later...

Both issues are down $70-$90 from highs as rates have risen. Back under $1300 conversion value (though since that is likely a ways off, I doubt it would matter much in long term total returns).

 

I have been close to pulling the trigger on these for a while. Thinking a little harder now.

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