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Profiting from Preferreds

We agree with Gregory Zuckerman and his article entitled, “Favorable Currents for Preferred Shares.”  Preferred shares are a unique type of security that feature characteristics of both stocks and bonds.  Like bonds, preferred shares are issued with a stated dividend coupon and a par value.  Although preferred shares don’t have the same voting rights as common stock, they are higher up on a firm’s capital structure and their dividends must be paid out before a common stock’s dividend can be paid, providing them with more safety in the event a company runs into trouble.  Preferred shares also have the benefit of trading like common stocks, both much easier and cheaper than trading bonds. The combination of attractive stock and bond features suggests that preferred securities are worth a serious look.

One of the appealing features that the article mentions about preferred securities as compared to common stock is the trading characteristics.  Andrew Zimmerman, the chief investment strategist at DT Investment Partners LLC, was quoted as saying, “Preferred shares are slightly more like bonds than stocks as their historical price volatility more closely matches that of bonds.”  The preferred securities’ high dividends and place on the capital structure help to act as a cushion against volatility and price swings when the market is confronted with economic shocks.  This quality is particularly appealing to investors who are reluctant to invest in common stocks which many feel are due for a pull-back given their strong year to date gains.

Traditional preferred shares also have a favorable tax treatment that is typically only reserved for common stock dividends.  The tax is much lower than that on corporate bond interest.  Traditional preferred shares’ dividends are deemed, “qualified,” meaning they are taxed at the long term capital gains rate instead of the ordinary income tax rate applied to interest from corporate bonds.  For those in the top tax bracket, the difference is between paying a 20% federal tax rate and 39.6%, respectively.  As such, a corporate bond would have to yield 9.27% to keep pace with a traditional preferred’s dividend coupon of 7% on an after-tax basis.  The preferential tax treatment of the preferreds compared to higher taxes and lower yields on corporate bonds makes preferreds a compelling choice.

Mr. Zuckerman appropriately noted however, that most preferred securities are perpetual in nature, and thus sensitive to interest rates.  As such, when interest rates go up it is common for the prices on these securities to go down, the same reaction long term bonds would produce.  While every investment has risks, a couple ways to partially mitigate the risk in preferreds is to find preferred securities from companies with improving fundamentals that are intent on redeeming their preferred shares.  An improving credit profile may result in an increase in the price of the preferred share that may partially offset a resulting decrease in price from rising interest rates.  Also, a company that is expected to redeem its preferred security will be less sensitive to interest rates similar to a short term bond. Another mitigating factor comes with preferreds that pay dividends over 7.5%.  High dividend yields are somewhat insulated from interest rate moves.

Traditional preferred securities combine many of the favorable features of both bonds and stocks into a unique security: high dividend yield, favorable tax treatment, and lower historical volatility than common stock. Given these security characteristics and investors’ need for income in this historically low interest yield environment, preferred securities present a compelling choice, which explains why they are a core component of our Defensive Growth strategy.

Weekly Update – March 22, 2013

The troubles in Cyprus could not dampen the Dow’s enthusiasm Friday as healthy quarterly earnings reports from Nike and Tiffany gave the index a boost and a 91-point gain.  For the week, the Dow was flat and for the year, the index is up 10.7%.

The European Union has set a Monday deadline for Cyprus to present a viable proposal to raise the 5.8 billion euros required to obtain monetary help from the European Central Bank (ECB).  At the heart of the proposal is levy on Cypriot bank accounts, held both by small domestic and large foreign savers, which would raise a substantial sum to help counter the country’s banking problem.  The proposed bank levy was initially voted down by Cyprus lawmakers earlier this week, but is back on the table given the need to quickly produce an austerity package.  Fearing a run on deposits, banks will remain closed until Tuesday.  Without ECB funding, Cyprus’ banking system would effectively collapse and could force the country to withdraw from the euro.  Needless to say it’s a situation worth watching.

Our trust preferred portfolios continue their nice performance, up almost 4%, on average, year-to-date through Thursday versus 3.05% for the S&P Preferred Stock Index and -.33% for the Barclays Aggregate Bond Index.

Oil rose $1.22 Friday to $93.67 per barrel, mostly due to weakness in the dollar.  For the week, oil was down .2%.

Next week, economic calendar highlights include February new homes sales on Tuesday, weekly jobless claims and a March manufacturing report on Thursday, and a consumer confidence report on Friday.  Expect new home sales to fall slightly from January, weekly jobless claims to remain in the 330,000 range, manufacturing to be flat, and consumer confidence to increase slightly from February.

Key upcoming events in resolving Greece debt problems

The Greek crisis has commanded a disproportionate amount of the headlines over the past few months.  Greece is looking to secure another round of bailouts, while Germany, France, and the rest of the Eurozone members are negotiating how to both stabilize Greece’s economy and prevent any spillover into their own economies.  Meanwhile, investors have been carefully analyzing every development and are impatiently waiting for any temporary resolution.  The attached timeline reviews the key past and upcoming events that will provide some clarity on the Greek crisis.

We believe that the following events will determine the next disbursement of Greek aid that will allow the country to avoid default.

  • On Oct 4, finance ministers from the European Union (EU) postponed the release of the next installment of aid to Greece. Greece Finance Minister Evangelos Venizelos said the country has enough cash to operate until mid-November. With cash needs covered until then, the Greek Parliament has time to pass more austerity measures required by the bailout plan.
  • Finland secured the right to have collateral backing its contribution to Greek aid. The collateral program found no other takers but Finland.
  • The Oct 4 meeting ended with a new sense of urgency among ministers that more has to be done to ring-fence the Greek debt problems to prevent contagion. A plan for concerted bank recapitalizations was discussed, but specific deals were not provided.
  • On Oct 9, Germany and France will meet in Berlin to discuss banks’ finances. Germany has cited the need to prepare for a Greek default that investors see as a sure thing. France, whose banks have the most to lose, is unwilling to gamble on letting Greece go.
  • On Oct 14-15, finance ministers from the Group of 20 (G20) nations will meet. Solutions to the Greek crisis should be discussed, but decisions for implementation (if any) should be considered during the November 3-4 meeting of G20 leaders.
  • On Oct 17-18, EU council leaders are expected to meet to finalize the expansion of the European Financial Stability Fund (EFSF) to 440 billion euros.
  • On Oct 24, inspectors from the EU and IMF are expected to present their audit reports on Greece finances and recommend the disbursement of aid to Greece, according to the Luxembourg Prime Minister.
  • Greece is working with inspectors from the EU and IMF in coming up with more austerity measures, such as the reduction of the minimum wage of government employees. Depending on the timing and pace at which Greece comes up with more reform plans to meet demands, disbursement for aid can occur between Oct 17 and late November. We expect aid to be disbursed before December, during which 10 billion euros of bond payments are due.

Conclusion: The passage of austerity measures, such as the unpopular property tax increase, demonstrates Greece’s commitment to reduce its budget deficit. We believe that the next installment of aid will be given to Greece. Financial markets should start to normalize after the next aid package is granted and continues to do so in November when a longer term plan is expected from the EU.

The following link points to a pdf file that features a complete timeline on the past and upcoming events in the Greek debt crisis:

Key upcoming events in resolving Greece debt problems

 

Ulland Investment Advisors

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