Passive Income with Preferred Stock

We’re going to explore finding passive income and total return using (bank) preferred stock.  But first, what is preferred stock?

I’ll let my AI friend Bard give the textbook definition:

Preferred stock is a type of equity security that has features of both debt and equity. Preferred stockholders have a higher claim on a company’s assets and earnings than common stockholders, but they do not have the same voting rights.

Preferred stock is often issued by companies that need to raise capital but do not want to give up too much control to common stockholders. Preferred stock can be a good investment for investors who are looking for a steady income stream and some downside protection.

Here are some of the key features of preferred stock:

• Dividends: Preferred stockholders are entitled to receive dividends before common stockholders. The amount of the dividend is typically fixed, but it can be variable.
• Liquidation preference: In the event of a liquidation, preferred stockholders are entitled to receive their investment back before common stockholders.
• Voting rights: Preferred stockholders typically have no voting rights. However, some preferred stocks may have limited voting rights, such as the right to vote on certain matters, such as a merger or sale of the company.

There are many different types of preferred stock, each with its own unique features. Some of the most common types of preferred stock include:

• Cumulative preferred stock: Cumulative preferred stock requires the company to pay all past due dividends before it can pay dividends to common stockholders.
• Non-cumulative preferred stock: Non-cumulative preferred stock does not require the company to pay past due dividends. If the company does not pay a dividend in a given year, the dividend is simply forfeited.
• Callable preferred stock: Callable preferred stock gives the company the right to repurchase the stock at a specified price.
• Convertible preferred stock: Convertible preferred stock can be converted into common stock at a specified price.

Preferred stock can be a good investment for investors who are looking for a steady income stream and some downside protection. However, it is important to understand the risks associated with preferred stock before investing.

Quick beach break, now back to human programming  

What is preferred stock?

• Preferred stock is a type of stock issued by real estate investment trusts, utilities, and banks for capital to use in their business.  

• Preferred stock carries a fixed or floating rate dividend that the company must pay first before they can pay any common stock dividend.   

• If a company were to liquidate, preferred stockholders get paid after bondholders but before stockholders.   

• Preferred stock dividends can be qualified dividends, depending on the company that issues the dividend.   Generally bank and utility preferred dividends are qualified while REIT dividends are not.

• Preferred stock is generally quoted in $25/share increments.  

Redemption Risk

• Substantially all preferred stock is “callable”, which means after a set number of years, the company can repurchase the stock for $25/share. If rates go down, the company can issue new preferred stock at lower rates and call away higher cost shares.

Price / Ticker / Dividend

• Preferred stock usually has a letter designation after the symbol.    For Example, Bank of America N series preferred can be found as BAC-N, BAC/PN, or BACPRN depending on the brokerage used.

• BAC-N is listed as a 5% preferred stock.   This means it pays a $1.25 annual dividend based on it’s $25 original price.   On 5/12/2023, BAC-N closed at $21.46, which equates to a 5.82% yield.  The values can go up or down based on interest rates and other risks.  

Cumulative or Non-Cumulative

• Cumulative preferred stock means if the company misses a dividend, they must “catch up”  before they can do certain other things, like redeem the stock or pay common stock dividends.  Most bank preferred stocks are listed as non-cumulative.

How big of a bank issues preferred stock?

Generally a bank has to be $20bil or so in asset size to issue preferred stock.   Smaller banks can’t issue enough to offset the capital markets costs and there are some regulatory limitations about how much preferred stock vs. common stock can be issued.

Why don’t all banks have preferred stock?

After 2012, the remaining banks were considered well capitalized.  There were limited growth opportunities and many banks chose not to issue new capital.  The rates required on the preferred stock were also higher than the common stock dividends paid, which negatively impacted the cash flow of the company. Over the last decade, many of the larger banks instead redeemed all of the 6%+ fixed rate preferred stock when interest rates fell and opted not to issue new preferred stock. 

What are the risks with preferred stock?

1) Default risk:   If a bank is failed by the FDIC, generally the preferred stock is wiped out.   If a bank elects to voluntarily liquidate, the preferred stock can be impacted.  In 2023, there were two banks that resulted in a loss to the preferred stock.  First Republic Bank was closed by the FDIC and saw it’s preferred stock go to zero.   Silvergate Bank elected to voluntarily liquidate and their preferred stock is currently trading for $10/share as investors expect a recovery.

In 2008, shareholders lost their preferred stock in a bank if it failed. However, preferred stock was not impacted by the numerous banks that were merged away at discounted prices, received governmental support, and/or had to issue substantially more common stock to survive.  

2) Interest Rate Risk: There is also a risk of principal loss if interest rates increase.  The price of preferred stock moves similar to a bond, which is inverse to interest rates.  If an investor needs to sell the stock after rates have risen, there may be a loss.  Generally the lower the interest rates at the time of purchase, the higher the risk of principal loss. Conversely, buying a preferred stock at a discount to $25 can provide an appreciation opportunity.

3) Capped Upside / Fixed Dividend. The fixed rate preferreds discussed here only have two components to generate a return:  The fixed dividend payment and the difference between the price paid and $25.  It usually requires a higher rate environment than issuance or some type of elevated risk for the company / sector to buy at under $25. Unlike a dividend growth stock, the payout does not increase as the company generates additional earnings.  It is fixed for the lifetime of the stock, which makes the price paid important 

How is risk priced?

Generally the “too big to fail” banks represent the lowest tier of risk in preferred stock.   As of 5/13/2023, Bank of America’s preferred stock provided a 5.79% yield.  Numerous large regional banks that are considered “financially sound” provide a yield around 6.5%.   From there, the rates go all the way up to close to the 9.68% the yield currently provided to new purchasers of Western Alliance preferred shares as of the date of this chart. 

Issuances with lower coupon rates also trade for a slightly lower yield than higher coupons.  There is less risk the bank will redeem the stock and terminate the investor’s cash flow stream.   I watch / hold a number of preferred stocks and built the following spreadsheet to track their prices, current yield, and what the maximum upside as an investor.

In the chart above, the ticker symbol is Google Finance’s formatting and the price populates and is quoted as of 5/13/2023.   I input the fixed dividend payment and have the sheet automatically update the yield based on that payment.

The right side of the sheet shows the appreciation opportunity with a capped upside at $25/share, the price the company has rights to redeem the stock for.   In reality, if interest rates fall, the preferred shares would trade for slightly above $25, which is equal to the redemption price plus investor’s guesses on the likelihood of redemption.  

How to Buy Preferred Stock 

Most of the bank preferred stock issues are between 4,000,000 and 20,000,000 shares.   The initial offering is sold into retail and fixed income investors seeking income.   You can typically find these at your discount brokerage by typing in the company’s common stock symbol and searching for the preferred stock. Regions Financial Preferred Stock E may be quoted as RF-E, RF/PE, or RFPRE depending on the firm.

There are a limited number of shares that trade in a day and the Bid / Ask can range from a few pennies to $0.50.   If a market order is placed, it’ll immediately go to the ask range and often only a few shares will be filled at the ask price then the price is moved up by the market maker.  I prefer to buy these with limit orders.  I’ve had insurance where I placed a limit order for 500 shares, entered it at the ask price, then I’ll have a token number of shares filled and the price will be increased.   The market maker is seeing how badly I want the shares and if I’ll increase my price.   When I don’t increase my bid, then the remainder of the order is filled ten to twenty minutes later.  I’ve also seen the ask price go up by $0.01 to $0.05 as soon as I place an order.   These are annoyances that come with commission free trading and something to be aware of if you look to buy these shares.  

Are there other industries to consider?

I have personally invested in the preferred stock of some real estate investment trusts in addition to banks.  Public Storage is the #1 storage operator in the country and has a number of preferred stock issuances currently paying 5.5%.  Entertainment Properties Trust owns movie theaters (45%) and various other entertainment properties like ski resorts, theme parks, and campgrounds throughout the country.  Due to the concerns around their theater tenants, the preferred stock pays 7.5%.  Interestingly this is less than the 8.05% paid by the common stock as investors prefer the safety of preferred stock in this company vs. the upside of future dividend increases.  This is likely because the common stock dividend was suspended during the pandemic while the company continued to pay the preferred.

Wrapping Up

Preferred stock can be considered for a portion of the portfolio as a lower risk / lower return investment for a near financial independence or post financial independence portfolio.   This income stream can be purchased via the Index ETFs of PFF and PGX, or a portfolio can be built out of a number of preferred stocks picking the industry risk, interest rate, and tax treatment of the stocks purchased.   At the interest rates available in 2023, this is a growing portion of our portfolio. 

Further Reading: Preferred Stocks from Early Retirement Now