Preferred-Stock Investors See More Choices in Today’s Market

Earlier this year, preferred stocks that had yet to reach their respective call dates were attractive, but "call protection" should be less of a consideration in today's preferred-stock market.

For two years, the market price for high-quality preferred-stock shares has been artificially inflated by the Federal Reserve's "quantitative easing" bond-buying program. By purchasing $85 billion of bonds each month, the program creates a shortage, which raises bond prices. As buyers pay more for the same interest income, the yield provided by these fixed-return securities has been pushed down, accomplishing the Fed's rate-lowering policy objective.

To some extent, where bonds go, so go other fixed-return securities, including preferred stocks. Since 2010, preferred-stock investors have seen high prices and falling yields. In fact, throughout last year and the first half of this year, average market prices for high-quality preferred stocks were higher than these securities' $25 par value.

The par value is the amount of cash shareholders will receive in the event that the issuing company redeems the preferred-stock issue (also known as a "call"). Risk-averse preferred-stock investors therefore seek to pay less than $25 for their shares.

More preferred-stock candidates to pick from
As we saw earlier this year, when a high-priced market forces buyers to go out on a limb and pay more than $25 per share, "call-protected" preferred stocks (those that have yet to reach their respective call dates and are therefore unable to be called by the issuing company) command an additional premium.

But in anticipation of the Fed backing out of its QE program, preferred-stock prices came back down over the summer. With the average market price for high-quality preferred stocks now at $24.18, the risk of capital loss that calls previously carried has gone away for today's buyers. In fact, those paying less than $25 per share in today's market will realize a capital gain if their shares are called by the issuing company.

Instead of fearing a call, as they did earlier this year, today's preferred-stock buyers are now looking forward to the capital gain that a downstream call will deliver.

Because high-quality preferred-stock shares can once again be purchased for less than $25 per share, issues that have exceeded their respective call dates and are now callable are coming back into the game, further broadening your choice of candidates to pick from.

Vornado Realty Series G and Series I
Vornado Realty (NYSE: VNO  ) provides two examples of preferred stocks that were avoided earlier this year but are now viewed more favorably. VNO-G and VNO-I, both of which offer cumulative 6.625% annual dividends, have exceeded their respective call dates by several years. VNO-G became callable on Dec. 22, 2009, while VNO-I reached its call date on Aug. 31, 2010.

In the event of a call by Vornado, buyers paying more than $25 per share would realize a capital loss, so until June of this year, these two preferred stocks from Vornado were off the table for most buyers.

Source: CDx3 Notification Service database, PreferredStockInvesting.com.

Before rates ticked up in June, Vornado could have issued a new preferred stock at about 6.125% and used the proceeds to redeem VNO-G and VNO-I. Doing so would have saved the company 0.5% in dividend expense. But for whatever reason, Vornado did not redeem VNO-G or VNO-I when it had the chance.

Because rates have gone up since then, issuing a new preferred stock at a rate below 6.625% and using the proceeds to redeem VNO-G and/or VNO-I is no longer possible for Vornado. So even though these two preferred stocks have exceeded their respective call dates, today's higher-rate conditions make them less likely to be called (until rates come back down again in the future), so they are back in play for today's buyers.

Foolish final words
As the Fed backs out of its QE program (or as the market anticipates such an action), preferred-stock dividend rates will tend to rise, providing higher dividend income for lower prices. Preferred stocks that are beyond their respective call dates have re-entered the game, providing buyers with more choices to pick from. Preferred-stock buyers who are still seeking call-protected issues, as they did earlier this year, need to update their thinking accordingly.

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