Preferred-Stock Investors Now More Risk-Tolerant With Bank Preferreds

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Rating agencies and preferred stock investors, while using different methods, usually judge the investment risk of a preferred stock with little disparity. Where agency ratings come in the form of a quantitative rating on a scale, investors' conclusions about risk are reflected in today's market price (and thus today's yield).

Preferred stocks that are viewed as having similar risk frequently have similar yields -- same risk, same reward. But what about when there is a disconnect between the risk as assessed by the rating agencies and that assessed by investors? Who's right?

There and back again
We learned during the global credit crisis that agency ratings were imperfect for a variety of reasons. Shortcomings of both mathematics and character led to grossly inaccurate ratings in too many cases. This was especially true with preferred stocks issued by banks.

But historically, in the absence of such crisis conditions, agency ratings have served millions of investors well for many decades. And as imperfect as these ratings are, the fact is that most investors have little choice but to use such ratings as a proxy for investment risk.

In fact, looking at the most recently introduced bank preferred stocks, it appears that the tides of doubt have turned entirely. With this most recent crop, Moody's is saying that the preferred stocks issued by banks represent more risk than investors seem to think -- exactly the opposite situation that preferred-stock investors faced not so long ago.

Take a look at this chart. Each diamond on this chart represents one of the 36 preferred stocks issued within the last six months that have been rated by Moody's Investors Service (this total includes 27 preferred stocks and nine exchange-traded debt securities, or ETDs. ETDs are very similar to preferred stocks and are often classified as such by brokerage systems).

The blue "best fit" line indicates the reward (as measure by current yield) being paid by these new preferred stocks at each risk level (as declared by Moody's). Moody's investment grade ratings (strongest to weakest) are Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2 and Baa3 while Moody's speculative grade ratings are Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca and C. Note how the yield demanded by preferred stock investors goes up with risk -- no surprise there.

Bank preferreds rated too low?
The table below the chart does the math for you. For example, as a group, today's preferred-stock investors are demanding a reward of 6.6% at the "Baa3" risk level (the lowest investment-grade Moody's rating).

During the crisis years, Citigroup (NYSE: C  ) was the poster child for what came to be known as "too big to fail," or TBTF, banks. Earlier this year, Citi introduced a new noncumulative traditional preferred stock with a 5.8% dividend rate (coupon). Moody's has issued this security a "B1" rating -- four notches into speculative-grade territory.

In today's market, a preferred stock at the "B1" risk level commands a current yield of 7.5%. But look at Citi's preferred stock, "C-C," on the chart: The market has priced C-C such that it finds buyers at a current yield of 6.6% -- a level of reward that is more consistent with preferred stocks with a much stronger "Baa3" investment grade Moody's rating.

Moody's is saying that C-C's risk is consistent with its "B1" rating, while investors are saying that C-C represents a much lower risk level ("Baa3").

While it is tempting to think that Citi's new preferred stock might be an exception, take another look at the chart. The red diamonds show the preferred stocks issued by TBTF banks over the last six months, and yellow diamonds indicate newly issued preferreds from smaller banks. Note how, as we would expect, the gray diamonds (nonbank preferreds) occur randomly on both sides of the best-fit line but that is not the case for those issued by banks.

Almost all new bank-issued preferred stocks are located to the right of the best-fit line, just like C-C, indicating that the market is accepting a much lower reward (i.e., yield) than Moody's is saying these investors deserve, given the risk.

Today's preferred stock investors seem to believe that the ratings provided by Moody's for new bank-issued preferred stocks are now more negative than deserved -- a complete reversal of how preferred-stock investors viewed the ratings of such securities just a few years ago.

Who's right?
The current disparity between how investors and Moody's assess the risk associated with bank-issued preferred stocks can have several explanations, and an argument can be made supporting both. For example, it could be that Moody's is simply behind the curve, as many of today's ratings resulted from a February 2012 global assessment of bank-issued debt (see "Moody's downgrades firms with global capital markets operations," published in June 2012).

But perhaps investors are not considering some of the recent regulatory changes that have increased the investment risk of these securities. Both the Wall Street Reform Act (domestically) and the Basel III regulations (internationally) include provisions that disqualify most bank-issued preferred stocks (specifically called trust preferred stocks, or TRUPS) from being counted in "Tier 1 Capital," a key measure of bank reserves closely watched by regulators.

TRUPS had the "cumulative" dividend provision, meaning that if the bank skipped a dividend payment, it was required to make it up to you downstream. But in an emergency, what good are bank reserves if someone else (e.g., TRUPS shareholders) has a claim to the bank's cash?

For the last two years, banks have been redeeming their cumulative TRUPS shares and replacing them with new noncumulative traditional preferreds, so today's bank-issued preferreds represent a higher level of risk to investors than they have in the past.

As the above chart clearly indicates, investors are consistently pricing bank-issued preferreds at a much lower risk level than Moody's has assigned. Because either could have it right, it is more important now than it has been in several years for those investing in bank-issued preferred stocks to go a step or two beyond agency ratings and seek to understand the risks associated with these securities.

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