Preferred stocks have become a way for income investors to secure a less risky position in a company, collect a higher yield, and still trade the securities on a relatively liquid market.
But in collecting this higher yield, preferred stockholders typically give up much of the upside to a company in the event its fortunes turn for the better. Here, I'll look at some convertible preferred stocks that offer investors the features of traditional preferred stock while also giving them the potential for upside in the form of capital appreciation.
As the housing market recovers, the demand for mortgages is expected to increase boosting the bottom lines of various banks. Although Bank of America and Wells Fargo also offer convertible preferred stocks, the conversion prices on these preferreds is at least three times the current trading price of the common stock. For those still interested in the Bank of America convertible preferred shares, I have written another article about this series of preferreds.
While I could see the potential for these big bank preferreds to eventually reach their conversion prices, it will likely be decades before they do so. Instead, I will look at the convertible preferred shares of two regional banks that also stand to benefit from a mortgage recovery.
For more near-term upside potential, the convertible preferred shares of KeyCorp (NYSE:KEY) and Huntington Bancshares (NASDAQ:HBAN) are worth a closer look. KeyCorp Series A Preferred Shares (NYSE:KEY-G) have a coupon rate of 7.75% but, because of the preferred trading above liquidation value, currently yield around 6%. The yield on this preferred handily beats out the common stock yield of 1.65% and may be a better pick for an income investor's portfolio.
For upside potential, these preferreds are convertible into 7.0922 shares of KeyCorp common stock. The conversion price is $14.10, about 6% above the current stock price. However, with the preferreds trading above liquidation, the common stock would have to top $18.18, 37% above the current stock price, before preferred shareholders buying today would make money in a conversion. Although it could be a while before the common stock reaches this level, investors in the convertible preferred can collect a sizable dividend while they wait for the common to appreciate.
Huntington Bancshares Series A Preferred Stock (NASDAQ:HBANP) has an investment basis similar to that of KeyCorp while offering a slightly higher yield. The preferred has a coupon rate of 8.5% but, like the KeyCorp convertible preferreds, the Huntington preferreds trade above liquidation resulting in a current yield of 6.75%. And, like at KeyCorp, the convertible preferred has a higher yield compared to the common stock, yielding 2.1%.
Huntington convertible preferreds are convertible into 83.668 shares of Huntington Bancshares common stock with a conversion price of $11.95, about 24% above the current share price. Because of the current price of the preferred shares, investors today would need to see the common rise to 57% to $15.06 before realizing any conversion upside potential. But, like with KeyCorp, investors in Huntington convertible preferreds can collect a solid yield while they wait for the common stock to make a conversion profitable.
Income and upside
Both preferreds are perpetual and can only be eliminated through a conversion by the holder or a conversion by the bank if the common stock trades 30% above the conversion price for 20 of the past 30 trading days. While this limits some of the upside if you are only interested in holding the preferred, if the common stock rises to 130% of the conversion price, the common stock will quite likely be paying a higher dividend. At this point income investors can choose to sell for a small gain on the conversion or hold the common stock as an income investment.
Most preferred stocks don't offer investors the opportunity to benefit from a rise in the common stock, but the convertible preferreds from KeyCorp and Huntington Bancshares can give income investors the income they're looking for with some added upside potential as the mortgage market continues to recover. For investors bullish on the mortgage market but also looking to add income generating securities to their portfolio, these convertible preferreds are definetly worth a further look.
Alexander MacLennan is long January 2015 $20 calls on Bank of America and is also long Bank of America 2018 Class B warrants. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool recommends Bank of America and owns shares of Bank of America, Huntington Bancshares, and KeyCorp. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.