As we start 2014, there are 928 preferred stocks and exchange-traded debt securities, or ETDS, trading on U.S. stock exchanges. ETDS are similar to preferred stocks and are frequently labeled as such on your brokerage statement. But they are actually bonds, recorded on the issuing company's books as debt, rather than equity, and they're often seen as having less investment risk than the same company's preferred shares.
With 928 issues to choose from, finding the most worthy ones can be a tedious, time-consuming task that few are anxious to jump into. However, using the four-step screen described here and the database at PreferredStockInvesting.com, I turned up a security offered by CenturyLink (NYSE:CTL) trading under the symbol CTW.
Risk versus reward
Using the Moody's rating scale as a proxy for investment risk and current yield as a measure of reward, this chart illustrates the trade-off that preferred-stock investors are making as of Jan. 2, 2014:
Notice how CTW stacks up against its other "Baa3"-rated peers. CTW currently provides a yield of 7.94%, but yield is far from the only consideration for risk-averse preferred-stock investors.
Here is an easy-to-follow four-step screen that helps me find high-quality preferred stocks trading at bargain prices.
Step 1: Moody's investment grade
Many preferred-stock investors are only interested in investment-grade securities, so let's start there. Moody's ratings fall into two categories -- investment-grade and speculative-grade. Filtering out securities that are not rated as investment-grade by Moody's reduces our list of candidates from 928 to 139.
Moody's investment-grade category has 10 subcategories, from "Aaa" down to "Baa3." While the criteria for any of these subcategories are stiff, the Baa3 subcategory is the easiest to qualify for and, therefore, offers more choices. Limiting our list to Baa3-rated securities on Jan. 2 cuts our list of 139 down to 40 U.S.-traded preferred stocks and ETDS.
Step 2: Dividend rate of at least 6.5%
As preferred-stock dividend rates go up, their market prices tend to go down, and vice versa. Preferred-stock investing is therefore long-term investing, taking advantage of this known inverse relationship between rates and prices over time.
Preferred-stock dividend rates, a.k.a. "coupon" rates, range between 6% and 9%. During a period of upward pressure on rates (now), it is important to stay off the bottom of the rate scale when considering a preferred-stock purchase. Companies have a history of buying your shares back from you (known as a "call" or "redemption") 91% of the time when they can save as little as 0.375% in dividend expense. Higher dividend payers tend to be called more readily than lower payers.
Put another way, the next time rates head down toward 6%, there is a 91% chance of a call for preferred stocks with a dividend rate of 6.375% or higher. Below that, you may not be able to sell your shares without realizing a capital loss.
Using 6.5% as the minimum dividend rate for purchases adds a layer of principal protection to your investment. Of the 40 Baa3-rated preferreds stocks and ETDS, there are 19 that offer a dividend rate of at least 6.5%.
Step 3: Currently priced below $25 par
In the event of a downstream call, the issuing company will pay you the security's "par value" per share (usually $25). By purchasing your shares for a market price that is below $25, you position yourself for a downstream capital gain in addition to the 6.5% or higher dividend that you are earning.
Selecting issues that have a $25 par value and are currently trading for a market price below that amount leaves 14 candidates.
Step 4: Highest current yield and highest dividend rate
So far, this method of identifying preferred-stock candidates has focused on lowering risk. Now let's look at the income side. By looking at dividend rate (i.e., coupon) and current yield side by side, we can easily see the highest payers. Of the remaining 14 candidates, CenturyLink's CTW offers a dividend rate of 7.5% (the highest in the group) and, priced at $23.61, has a current yield of 7.94% (second-highest).
As a bonus, CTW also carries an investment-grade rating from S&P and is an ETDS.
Add a capital gain to 7.94% dividend income
CTW, issued by CenturyLink's Qwest cable-laying subsidiary, is a double-investment-grade-rated ETDS with a 7.5% dividend rate and selling for a below-par $23.61 per share. Further, CTW's call date does not arrive until Sept. 15, 2016, so this security cannot be called by CenturyLink until after that date (see prospectus for more details). In the event of such a call, those purchasing shares at today's $23.61 will receive CTW's $25 per share par value from CenturyLink, adding a $1.39-per-share capital gain to the 7.94% dividend yield you will be earning in the meantime.
Whether or not CTW is consistent with your personal risk tolerance, resources, and goals is a decision that only you can make. But following this four-step process will allow you to identify high-quality preferred-stock candidates for consideration at any time.
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Doug K. Le Du is the author of Preferred Stock Investing, Fifth Edition and owner of the CDx3 Notification Service database that was used for this article. He has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.