Why CenturyLink and Bank of America Preferred Stocks Look Good Right Now

For different reasons, four specific preferred-stocks stand out among the crowd as January comes to a close.

Jan 28, 2014 at 6:46PM

Preferred-stock prices increased during January to an average of $23.79 per share, up from December's $23.05. That's a significant increase in just one month but still below these securities' $25 par value. Purchasing shares below the par value of a preferred stock adds a layer of principal protection to your investment because, in the event of a downstream call, shareholders will receive the par value in cash from the issuing company.

Many preferred-stock investors also consider agency ratings an important indicator of risk. Moody's classifies preferred stocks in two categories -- investment-grade and speculative-grade -- with the investment-grade category having 10 subcategories: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, and Baa3.

The chart below gives us a look at the U.S. market for preferred stocks as of Jan. 24, 2014. Using these preferred stocks' market price (either above or below $25) and Moody's rating (investment-grade or speculative-grade), the chart is divided into four quadrants. Each diamond represents a U.S.-traded preferred stock.

Source: CDx3 Notification Service database, www.PreferredStockInvesting.com.

The criteria used to include and exclude securities for the chart are provided in the footnote below the table.

Sensitive to the upside
On Jan. 10 we got a good look at how sensitive preferred-stock investors still are to negative economic news. The U.S. economy needs to generate about 200,000 new jobs per month to break even. The horrible December jobs report, tallying only 74,000 new jobs, triggered a rush to purchase high-quality preferred-stock shares, with investors fearing that the bad news would motivate the Fed to postpone its quantitative-easing "tapering."

We saw the same sensitivity a few days later when China reported a manufacturing slowdown. By the end of January, average preferred-stock prices had increased by $0.74 per share.

What does $25 buy?
The diamonds on the above chart provide examples (not to be taken as recommendations) of preferred stocks from each quadrant, all of which are trading at, or very near, $25 per share. The dividend rate (a.k.a. coupon) offered by each security is also indicated.

CenturyLink's (NYSE:CTL) CTQ and CTW offerings would interest preferred-stock investors looking for competitive, multiyear income-production with relatively low investment risk. These two securities, issued within three months of each other in 2011, are nearly identical and both offer Baa3 investment-grade ratings.

CTQ, issued on June 2, 2011, cannot be redeemed by CenturyLink until June 1, 2016. This security offers a 7.375% annual dividend (coupon), paying $0.46 per share each quarter. CTQ closed at $24.98 on Jan. 24. About three months after CTQ began trading, CenturyLink introduced CTW, with a 7.5% coupon. CTW typically trades very close to its $25 par value as well.

The real bonus with these two securities is that they are actually exchange-traded debt securities, rather than preferred stocks. ETDS, often mistaken for preferred stocks and frequently listed as such on brokerage statements, are actually bonds (and are therefore recorded as debt, rather than equity, on the company's books). As bonds, ETDS are viewed as having less risk than the company's preferred stocks.

A place to park some short-term cash
On the speculative-grade side of the chart, two preferred stocks from Bank of America (NYSE:BAC) are indicated. While CTQ and CTW would attract long-term income investors, B of A's MER-M and BAC-Z would be interesting to those with a shorter-term cash-storage need.

Those who have some excess cash on hand and want a place to park it for, say, six months to a year are hardly impressed with today's 1% bank CD interest rates. But what about 6% or so?

Bank-issued trust preferred stocks, or TRUPS, have mostly been redeemed due to changes to reserve formulas imposed by the 2010 Wall Street Reform Act. Those TRUPS that are still trading are highly likely to be called sooner rather than later, with shareholders receiving $25 per share in cash. Because of the high likelihood of a call, market prices of the remaining TRUPS stay close to these securities' $25 par value, so the risk of losing principal is very low, especially if you purchase TRUPS shares below $25.

Faced by a mountain of litigation, Bank of America has been unwilling or unable to redeem its TRUPS, even though replacing them with traditional preferred stocks would substantially ease the bank's Tier 1 reserve compliance burden. But that just changed.

As reported by Reuters on Jan. 15, Bank of America reported a stunning quarterly profit increase of almost $3 billion. And over the last 12 months, the bank has slashed its mortgage losses by about 70% from $3.7 billion to $1.1 billion. With those kinds of numbers, the prospect that the bank will catch up on its TRUPS redemptions soon becomes more real.

MER-M is a TRUPS originally introduced by Merrill Lynch in April 2007. MER-M pays a modest 6.45% annually and has a Ba1 Moody's rating (one notch below investment-grade). Similarly, BAC-Z, issued by Bank of America in August 2005, offers a miserly 6% coupon. While this is cheap money for the bank, it is not the low dividend expense that matters; rather, it is the bank's need to meet its Tier 1 reserve requirement.

For preferred-stock investors looking for a place to store some short-term cash without much risk to principal, betting that Bank of America will redeem these TRUPS within the next year delivers a 6%-plus percent return in the meantime.

What does $25 buy? Whether you are a long-term income investor or are looking for a place to park some shorter-term cash, today's preferred-stock market has something to offer a wide variety of investors.

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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 recommends Bank of America. The Motley Fool owns shares of Bank of America. 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.

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