The banking sector as a whole has improved tremendously since the financial crisis, but the future of many of the big banks is still a little too uncertain for a lot of investors without high risk tolerance. However, there is a way to get in on the action without too much risk, and while creating a nice stream of income as well.
I'm talking about the banks' preferred stocks, which are similar to bonds but have a nice chance for capital gains as well as income. Here's why the preferred stocks of banks like BB&T (NYSE:BBT), JPMorgan Chase (NYSE:JPM), and Bank of America (NYSE:BAC) might be a better fit for your portfolio than buying common shares.
How are they different from common stock?
Most importantly, preferred stock isn't directly dependent on the performance of a company. All preferred shares have a fixed dividend amount, which stays the same as long as shares are in existence. So, if a preferred stock pays $1.00 per year, it won't change over time like common stock dividends.
Because of this, preferred stock is a much safer investment than common stock. In the event of a liquidation or severe cash flow problem, preferred shareholders must receive their money before common stockholders see a dime.
But isn't that the same thing as a bond?
Well, not exactly. Like bonds, some preferred stocks are callable, meaning the company can buy them back at a predetermined time for $25 per share (the par value of all preferreds). Also, some are convertible and can be exchanged for common shares.
Despite the similarity, there are some big differences to be aware of. First is their accessibility to everyday investors. You can readily buy preferred shares on major exchanges, with a much more liquid market than most bonds. Also, the price of entry is much lower at about 1/40th the cost of a bond for each preferred share.
Another important distinction is that preferred shares are subordinate to bonds. In terms of seniority, preferred shares rank higher than common ones in terms of dividend payment and recovery of assets in the event of liquidation, but only after bondholders are made whole. However, because there is less of a guarantee on preferred dividends than on bond payments, preferred stocks generally pay higher interest rates than bonds.
Why should you bother with preferreds?
Preferred stocks offer investors the best of both worlds; the safety of bonds and the high returns you would expect with common stock. Additionally, many preferred stocks trade for a substantial discount to par value, meaning there is significant upside potential. This brings me to another important point: The further below par value shares are trading, the lower the dividend will be. Think of this as a trade-off...less income means more potential upside in the share price.
For instance, look at the first two preferred stocks on the list below; with symbols BAC-D and BAC-E. The first one actually trades for a slight premium to its par value of $25, meaning that if shares were called away you wouldn't make any money. However, you would receive an annual dividend of nearly 6.2% as long as you hold the stock.
However, if you were to buy the BAC-E preferred shares, you would only receive a 4.4% yield as income. But, the shares trade for a nice discount to their par value. If the bank called the shares, they would have to pay you the full $25 par value, which would give you a nice 11.6% gain on your principal, as well as all of the dividends you were paid for holding the shares.
How do I get started and where can I find preferred stocks?
Preferred stocks are listed on the major stock exchanges, so they're easy to find. Some brokerages use different symbols for preferreds (like BAC-D instead of BAC-D), but it's usually some variation of the common stock's ticker symbol. Here is a quick chart of information about the preferred stocks of the largest banks, along with their dividend rate, share price, and current yield.
|Bank||Ticker||Share Price||Annual Dividend||Current Yield %|
|Bank of America||BAC-D||$25.18||$1.55||6.17%|
This is by no means a complete list, and many of these banks have more varieties of preferred shares than are listed here. In fact, a quick search on TD Ameritrade reveals Bank of America has nine different types of preferred shares listed on the NYSE.
The catch Is this a better investment in banks than their preferred shares?
Preferred stocks can produce great income, but you should be aware of what you're giving up. No matter how well the banks do, you won't see too much upside on your investment, but such is the price of safety. However, for the "safe" portion of your portfolio, there is nothing wrong with 6% yields and a little upside potential.
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Is this a better investment in banks than their preferred shares?
Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America and JPMorgan Chase. 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.