AFLAC Preferred Stock Remains Popular Despite Japan-Centric Risk

AFLAC, (AFL 0.63%), a U.S. supplemental insurance company with a $30 billion market capitalization, is well known for its very clever duck commercials. AFLAC's common stock is providing a current dividend yield of 2.3 percent while the current yield of its single exchange-traded debt security (ETDS) is offering 5.6 percent to today's buyers (June 27, 2014).

ETDS are very similar to preferred stocks and are often labeled as such on brokerage statements. But ETDS are recorded on the company's books as debt, rather than equity, and are actually bonds that trade on the stock exchange (rather than the bond market). As debt, ETDS are often considered to represent lower investment risk than the same company's preferred stocks and distributions are classified as interest income.

Trading under the symbol AFSD, the security boasts double investment grade ratings (Baa1/BBB) and offers a 5.5 percent annual dividend (coupon).

Description and History
AFLAC was established in 1955 as a family insurance business, its current CEO, Dan Amos, being the son of one of the original brothers that founded the company.

AFLAC has a very interesting business model in several ways. Rather than offer primary insurance policies, AFLAC offers health and life supplemental policies as additional coverage to a policyholder's existing insurance.

That strategy has served the company very well in recent years. In the U.S., it has allowed them to, at least for now, sidestep much of the teeth-gnashing that has consumed primary health insurance providers over the Affordable Care Act. And in Japan, being a supplementary coverage provider has allowed them to do a megadeal with Japan Post. Because of that deal, AFLAC now insures one out of every four households in Japan.

The percentage of AFLAC's revenue that comes from its Japan operations has grown to 74 percent, dwarfing its U.S. business.

Source: AFLAC website, aflac.com

Obviously, the stability of Japan's economy, monetary policies and currency have a lot to say about AFLAC's wellbeing.

But AFLAC's investment portfolio also raises eyebrows. Like most insurance companies, premium revenues are invested primarily in AAA-rated government bonds and AFLAC is no exception. However, a closer look at their portfolio reveals that their holdings are primarily in Japan Government Bonds (JGBs). While the company has sought to move away from this "double-down" of their Japan-centric risk, 74 percent of new cash flow during Q1 2014 was investing in JGBs with the remaining 26 percent going to U.S. securities.

Lastly, in addition to the risks associated with 74 percent of their revenue coming from its Japan Post deal and the majority of the proceeds being invested back into JGBs, Japan Post is owned by the Japanese government (despite enormous and very controversial efforts to privatize the agency over the last few years).

AFLAC's Preferred Stock
The U.S. preferred stock market is currently a 6.8 percent market and prices have returned to pre-QE2 levels.

Further, there are currently 39 high-quality preferred stocks, most with double investment grade ratings and cumulative dividends, offering dividend rates of at least 6.5 percent (June 27, 2014).

AFSD, AFLAC's sole offering to preferred stock investors, was issued in September 2012 at 5.5 percent with a September 2017 call date and a September 2052 maturity.

Source: CDx3 Notification Service database, PreferredStockInvesting.com

Trading recently at $24.54 per share, a $0.46 discount to par, AFSD is offering buyers a below-market current yield of 5.6 percent but compares favorable to the company's common stock yield of 2.3 percent.

Given the alternatives currently available, a compelling case for AFSD seems like it would be hard to make. But AFLAC's AFSD trades over 30,000 shares on most days. That's relatively high for this type of security, especially one that is almost two years old.

What's Next?
Due to AFSD's relatively low 5.5 percent dividend rate, this security is particularly exposed to the "perpetual ownership trap." Such securities with a dividend rate of at least 6.5 percent are generally able to ultimately be sold for a capital gain either on the open market or to the issuing company as the result of a redemption (there have only been two exceptions since January 2001). Those holding shares that offer a dividend rate below 6.5 percent, however, have not been as fortunate (Preferred Stock Investing, Fifth Edition, page 141).

Investing in AFLAC's AFSD is attractive to very long-term investors who are looking for the stability implied by a decades-old company with very solid financial performance and management offering a fixed-return ETDS with double investment grade ratings and cumulative dividends. AFSD's 2052 maturity date redefines long-term preferred stock investing, but with over 30,000 shares trading every day, stability more than income is the attraction here.