Common shares of Bank of America (NYSE:BAC) have been on a tear, but there may be opportunity in areas overlooked by investors. Preferred stocks are generally seen as less exciting investments designed to generate income over the long haul. For many investors, preferred stocks are compared to other income investments whether they're in Treasuries, corporate bonds, or even blue-chip dividend stocks.
But these two preferred stocks provide investors with both the high yields that attract income investors and upside potential for long-term growth investors.
Convertible bank preferreds
In early 2008, shortly before the entire financial system was thrown into turmoil, Bank of America issued Bank of America 7.25% Series L Preferred Stock (NYSE:BAC-L). As a major financial institution, Bank of America has enough series of preferred stock to keep any income investor busy. But the Series L preferreds have some notable differences.
Unlike many other series of Bank of America preferred stock, Series L is not redeemable by Bank of America at any time (but Series L can be converted, and we'll discuss this soon). While most series of B of A preferreds trade near liquidation value, a rise in investor confidence surrounding B of A could push prices of B of A preferreds above liquidation. Under that scenario, Bank of America could redeem the preferreds at liquidation limiting potential upside.
Bank of America has already been redeeming some higher yielding classes of preferreds at liquidation. Bank of America Series L preferreds avoid this redemption risk and allow investors to see the full upside of a B of A preferred stock recovery.
But also unlike other series of B of A preferreds, Series L gives exposure to Bank of America common stock upside as well. Series L is convertible at the holder's option to 20 shares of Bank of America common stock at $50 per share (making whole on the $1,000 liquidation value).
There are many reasons to be bullish on Bank of America. A low price to book value, substantial potential earnings growth, greater dividends and share buybacks, and a slowly recovering economy. I've seen reasonable arguments made that B of A common shares could be in the $20 range next year with some predictions figuring for a share price in the $30 range over the next few years. While this would make for great returns for current common stock investors, it's still quite a distance away from the $50 per share conversion level in Series L.
But with Series L not being redeemable for cash by B of A, Series L investors essentially get a perpetual option to buy 20 shares of B of A at $50 per share. And since Series L provides roughly the same yield as other classes of B of A preferreds, this option comes at virtually no cost to the buyer.
It should be noted that B of A can convert Series L to common stock at its own option; however, the common stock price must be at least 30% above the $50 conversion price for 20 of the 30 previous trading days. In other words, Bank of America would have to shell out at least $1,300 in common stock to redeem Series L, currently trading around $1,050.
Royal Bank of Scotland Group (NYSE:RBS) remains a hot button political issue in the U.K. as the financial giant remains effectively 81% owned by the government. Fears surrounding the potential actions of the government have kept yields on many series of RBS preferred stock above 7%.
Investors willing to accept this risk on the idea that the government will eventually reprivatize the bank not only collect 7%+ yields, but can acquire preferred shares at a substantial discount to liquidation value. With $25 liquidation values, many shares trade below the $22 range with RBS Series L preferred stock (NYSE:RBS-L) occasionally slipping below $20 per share while still offering a 7.2% current yield. As with Bank of America, RBS has enough series of preferred stock to fill a shopping catalog, so investors should look at other series as well and decide which is best for them.
If RBS is returned to the private sector or a clear plan for doing so is laid out, RBS preferreds could rise closer to liquidation value. Additionally, stronger earnings and a better outlook likely to happen in a European banking recovery should increase confidence in RBS, making preferred stock less risky and more valuable.
Alexander MacLennan is long $20 January 2015 Bank of America call options and Bank of America 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. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days.