Wednesday, March 11, 2009

High Yielding Preferred Stocks Could Also Get the Dividend Axe

Preferred shares are typically equity with a higher ranking than ordinary shares. Preferred stock does not have voting rights but has a fixed dividend payment, just like a bond. In a bankruptcy or liquidation of the corporation, preferred shareholders have a superior priority over common shareholders, but a lower priority in comparison to bond holders. Preferred stockholders are also first in line to receive dividend payments, which are typically fixed. They don’t typically get to share in the prosperity of the enterprise however as preferred stock dividends do not increase. In tough economic conditions however, preferred stock dividends are much less likely to be cut or suspended; as long as the company continues operating as a going concern preferred stock dividends continue getting paid.

There are several ETF’s, which enable investors to participate in a basket of preferred stocks. One of the most active ETFs is the iShares S&P U.S. Preferred Stock Index (PFF) and the other is Powershares Financial Preferred (PGF). PFF currently yields 10.77% and has an expense ratio of 0.48%. Financials account for over 81% of PFF’s asset allocation, while materials and Health Care account for 8% and 7% respectively.

PGF currently yields 19.90% and has an annual management fee of 0.72%. PGF’s holdings consist only of financial preferred shares. The main difference with PFF is that PGF holds preferred stock in foreign banks such as Credit Suisse, HSBC, Royal Bank of Scotland and ING Group.

Preferred stocks have typically enjoyed above average dividend yields. In addition to that preferred shares have usually come from financial companies. Regulators require banks to have adequate capital to support their liabilities and require that they hold a certain minimum level of Tier 1 capital. Because preferred shares are normally less expensive to issue than common stock, banks issue preferred stocks quite often.

The financial crisis that started in 2007 has affected negatively the market for preferred shares, which have taken a beating. Investors who chased high yielding preferred stock ETFs got burned in the process as well. The iShares S&P U.S. Preferred Stock Index, which lost almost 24% in 2008 are down 45.70% year to date. The Powershares Financial Preferred ETF also lost 27.30% in 2008 and 55.7% so far in 2009.

Main reason why investors are fleeing preferred stocks is the high allocation of financial companies. The bailout of Freddie Mac (FRE) and Fannie Mae (FNM) by the US government resulted in elimination of dividends for preferred shareholders. Most recently Citigroup (C) announced that it would suspend dividends on some preferred shares, which could be a final blow to investors seeking fixed income. Investors are worried that the rest of financial stocks, which received TARP money, such as Bank of America (BAC), Wells Fargo (WFC) and US Bancorp (USB), could be next to cut the dividend payments on their preferred shares.

Because of the current uncertainty in preferred dividends, I do not view PFF and PGF as buys at these levels. Investors who learned the hard way not to chase yield should think twice before diworsifying into preferreds.

Relevant Articles:

- TARP is bad for dividend investors
- Can USB and WFC maintain their current dividends?
- Don’t chase High Yielding Stocks Blindly
- Which Bank will be next? Follow the dividend cuts

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