An Historic Value in Financial Preferred Stock?

The economic crisis has pushed yields on financial preferred shares to record highs. How to enjoy diversified dividends in exchange-traded funds

With talk of bank nationalizations in the air, financial stocks have been whipsawed, dragging their preferred stock counterparts with them. Amid the volatility, Donald Crumrine, chairman of Flaherty & Crumrine in Pasadena, Calif., which manages $2.3 billion in preferred portfolios, sees opportunity. The gap in yield between Treasuries and preferreds has widened to around nine percentage points, compared with its previous peak of three points in 2000. That means investors are pricing in doom. "Valuations are historically cheap," Crumrine says. "The market is discounting default rates that significantly exceed those of the Great Depression."

The appeal of preferreds is that their dividends are higher than on common shares, and they get paid first. But they trade more like bonds, so the bulk of their returns come from income, not capital appreciation. Today, because banks and other financial institutions are the biggest issuers of preferreds, investors fear that if banks are nationalized, their holdings could be wiped out. After all, preferred shareholders in Fannie Mae and Freddie Mac got squeezed when those companies were nationalized last year.

Selective Buying at Bargain Prices

As fear spread recently, yields on some of Citigroup's (C) preferreds rose to more than 26%, while those of Wells Fargo (WFC) reached 14%. But many preferreds are being tarred by association, some money managers say, as the market awaits clarity from Treasury Secretary Timothy Geithner on what the government might do if a major bank were nationalized.

John Maloney, chief executive officer of New York-based M&R Capital Management, points to Royal Bank of Scotland Group (RBS)—now 70%-owned by the British government—rather than Fannie and Freddie as a model for how the current anxiety over preferreds might play out. Royal Bank of Scotland announced in late February that it would continue to make some preferred payments. While banks have been cutting common dividends, Maloney says, they are "likely to continue to pay" their preferreds, citing the possibility of financial contagion if they did not. Insurance companies are big holders of preferreds, he notes, and if they have to mark down holdings, the financial crisis could worsen. On the other hand, "even if Geithner comes out and clarifies everything and there's a rally, these things are still going to have tremendous yields," he says. "You can selectively buy at dramatically knocked-down prices."

The $400 billion preferred market isn't limited to deeply distressed financial institutions, of course. Investors willing to take the risk, Maloney argues, might buy issues of less troubled institutions, such as JPMorgan Chase (JPM) or Wells Fargo. Issuers among the top holdings in Flaherty & Crumrine's closed-end funds include Liberty Mutual Group, Banco Santander (STD), and Sovereign Bancorp—companies that aren't at the center of nationalization concerns.

Most investors would do best to buy a diversified portfolio of preferreds. One strategy: Invest in an exchange-traded fund such as PowerShares Preferred Portfolio (PGX) ETF or PowerShares Financial Preferred Portfolio(PGF) ETF. Ed McRedmond, senior vice-president for portfolio strategies at Invesco PowerShares (IVZ), says fat yields are one reason for strong investor interest recently. Despite abysmal returns, the ETFs have drawn $222 million in net cash inflows this year.

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