Income Expert Prefers 'Preferreds'

Income Expert Prefers 'Preferreds'

By Richard Lehmann | 23 June 2008

We have been lamenting for the last few years about the shrinking supply of preferred issues for individual investors. No more; from famine we now have a feast before us.

In my Forbes/Lehmann Income Securities Advisor, I said 2008 will likely go down as the year of the preferred. Here, we look at new high-yielding preferreds from Fannie Mae (NYSE: FNM) and Bank of America (NYSE: BAC).

We are seeing large investment grade companies putting out multi-billion dollar issues and paying upwards of 8%, a yield they have not had to pay since the early 1990s. Now why would AA and A rated banks, insurance companies, finance companies and brokerage houses pay such a premium yield when they could raise capital by issuing bonds yielding more like 6%? The answer is that they need to raise ‘statutory capital’ a benchmark of the ratio of permanent capital to debt which regulated financial institutions need to have in order to maintain their license to do business.

The mortgage debt crisis and the subsequent mark to market writedowns which these financial institutions suffered impaired their regulatory capital and thus, forced all of them to seek statutory capital at the same inconvenient time. Hence, the 8% yields. This search for statutory capital is world wide and is not limited to straight preferred stock. These companies are also issuing more common stock and convertible preferreds.

In fact, these convertible preferreds that yield 8% and are being issued at a time when the stocks of these entities are depressed and represent a major buying opportunity. Fannie Mae 8.75% Series 08-1 Preferred (NYSE: FDRNP) has a par value of $50.00, a current price of $49.88 and a current yield 8.95%. On May 13, 2011 these non-cumulative preferred shares will automatically convert to 1.5408 shares of common stock if the common is at or above $32.45. If the common is at or below $27.50 the conversion rate will be 1.8182 shares. Between the two common prices, holders will receive $50.00 worth of common.

Fannie Mae, a public company operating under a federal charter, is the nation’s largest source of financing for home mortgages and is the largest non-bank financial services company in the world. The company buys loans from lenders, holding some and packaging others for resale thereby providing greater credit availability. Fannie Mae has gone through several years of investigations and Senate hearings because of questionable accounting and reporting and now they are deeply entangled in the sub prime mortgage dilemma.

The company reported for the first quarter 2008 a net loss of $2.19 billion. For the same period in 2007, they had net income of $961 million. This issue qualifies for the 15% dividend (QDI) tax. Fitch has this issue rated AA. Based solely on ratings, this issue would be ideal for low-risk investor, however, due to the uncertainty in the credit and capital markets as well as the housing market, I suggest conservative investors stand aside. Medium to high-risk investor buy this preferred at or below $52.00.

Bank of America 8.20% Series H Non-Cumulative (NYSE: BAC H) has a par value of $25.00, a current price of $24.94 and a current yield of 8.22%. The issue is rated A1/A+. Bank of America is the second largest bank in the country with 6,100 locations in 30 states. In addition to banking services BAC offers asset management and other financial and riskmanagement products, global corporate and investment banking and equity investments.

For the first quarter 2008, BAC reported net interest income of $9.99 billion and net income of $1.21 billion. For the same period last year, net interest income was $8.27 billion and net income was posted at $5.26 billion. First quarter provision for loan loss was $6.0 billion compared to $1.24 billion in 2007. This is a good issue for lowrisk income portfolios. Buy at or below $25.35.

It is likely that these securities will sell at a premium once the current financial crisis abates and the earnings of these financial organizations recover. I can’t remember the last time I got paid 8% to wait for an investment grade issuer to also deliver a capital gain. Happy days are here again. Indeed!

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Normxxx    
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