Reader Question: What is behind the price movements of preferred shares. They work like bonds, but why do they seem to move in tandem with the issuing entity? When the Fed raises the rate, bond prices would fall, but what about preferred shares? The yields for preferred shares still seem rather high. Standard Chartered recently launched preferred shares with a yield of 9.5%, is this the normal yield in a normal market?
Question From Article: Investing In Preferred Shares/Stock And Corporate Debt
The price movements of preferred shares
In normal economic times and market conditions, the price of preferred shares don’t tend to fluctuate quite as much as we have seen since the beginning of the stock market decline. Within the past year alone we have seen a wide range of issues fluctuate greatly. One example is issues by Wells Fargo & Co, which changed from close to $24 to $13, and now all the way back to around $24. The stock market crash/decline, financial sector’s problems, and general fear of corporate collapse are the causes of such recent price swings. However, similar price movements have been seen in preferreds of other industries, and not just in the financial sectors (which were the first to experience the significant declines).
Why do the preferred share prices seem to have been moving in tandem with the issuing entity?
One reason is that during this type of economic turmoil, investors are uncertain whether the issuing entity can financially sustain the issued debt obligations (make the regular payments). Remember, preferred shares are like loans. They need to make regular payments to the holders (lenders). When the current investors and potential investors (potential lenders) start to doubt whether or not they can make future payments, fewer lenders want to purchase or trade for those debt obligations. This situation causes the prices to decline. Similarly, the same situation will occur with the bonds, as we have seen within the past two years. The issuing entity’s common share price will also be treated in a similar way.
This market crash has been dubbed the “credit crisis”. We have seen companies struggle to refinance their debts, or get new loans. Companies that were unable to refinance existing debts experienced massive losses and/or collapsed because of that. Because of credit problems, and financial instability, this raised more uncertainties regarding the true financial health of companies and the domino effect in industries (resulting collapse of one company actually affecting another).
In normal economic times, investors may be disappointed with earnings or growth prospects may not be as rosy as they would like to see. However, they may not be worried about the company’s financial condition or ability to make payments on debt obligations. So it is likely in that situation that we would observe common share prices decline (due to earnings/growth disappointment), but little movement in the preferred share (sustained confidence in the overall financial condition).
I am thinking of structuring a leveraged core portfolio with preferred shares… My main concern is the price stability of the preferred shares as if it falls too much, it will trigger a loan top up.
With the above being said, even in normal times, it is quite possible to preferred share prices decline significantly (perhaps for a short and temporary period), upon negative rumors, disappointments (expectations), perceived negative news (hostile takeovers, government regulation changes, law suits, economic indicators, industry related problem, etc). Sometimes, all it takes is for one person (like a Jim Cramer) to say something negative, to send the stock and its preferred tumbling. Sometimes, it may be totally unrelated to the company or industry. Because the market works on the trades of individuals and institutions (controlled by individuals), the market movements can be unpredictable, wild, and totally irrational. Investors need to be aware that such behavior exists and is likely. They need to factor the irrational behavior into their strategies, and not ignore or downplay them as being highly unlikely, which is how the market comes tumbling down in the first place each time there is a crash. So when considering a leveraged portfolio, even with preferreds or any other corporate debt instruments one needs to plan it out carefully. One might also consider using another type of loan facility instead of using margin (to avoid triggering a loan top up) if possible. One idea might include a secured line of credit, against something like GICs (although those GICs should not be emergency money).
When the Fed raises the rate, bond prices seem to fall, but what about preferred shares?
With preferred shares we don’t really see this being the case too much, and is likely due to the yield being much higher than any risk free investment, but it really depends on the specific issue. In general, such observed phenomenon can be attributed to increased borrowing costs. To put this into perspective, lets say a preferred has a yield of 3.5%, and a regular long term GIC has a rate of 2.5%. If the Fed raises the rate, and the banks raise their rates, the borrowing costs go up. This also means that the interest on deposits and other interest bearing instruments go up as well. The long term GIC might now have a rate of 3% which is so close to the 3.5% preferred, but without any risk of investment loss. So as an investor, the 3.5% might not make any sense (if we just compare yield for yield). The prices of the preferred may decline to a point that results in a yield of 5%. At 5%, such a premium may satisfy investors to make them invest in the preferred over the GIC.
Bonds, in general are also perceived by the majority of the population to be less risky than preferred shares/stock. One reason may be because people see the preferreds being traded on the stock exchange, having ticker symbols and all. They might associate them and their risks, with that of common stock. There may also be a general lack of understanding of preferred shares. People may not be aware of that preferreds have so many conditions and stipulations on them that make them difficult to compare, without going into the details of each specific issue.
Yields for preferred shares still seem rather high, for example, Standard Chartered recently launched preferred shares with yield of 9.5%. Is this the normal yield in a normal market?
In general, the yield of 9.5% is pretty high, and is historically speaking above the usual yield in normal market conditions, and among similar companies in the same industry. However, we would probably want to look at the company itself to compare with what they issued before.
Without taking into consideration the different conditions and going into the details of each issue’s features (which may actually affect what the yield may become later on, etc.) we can just compare initial percent yields to get a quick gauge.
Tier 1: 8.125%, 7.014%, 6.409%, 7.375%, 8.25%, 8.16%, 8.103%
Tier 2: 7.75%, 5.375%
Upper Tier 2: 3.35% – 8.00%.
Lower Tier 2: 3.35% – 8.00%.
We can see that 9.5% is indeed high and not normal. This is pretty much the case across the board for the industry. Given the current market conditions, investors are demanding a premium on investments. In order to attract investors, the banks and even other industries have been issuing preferreds with higher than normal yields. An investor needs to look at their financial analysis and research to determine whether such a yield is sustainable.
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