A Preference for Preferred Stocks

During the financial crisis, regulators prevailed upon BB&T (symbol BBT), the nation’s 12th-largest bank, to chop its common stock’s 47 cent quarterly dividend by more than two-thirds. The shares, which had been as high as $45 in 2008, bottomed at $11 in early 2009. But long-term investors properly counted on BB&T to outlast the downturn with its independence and marketing muscle intact. All the while, the Winston-Salem, N.C., company remained profitable. And this spring, for the first time since the Great Recession, BB&T’s stock crossed $40.

Special Report: Investing for Income

Although BB&T has raised its payout a few times since the crisis, it will be many years before the dividend, now 23 cents a quarter, returns to its prerecession level. So why would I call BB&T a splendid income investment with a capital-gains kicker?

The answer: I’m not talking about its common stock. I’m betting on the bank’s preferred shares. And it’s not just BB&T’s preferreds that look attractive. I could say the same about preferreds from dozens of banks, insurers and real estate investment trusts. Many preferred shares trade below their offering prices (typically $25 per share) and offer better current yields than junk bonds issued by companies with lower credit ratings.

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Preferred stocks pay fixed dividends, which may or may not qualify for favorable tax treatment. Prices bop around daily in response to interest-rate gyrations because preferreds are bondlike securities. But unlike bonds, few preferreds ever mature.

Beyond the fixed dividend rate and the yield, the key number for preferreds is their $25 issue price. That’s the price at which the issuer can redeem, or call, the shares, generally starting five years after their issuance. If you pay more than $25 a share, expect to lose principal. Buy at less than $25 and you will realize a gain upon redemption or, if the issuer never redeems, receive a better yield than you would have received had you bought the preferred when it was issued.

BB&T has four preferred issues: Series D, E, F and G. Tickers are BBTPRD, BBTPRE and so on. Standard & Poor’s gives all four issues an investment-grade rating of BBB, and their dividends qualify for favorable tax treatment. As of April 4, the prices of the four preferreds ranged from $20.92 to $23.69, and their yields to call (that is, what you would earn in income and appreciation if BB&T were to redeem an issue at $25 per share as soon as it could, in 2017 or 2018) ranged from 8.0% to 10.9%.

Muted risks. These numbers are so compelling that I ransacked my library and called some sages for perspective. I found boilerplate about the risks of inflation, rising interest rates and default. But inflation is minimal, and if you sense rates getting ready to surge, you can sell a preferred as easily as you can a regular stock. As for default risk, yes, it’s true that the claims of bondholders precede those of preferred investors in case of bankruptcy. But investing involves making choices between risk and reward; in this case, with BB&T bonds due in 2018 yielding a mere 2.1% to maturity, the preferreds clearly look like a better choice.

To make sure I wasn’t suffering from irrational exuberance, I checked in with strategist Larry Swedroe. He dissed preferreds in a 2006 book about bonds, arguing that he could not endorse any security without a known maturity. He still thinks that way. In investing, “there’s no free lunch,” he intoned when I asked what’s wrong with trying to turn $20.92 today into a likely $25 by 2018 while collecting fat dividends to boot. But he did approve of using low-cost exchange-traded funds to own preferreds. My two favorites: iShares U.S. Preferred Stock (PFF, yield 5.8%) and PowerShares Preferred (PGX, 6.4%).