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Deep Dive: Preferred stocks can offer hidden opportunities for dividend investors. Just look at this JPMorgan Chase example.

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This is shaping up to be a brutal year for bank stocks. But a deeper look can highlight an opportunity for income-seeking investors to make money on banks’ preferred stocks.

On Aug. 17, we published this look at banks expected to enjoy the widest expansions of their net interest margins as the Federal Reserve raises interest rates. A bank’s net interest margin is the spread between its average yield on loans and investments and wait it pays for deposits and borrowings. A widening margin can mean significantly higher profits.

But the S&P 500
SPX,
+1.53%

bank industry group’s stocks pulled back a weighted 9% from Aug. 16 through Sept. 6, and were down 23% for 2022 (excluding dividends), according to FactSet. It would seem investors’ worries over the industry slowdown for capital-markets business, as well as a possible recession and resulting credit losses, are outweighing enthusiasm for wider interest spreads.

In a note to clients on Sept. 7, Odeon Capital analyst Dick Bove wrote that this sour environment for banks’ common stocks was highlighting an opportunity in preferred stocks. He used JPMorgan Chase Corp.’s
JPM,
+0.48%

Preferred Stock Series JJ as an example.

“At present, investment banking is under significant stress while traditional banking is doing quite well,” Bove wrote, explaining his “hold” rating for JPMorgan Chase’s common shares. But he believes it “makes sense” to step aside from the risk of large banks’ stocks and “buy bank preferreds selling at a discount.”

For the JPMorgan Chase Preferred Stock Series JJ discussed here, Bove wrote: “The dividend is very secure in virtually any predictable economic environment.

Preferred stock terminology

Anyone can buy a preferred stock if they have a brokerage account.

If you are unfamiliar with preferred stocks, we should begin with some definitions.

A preferred stock is different from a common stock in that its owner has no voting rights. Preferred stockholders also have preference over common stockholders in the event a company is liquidated. A simplified pecking order in the event of bankruptcy and liquidation is bondholders, then preferred shareholders and then common shareholders.

A company may have several preferred stock issues. Investors buy preferred stocks for dividends, just as they would buy bonds for interest income. Preferred dividends are typically paid quarterly.

More definitions — all are important:

Par — This is the price at which a preferred stock is issued. It is typically $25 but could be $100 or another price. The par value is similar to the face value of a bond. It is what the investor will be paid if the preferred stock is redeemed by the issuing company. Just as bonds’ market values fluctuate, preferred share prices fluctuate, typically in the opposite direction of interest rates in the economy. In the current environment, with interest rates rising, many preferred stocks are trading at discounts to par.

Coupon — A preferred stock’s stated yield, based on the par value.

Dividend rate — The stated yield multiplied by the par value. JPMorgan Chase’s Preferred Stock Series JJ was issued on March 10, 2021, at a par value of $25 with a 4.55% coupon. The annual dividend is $1.375.

Current yield — The annual dividend rate divided by the current market price. JPMorgan Chase’s Preferred Stock Series JJ closed at $19.65 on Sept. 6. That made for a current yield of 5.79%.

Call date — The date when the issuer may decide whether to redeem the preferred stock. The issuer can redeem some or all of that preferred series any time beginning on this date. If interest rates are significantly lower than they were when the preferred stock was issued, the issuer is likely to redeem.

Maturity date — The date when the preferred series will be completely redeemed. These days, most preferred stocks are “perpetual,” which means there is no maturity date, although there is typically a call date. JPMorgan Chase’s Preferred Stock Series JJ is a perpetual preferred with a June 1, 2026, call date.

Cumulative/non-cumulative — A preferred-stock issuer might be forced to suspend its dividends on one or more preferred series if it is in financial trouble. If a preferred stock is cumulative, suspended dividends will accrue in arrears to be paid later when (or if) the dividend is restored. Banks issue noncumulative preferred stock because regulators want them to have the flexibility of suspending dividends and never making up for them, in the event of severe financial or economic distress. It is very rare for an investment-grade issuer to miss a preferred-stock dividend payment.

The ins and outs of preferred stocks

Preferred stocks are for income-seeking investors. They are not designed to be growth investments. That 4.55% coupon for the JPMorgan Chase Preferred Stock Series JJ may not have been very attractive when the shares were issued at $25 on March 10, 2021. Then again, on that date, 10-year U.S. Treasury notes
TMUBMUSD10Y,
3.314%

were yielding 1.53%. The 10-year yield was 3.50% on Sept. 6.

So the current yield of 5.79% for an investor who purchased the JPMorgan Chase Preferred Stock Series JJ at the discounted price of $19.65 on Sept. 8 is attractive.

And that discount could mean a lot of gravy down the line. Following that June 1, 2026, call date, JPMorgan Chase can redeem the shares at any time, and will probably do so if the bank no longer needs that capital or if it can replace the funding at a rate lower than the 4.55% coupon (plus underwriting expenses).

So if interest rates eventually head significantly lower from here, the JPMorgan Chase Preferred Stock Series JJ will probably trade much higher than its Sept. 6 closing price of $19.65. The shares can be sold at any time.

If the preferred stock is redeemed on or after the call date, the bank will pay $25 a share, which means if you scooped them up at $19.65 your profit will be $5.35 a share, or 27%, on top of the dividends you have been receiving all along.

There are many other examples of preferred stocks out there trading at discounts, or for those with higher coupons, trading at premiums you might find reasonable. Ask your investment adviser or call your broker for more information.

For income-seeking investors, preferred stocks are worth studying.

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Hear from Ray Dalio at MarketWatch’s Best New Ideas in Money Festival on Sept. 21 and 22 in New York. The hedge-fund pioneer has strong views on where the economy is headed.

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