Rating agencies and preferred stock investors, while using different methods, usually judge the investment risk of a preferred stock with very little disparity. Where agency ratings come in the form of a quantitative rating on a scale, investor conclusions about risk are reflected in today's market price (and hence yield).
Preferred stocks that are viewed as having similar risk frequently have similar yields - same risk, same reward.
We learned during the Global Credit Crisis though that agency ratings were imperfect for a variety of reasons. Shortcomings of both mathematics and character led to grossly incorrect ratings in too many cases.
But historically, short of such crisis conditions, agency ratings of securities have served millions of investors all over the globe very well for many decades. And as imperfect as these ratings are, the fact is that most investors have little choice but to use such ratings as a proxy for investment risk - even though what the investor wants to know and what the rating is measuring are, at least to a certain extent, two different things.
Investors are usually trying to determine the likelihood of a bankruptcy of the company they are considering investing in while rating agencies are trying to quantify creditworthiness (the likelihood that the company will be able to meet its prospectus obligations).
To most investors, these are usually two views of the same scenery.
Moody's Versus the Market
When rating agencies and investors see risk the same way, a group of preferred stocks with the same rating would be priced by the market such that they offer the same yield [1].
This theory is easily demonstrated by comparing the current yield of two similar preferred stocks issued by the same company. For example, on October 2012, General Electric (GE) introduced GEB with a 4.875% dividend. Three months later, the company introduced GEH at the same rate [2]. These two securities are essentially identical and both have the same A1 investment grade rating from Moody's Investors Service.
Since both of these preferred stocks carry the same investment risk (as rated by Moody's), we would expect investors to price them such that they have a similar return (as measured by dividend yield) - and they do. The spread between their yields is rarely more than 0.05% [3].
By finding preferred stocks where this is not the case (same rating but substantially different yield), we should be able to identify specific issues that warrant a closer look; are there buying opportunities where such securities have been underpriced or is something else going on?
To maximize the comparability of the preferred stocks used for this analysis, I limited the sample to today's preferred stocks that:
have a par value of $25.00;
are currently trading on U.S. stock exchanges (excluding the Over-The-Counter exchange);
are rated as investment grade by Moody's Investors Service;
have cumulative dividends;
are call protected;
are paying dividends (issues with deferred or suspended dividends were excluded);
have a fixed dividend rate (preferreds with variable or adjustable dividend rates were excluded);
had a non-zero trading volume on the day that the data was collected; and
are not convertible to another type of security.
Here is how the market's assessment of risk (as measured by yield) compares to Moody's assessment (as measured by their investment grade ratings, highest to lowest) for the resulting group of 96 securities.
Each diamond represents a specific preferred stock. If the market and Moody's were in agreement (which they usually are), we would see the diamonds above any given Moody's rating (risk level) stack up very close to each other (they would have similar yield).
But that is not the case with this group of 96 similar preferred stocks.
Looking at the Baa3 level, you can see that there is no agreement whatsoever between the market and Moody's. The 33 high quality preferred stocks that Moody's is saying are exposed to the same level of risk are providing yields from 4.9% all the way up to 8.8%. That's a 3.9% spread [4].
What's more is that today's preferred stock investors are paying an average market price of $26.14 per share for this type of security, $1.14 beyond these securities' $25 par value (see the table under the chart).
While all of the preferred stocks that are included here are currently call protected, these buyers are exposing themselves to a capital loss in the event of a future call (since shareholders will receive the $25 par value if the issuing company redeems the shares downstream).
Has the market blown the call here or has Moody's misjudged the risk? If the risk level is the same (Baa3), is the preferred stock with the 4.9% yield overpriced (pushing its yield down) or is the one with a 8.8% yield underpriced (pushing its yield up)? Or is something else going on here?
A Closer Look
The disparity that we see between preferred stock investors and Moody's can be explained when we take a closer look at how risk is being defined. Investors and Moody's are currently applying two different definitions of risk to preferred stocks.
On the above chart, I have highlighted in purple two securities from Prudential Financial (PRU) and two from CenturyLink's (CTL) Qwest Corporation in yellow.
Notice how different these cases are from the General Electric pair that we saw earlier. In both the Prudential and Qwest cases, we have two very similar securities issued by the same company that are rated at the same Baa3 risk level by Moody's but have vastly different yields (i.e. the market is pricing them as if they represent very different levels of risk).
The reason becomes clear when the call dates of these securities are taken into consideration. The following chart shows the same preferred stocks with a Baa3 Moody's rating, but now I have sorted the presentation by their respective call dates.
Preferred stock investors are currently willing to give up yield in favor of call protection.
Many of today's preferred stock investors are willing to pay more than $25 per share for these particular securities as long as a call remains unlikely. And the easiest way to help protect against an unwanted call is to buy securities with a call date out into the future as far as possible.
Consequently, we have a market where certain preferred stock investors are willing to pay high prices (above par) if doing so allows them to reduce their risk of a capital loss triggered by a redemption of their shares. The wisdom of this approach depends entirely on your personal goals, resources and risk tolerance. But the result is a market where yield is given up for additional call protection as shown on the above chart.
While call protection is currently a key component in the risk assessment performed by today's preferred stock investors, no such component is included in the evaluations performed by rating agencies. Preferred stock investors and rating agencies are viewing the same market but seeing different risks.
Footnotes:
[1] Source for all preferred stock data in this article: CDx3 Notification Service database. Disclosure: The CDx3 Notification Service is my preferred stock email alert and research newsletter service and includes the database of all preferred stocks and exchange-traded debt securities traded on U.S. stock exchanges used for this article.
[2] General Electric's GEB and GEH are exchange-traded debt securities (ETDs) which are very similar to, and often referred to as, preferred stocks but are actually individual bonds that trade on the stock exchange (rather than the bond market). For more on ETDs, see "Preferred Stock Investors: 'Exchange Traded Debt Securities' Offer Same Reward, Lower Risk."
[3] The yield values seen here uses the same yield formula that you see in your brokerage account or websites that show yield for dividend-paying securities. It does not consider the potential for a future capital gain or loss but, rather, is intended to be used for comparison purposes here. Other yield formulas can be used for this analysis as well (e.g. yield-to-call, yield-to-maturity, effective annual return, etc.). As long as you are consistent and use the same calculation throughout, the results shown here will not change. For more on the strengths and weaknesses associated with the various methods for calculating the return from a preferred stock investment see "Preferred Stock Investors: What Is Your Rate Of Return?"
[4] A similar analysis was published at this time last year. While a similar disparity existed between Moody's and the market at that time, the reason was very different. To see how things have changed over the last year see "A 2-Step Method Identifies Underpriced Preferred Stocks."
Disclaimer: Securities identified within this article are for illustration purposes only and are not to be taken as recommendations.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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