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I recently put several hundred thousand dollars into Bank of America preferred stock, and I want to break down every step I took to making that decision.
I’m active on a few investment forums. This particular idea came from a fellow member. The two sentences I got on it were: the Bank of America preferred stock series L is currently paying out about 6% in qualified dividends, which means they are eligible for the preferred tax rates of between 0%-20% depending on which tax bracket you fall into.
I ignore a lot of ideas I see on these forums because they’re not right for my needs. My interest was instantly piqued by this one, though, because as a retired person with no steady income the need for stable annual cash flow is increasingly important to fund our outgoing annual expenses. I’ve been pretty vocal about how I think now is not the right time to actively stockpile bonds, so my allocation into steady cash flow instruments is low compared to what I want it to be.
Preferred Stock Basics
Some quick background: BAC-L is a specific series (L series) of preferred stock issued by Bank of America. Preferred stock is equity. Preferred means that there are some rights associated with ownership of the stock that aren’t available to common shares. Two of the most common rights attached to preferred stock are a liquidation preference and a dividend. Not every preferred stock offers these, but many do. Also, note that for BAC-L in particular, given how much of a premium the preferred is trading at compared to the common, I view this investment as primarily a fixed income opportunity rather than a chance to ride the equity story of Bank of America. You wouldn’t buy Bank of America preferred stock if you thought they were going to have a killer quarter. For that, you’d buy the common. Not all preferred stock trades at this kind of premium to the common and creates this kind of dynamic.
Step 1: Find an Overview
My first step after hearing about the idea was to go to a site that could give me a basic overview of the preferred stock – confirm the payout, explain any catches, that sort of thing. For income-focused instruments, there is a site called Quantum Online. I entered my ticker symbol and read through the details. Things still sounded pretty good after that first read. Quantum Online offers a link to the offering prospectus right below its summary, so I went ahead and clicked on that.
Step 2: Read the Prospectus
This is a really important step. You want to make sure you understand the details of your rights. My friend on the forum used shorthand to describe the opportunity: “it’s paying 6%”. Here’s what it really meant: the original offering sold at $1000 a share and offered a dividend of $72.50 per year (paid quarterly). This dividend was only paid “when and if” declared by the Board of Directors. That meant if the Board declared a dividend I would get my $72.50, but if for whatever reason the Board didn’t declare a dividend, I would get zilch. It also had a liquidation preference which meant that if the company were to be liquidated, I would get the $1000 initial investment back before any common shareholders saw a dime. This is all important information to have, because the price of these shares is actually now trading at $1178. That meant the net dividend to me was roughly 6%, and my liquidation preference if the company went under would cover $1000 of my investment but not my entire investment. The other really important thing I learned about this preferred stock were the terms around how the company might buy me out of my preferred stock. I’m doing all this work to lock in my 6% – I want to know that I can keep it for a good long while!
Step 3: Write Down a List of Outstanding Questions
After getting a grip on what this thing actually was, I had follow-ups. The idea of 6% money still sounded good to me, but I needed more details. Here were the questions I wrote down that I still needed answers for:
- How financially healthy is the company? Specifically, how did its total annual obligations on debt and potentially to preferred stockholder compare to its total profit? If this ratio is very high, that doesn’t bode well. That would mean there is not a lot of room for error on the company’s part before I feel the pain of not having my dividend paid out.
- What has the company’s history been of declaring and paying dividends each quarter? I was particularly interested in whether these payments happened during the subprime crisis.
- How strong was my principal protection? To answer this, I needed to know how much total preference there was plus how much debt there was, and compare that to the balance sheet of the business If a company gets liquidated, debt holders get all their money back first, then the preferred, then common shareholders. I wanted to see how much buffer in shareholder equity there was; the larger the amount, the more likely in a liquidation scenario that I would get the full $1000 per share.
Step 4: Comb the Company 10-K
I took my questions and went hunting in the 10-K for answers. This part of the process is the most boring and arduous. The high level profit numbers were easy to find because companies make their consolidated financials easy to find. The smaller details around dividend payments on the preferred and such were harder to locate.
Step 5: Email Outstanding Questions to Investor Relations
I found maybe half of the answers to my questions myself. As it turns out, almost all of them could be found with enough hunting, but I was new/impatient/hungry-angry enough that I missed a few. No matter. I emailed the main investor relations email with my outstanding questions and got a nice set of responses back within 48 hours. Notably, the company’s dividend history was not available in the 10-K. I was given the link to the company’s dividend payment history. Rad.
Step 6: Consider Alternatives
In my research of the total preference stack, I came across a list of all the other preferred stock series the company issued, and wanted to examine whether any of those were yielding more than BAC-L. I looked into a few using Quantum Online, but was turned off by the fact that most of those had redemption clauses, which meant that after a certain date, the company could call those shares and buy them back from you. This was coupled with the fact that the return was about the same, so I was taking more risk for no additional return. I concluded BAC-L was still my best option.
Step 7: Write An Investment Summary
Now that I had all the answers I needed, it was time to organize it all into a cohesive thesis. I like to write down all the pertinent details into a one page summary document. I think this part is extremely important and would urge you to do the same. You can share this document with others who can challenge your thesis. You can also easily see where holes are to your research. I’ve heard on several forums of people who like to just “keep it in their heads”. This strikes me as incredibly lazy. If you’re going to make a decision that is tens or hundreds of thousands of dollars, you can write it down. It makes your thinking auditable.
When I talk write investment summaries, I like to show what the return would be in an upside scenario, and what the return would be in a downside scenario.
My Investment Summary
Here is a version I sent to my husband. Note that while “Investment Summary” sounds fancy, it can be as informal as a bullet list in an email:
I’ve spent some time over the past two weeks evaluating a position in Bank of America Preferred Stock. I’d like to deploy $___ of our funds here.
Please let me know what you think by this weekend so I have time to chase down any answers in advance of trying to take a position the following week.
BAC-L Series Description:
- See offering prospectus here
- Currently trading at $1178 per share (note this is above issue value)
- $1000 liquidation preference per share
- $72.50 annual dividend per share. Notably, this is non-cumulative and only is paid if the board declares a dividend. If there is a quarter the board doesn’t declare a dividend, you get nothing and it does not accumulate into the next quarter (you are owed nothing for that quarter)
- Stays out in perpetuity – some series have a redemption period where at a certain date the company is allowed to buy back the shares.
- The holder has option to convert the preferred stock at any point to common stock, 1 share of preferred to 20 shares of common (a conversion price of $50 per share). Common trades at $25.41 a share right now. That’s worth about $580 so we wouldn’t do this.
- Bank of America can choose to convert you into common shares at its discretion if the price to convert exceeds 130% of initial conversion price. That means $50 *1.3 = $65 a share. That would be equivalent to $1300 of common share value against a price we pay of $1178 to get in. I’m okay with this. They appear to be a very long way from having the opportunity to do this, and if they do at some point get to a point where they can, we’ll have collected some great 6% returns then see an additional almost 10% on the face value we paid.
- Dividends qualify as ‘qualified dividends’ for tax purposes, meaning a 15%-20% tax rate for us.
Our Expected Return:
- 6.15% annual pre-tax return. If we put this in tax advantaged accounts, we’ll get 6.15%. If not, we’ll get about 4.92%
- Some equity upside but I would write this down to zero because the price we’re paying for the preferred relative to its conversion to common is almost double what the common is worth right now.
- Note that the face value may decline if the Fed moves forward with interest rake hikes planned for the year. In the past six months including two rate hikes by the Fed, the price appeared to decline about 2.5%. If we are collecting our coupon along the way, we’d still have netted 3.65% for the year. If the economy does well, our stock allocation will do incredibly well and we will net perhaps something closer to 3.65% factoring in a decline in face value on the bonds. And if the economy is not doing well, it is unlikely for the Fed to move forward with rate hikes and we will be happy to be collecting 6.15%. I consider this a place to park some of our dollars for this reason. Even though it has sensitivity to interest rates similar to the bond options we considered and discarded, I consider this superior and worth moving on because of the higher dividend relative to my personal view on risk of default/non-payment and the decline I observed in BAC-L being significantly more muted than what we have observed in the leveraged bond funds we considered.
- They do not declare a dividend for several quarters so we get nothing. I think this is very unlikely, see below.
- The company goes bankrupt and our liquidation preference is $1000 a share but we paid $1178. I think this is very unlikely, see below.
- The Fed raises rates, causing the face value of our shares to decline such that the dividend being offered equals the going rate of newly issued bonds/notes at those higher rates. This is a very real concern. Mitigant: See discussion in “Expected Return” – I believe our net downside exposure if this happens based on the most recent rate hikes is a net return of 3.65% rather than a major principal loss as we will be collecting the dividend along the way.
- I know very little about banks. I could be incorrectly evaluating the strength of the company’s financials because I don’t fully understand how their business works (for example, they carry a ton of assets in the form of loans extended, so their cash flow numbers look strange to me compared to other verticals). I may be missing some key element around regulations for banks being able to payout dividends. I take comfort that BAC paid dividends all throughout the subprime crisis (sometimes only a penny, but I believe that would have been enough to trigger the dividend payout for the preferred unless there was some cut there that I didn’t uncover- there’s no loophole according to prospectus docs but I could be wrong). I also lean here on the rating agencies’ rating of the credit. Baa3. Our likely downside in this scenario if no dividends are paid for a while is most certainly not all our principal. Maybe a 10%-30% loss in depreciation or missed payment in an extreme circumstance.
Dividend Declaration History
- BofA has declared a dividend every quarter for over 23 years, including all the period following the subprime housing crisis. Note that this is the dividend they declared on common stock. The one piece of research I have not confirmed is whether any modifications were made on the amount paid out to their preferred. I read the offering for BAC-L and it says if a dividend is declared you get X amount and there did not appear to be any outs or chances to modify, so I all I care about is seeing that a dividend was declared each period. I could stand to do a little more here though.
Key 10-K Information
- See 10-K here
- Bank of America has a total of $28 billion of liquidation preference on all the preferred stock it has issued.
- Based on current balance sheet, it has $266 billion of shareholder’s equity. This would be the bit we eat into if for whatever reason the company dissolved and we cared about how likely we were to get our liquidation preference back. This assumes assets were booked at values truly reflective of their market value – perhaps they would be inflated and the buffer for liquidation preference less. It’s also a sign of health of the company.
- It paid $1.6 billion in dividends to preferred stock in 2016. I wanted to compare this number to total profits.
- Compare this to a $25 billion of income before income taxes in 2016. Seems healthy to me.
- It paid $10 billion of interest payments on debt vs $51 billion of interest income
- I’m trying to wrap my head around the cash flow statement. I generally liked to see positive cash flow statements for my companies. They’re a bank so maybe this is normal but they ate about $10 billion into their cash reserves… prob not a huge issue but that was something I flagged for more exploration
Alternatives to BAC-L
- I naturally wondered if any of the other preferred stock offered a better return. There is a list of the options here on Page 181 of the 10-K (link above).
- None of them are perpetual, meaning they have redemption windows.
- Many of them had lower yields. These were instant passes.
- Checked a few of those that had initially higher yields to see where they were trading and if the net effective yield was better than BAC-L. I found one that was better by .05% but it was available to be redeemed any time. I think of this as fairly attractive and it sounds like banks have been able to issue lower coupon products recently on the debt side so it’s like they will redeem their higher rate stuff when they can. In fact, I checked on one series and it had in fact just been redeemed by BAC in Aug 2016.
A Final Word
This is just an example of how I approach an investment decision. I strongly believe in a framework for the decision making process because it is so, so hard to keep it all in a jumble in your head.
An important caveat: the best process in the world cannot save me from my own ignorance when it comes to a new market or business model. I may end up learning by trial and error that there are important pieces to the due diligence on a bank or on preferred stock that I’ve missed given my limited exposure to both. But the process will certainly accelerate my learning and prevent me from making a dozen other possible mistakes by providing clarity in what I’ve addressed and not addressed prior to pulling the trigger.
Share how you approach an investment decision! Any fixed income experts who can weigh in on other important steps when vetting an opportunity? Anyone just overwhelmed by the sheer word count of this post and need a drink?
Note: For folks checking out BAC-L’s historical price chart, note that the price fluctuates around dividend announcements (shares fall on the day a buyer would not qualify for the latest dividend because they’d be parking their money there for 3 months doing nothing until the next dividend).