The Good News in Preferred Stocks

Dividend Investing, Preferred Shares

Last week I was a speaker at the MoneyShow in Las Vegas. Besides speaking, I like to network with a wide range of investment professionals. I was intrigued by one idea concerning preferred stocks from the discussions: that they will allow investors to benefit from the Fed’s interest rate increases.

Preferred stock shares can be quite bland. Preferred dividends are safer than common stock dividends, with the trade-off that preferred dividends pay at a fixed rate, rather than growing, as common stock dividends can.

Most preferred shares are perpetual but, at some point, become callable by the issuer. Whether preferred shares get called in is entirely at the company’s discretion. I tell my subscribers to think of preferred investing as buying a long-term income stream.

Different preferred stock issues may have a range of features to either enhance the investment potential or protect the issuer. One such feature would be a fixed-to-floating interest, or coupon rate, structure. With this feature, when a preferred stock becomes callable, it also changes from paying a set dividend rate to a variable rate.

The floating rate will be the secured overnight financing rate (SOFR) (which replaced LIBOR, the London interbank offered rate), plus a fixed margin put out in the prospectus. The margin would be lower than the initial coupon rate, and when interest rates were low, the automatic conversion to a floating rate would have been a bad deal for investors.

Now, after a series of interest hikes by the Federal Reserve Board, SOFR stands at about 4.8%, and any preferreds that go fixed-to-floating will be paying significantly larger dividends. Here is an example:

The Rithm Capital Preferred A (RITM.PA) shares have a 7.5% coupon rate. The dividend is calculated on the $25.00 par value, so RITM.PA pays $0.46875 per share per quarter. This preferred share currently trades for $20.90, giving a current yield of 9.0%.

RITM.PA becomes callable and switches to a floating rate on August 15, 2024. The floating rate margin is 5.802%. If SOFR is the same on August 15 next year as it is now, the coupon rate for RITM.PA will jump to 10.6%. If SOFR is above 1.7%, the preferred share dividend rate will increase. Actual dividends are always calculated based on the $25.00 par price.

Of course, Rithm Capital could choose to call in the shares, doing so would mean paying $25.00 per share.

The fixed-to-floating rate means there is a lot of upside plus income potential for investors buying now at around $21.00 per share. RITM.PA is a recommended investment in my Dividend Hunter recommended portfolio.

I know that the managers of the Virtus InfraCap U.S. Preferred Stock ETF (PFFA) are focused on growing their portfolio income with fixed to floating rate preferred issues that will soon convert to floating rate. PFFA pays monthly dividends and yields over 10%.

If the fed funds and SOFR rates stay high, as preferreds go to floating rates, the higher coupon rates should drive up share prices. Watch for preferred stocks that convert to floating rates soon, and are trading at discounts to the par value.

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