The current market environment is made difficult by the fact that investors have nowhere that they can go to confidently earn a decent return. There are no good deals to be found anywhere, in any area of the investment universe. Some see that as a failure of markets, but I see it as an achievement. A market that is functioning properly should not offer investors good deals. When adjusted for risk, every deal that’s on the table should be just as good as every other. If any deal shows itself to be any better than any other, market participants should notice it and quickly take it off the table.

We live in a world in which there is a large demand for savings, but a small relative supply of profitable new investment opportunities to deploy those savings into. We can debate the potential causes of this imbalance–aging demographics, falling population growth, stagnation in innovation, zero-sum substitution of technology for labor, globalization, rising wealth inequality, excessive debt accumulation, and so on. But the effect is clear: central banks have to set interest rates at low levels in order to stimulate investment, encourage consumption, and maintain sufficient inflationary pressure in the economy. The tool they use may not work very well, but it’s the only tool they have.

Low interest rates, of course, mean low returns for whoever decides to hold the economy’s short-term money. In a properly functioning market, those low returns should not stay contained to themselves. They should propagate out and infect the rest of the investment universe. And that’s exactly what we’ve seen them do. As it’s become clear that historically low interest rates are likely to persist long out into the future–and quite possibly forever–every item on the investment menu has become historically expensive.

Thinking concretely, what types of things can a value-conscious investor do to cope with the current environment? Personally, I can only think of two things: (1) Figure out a way to time the market, or (2) Try to find places inside the market where value still exists. With respect to the first, market timing, I already shared my best idea, which is to go to cash when both the price trend and the trend in economic fundamentals are negative, and to be long equities in all other circumstances–regardless of valuation. That approach continues to work–it’s still long the market, and hasn’t fallen prey to any of the usual fake-outs (fears of recession, concerns about valuation, etc.). With respect to the second, finding value inside the market, I think I know of a good place. That’s what this piece is going to be about.

The specific part of the market that I’m going to look at is the space of preferred stocks , a space riddled with inefficiencies. There are two individual securities in that space that I consider to be attractive values: two large bank convertible preferred issues. At current prices, they both yield around 6.15%. They carry very little credit risk, they can’t be called in, and their dividends are tax-advantaged. The fact that they could be priced so attractively in a market filled with so much mediocrity is proof that markets are not always efficient.

I should say at the outset that I don’t have a strong view on the near-term direction of long-term interest rates. My bias would be to bet against the consensus that they’re set to rise appreciably from here, but I can’t make that bet with any confidence. If they do rise appreciably, the securities that I’m going to mention will perform poorly, along with pretty much everything else in the long-term fixed income space. So if that’s your base case, don’t interpret my sharing them as any kind of recommendation to buy. Treat them instead as ideas to put on a fixed income shopping list, to consult when the time is right.

The piece has five sections (click on the hyperlinks below to fast-forward to any of them):

In the first section, I explain how preferred stocks work. (Highlight: A helpful “simultaneous trade” analogy that investors can use in thinking about and evaluating the impact of callability.)

In the second section, I analyze the valuation of preferred stocks as a group, comparing their present and historical yields to the yields on high yield corporate, investment grade corporate, emerging market USD debt, and treasury debt. I also quantify the value of the embedded tax-advantage they offer. (Highlight: Tables and charts comparing yields and spreads on different fixed income sectors. Periods examined include 1997 to 2017 and 1910 to 1964.)

In the third section, I discuss the unique advantages that financial preferred stocks offer in the current environment. (Highlight: A chart of the Tangible Common Equity Ratios of the big four US banks, showing just how strong their balance sheets are at present.)

In the fourth section, I introduce the two preferred stocks and examine the finer details of their structures. (Highlight: A price chart and a table that simplifies all of the relevant information)

In the fifth section, I make the case for why the two preferred stocks are attractive values. I also offer possible reasons why the market has failed to value them correctly, looking specifically at issues associated with duration, supply, and index exclusion. (Highlight: I look at one of the most expensive fixed income securities in the entire US market–a 1962 preferred issue of a major railroad company that still trades to this day. I discuss how supply-related distortions have helped pushed it to its currently absurd valuation.)

Preferred Stocks: A Primer

Recall that a common stock is a claim on the excess profits of a corporation, which are ultimately paid out as dividends over time. A common stock is also a claim of control over the company’s activities, expressed through voting rights. A preferred stock, in contrast, is a claim to receive fixed periodic dividend payments on the initial amount of money delivered to the company in the preferred investment–the “par” value of each preferred share. Such a claim typically comes without any voting rights, but voting rights can sometimes be triggered if the promised payments aren’t made. In a liquidation, preferred stock is senior to common stock, but subordinate to all forms of debt.

Importantly, a preferred stock’s claim to dividends is contingent upon the company actually being able to make the promised payments. If the company can’t make those payments, it won’t go into default like it would for a missed bond payment. Rather, it will simply be prohibited from paying out dividends to its common shareholders, and also from repurchasing any of its common shares. This constraint is what makes preferred shares worth something as pieces of paper. If a company fails to fulfill its obligations to its preferred shareholders, its common shareholders will have no prospect of earning cash flows on their investments, and therefore their shares–their pieces of paper–won’t carry value.

A preferred share can be cumulative or non-cumulative. When a preferred share is cumulative, any past missed dividend payments, going all the way back to the share’s date of issuance, have to be paid in full before any common dividends can be paid or any common shares bought back. When a preferred share is non-cumulative, this restraint is narrowed to a given period of time, usually a calendar quarter. The company cannot pay dividends in a given calendar quarter or buy back shares in that quarter unless all preferred dividends owed for that quarter have been paid.

Preferred shares usually come with a call feature that allows the company to buy them back at par after some specified date. The best way to conceptualize the impact of this feature is to think of a callable preferred share as representing two separate investment positions. First, the preferred share itself, a perpetual security that pays out some fixed yield. Second, a call option that is simultaneously sold on those shares. When you buy a callable preferred, you’re effectively putting yourself into both types of trades–you’re purchasing a perpetual fixed income security, and you’re simultaneously selling a call option against it at a strike price of par, exerciseable after some specified date.

The existence of a call option on a preferred share significantly complicates its valuation. For an illustration, let’s compare the case of a non-callable share with the case of a callable one. In the first case, suppose that a company issues a non-callable 4% preferred share to an investor at a par value of $25. Shortly after issuance, yields on similar securities fall from 4% to 3%. The share has to compete with those securities, and so its price should rise to whatever price offers a 3% yield, matching theirs. In the current case, that price would be $33 (logic: $1 / $33 = 3%). But now suppose that the share comes with a call option that allows the company to redeem it at par, $25, in five years. With the impact of the call option added in, a price of $33 will no longer makes sense. If an investor were to buy at that price, and the security were to eventually be called in at par, $25, she would lose $8 per share on the call ($33 – $25 = $8). Instead of being 3%, her total return would end up being negative.

For any assumed purchase price, then, the investor has to incorporate the call–both its impact on the total return if exercised, and its likelihood of being exercised–into the estimate of the total return. In the above scenario, if we assume that the call option becomes exerciseable 5 years from now, and that it will, in fact, be exercised, then the right price for the shares, the price that implies a 3% yield competitive with the rest of the market, is not $33, but rather $26.16. At that purchase price, the $5 of dividends that will be collected over the 5 years until the call date, minus the $1.16 that will be lost from the purchase price when the shares are called in at $25, will produce a final total return that annualizes to 3%, equal to the prevailing market rate.

Now, for some definitions. The “current yield” of a security is its annual dividend divided by its market price. The “yield-to-call” of a callable security is the total return that it will produce on the assumption that the investor holds it until the call date, at which point it gets called in. The “yield-to-worst” of a callable security is the lesser of its current yield and its yield-to-call. This yield is referred to as a yield to “worst” because it represents the worst case total return that an investor can expect to earn if she holds to maturity–assuming, of course, that the shares pay out as promised.

Companies typically decide whether or not to call in preferred shares based on whether they can get better rates in the market by issuing out new ones (and the new issuance need not be preferred–it could be debt or even other forms of equity, if the cost to the company is less). For that reason, legacy preferred shares that were issued at yields substantially higher than the current market yield tend to behave like short-term fixed income securities. Because their costs to the company are so much higher than the current market cost, the investor can be confident that the company will call them in on the call date. Instead of treating them as long-term securities, then, she can treat them as securities that will soon mature at par.

As with a bond, we can separate the risk inherent in preferred shares into credit risk and interest rate risk. The credit risk is the risk that the company will not be able to make the promised payments on the shares. The interest rate risk is the risk that prevailing market interest rates on similar securities will change, causing the price of the security in question to change.

Looking more closely at this second risk, callable securities suffer from a unique disadvantage. When interest rates rise after issuance, they behave like normal fixed income securities. They fall in price, imposing losses on investors, until their market yields increase to a value that’s competitive with the new higher rates. But, as we saw in the earlier example, when interest rates fall after issuance, callable securities are not able to rise to the same extent. That’s because, as they go above par, the potential of a loss on a call is introduced, a loss that will subtract from the total return. To compound the situation, as interest rates fall, a loss on a call becomes more likely, because calling the shares in and replacing them with new ones becomes more attractive to the company, given the better available rates.

Because the company has a call option that it can (and will) use to its own benefit (and to the shareholder’s detriment as its counterparty), preferred shares end up offering all of the potential price downside of long-term fixed income securities, with only a small amount of the potential price upside. When it’s bad to be a long-term bond, they act like long-term bonds. When it’s good to be a long-term bond, they morph into short-term bonds, and get called in. Now, you might ask, given this unfavorable skew, why would anyone want to own callable preferred shares? The answer, of course, is that every security makes sense at some price. Callable preferred shares do not offer the upside of non-callable long-term fixed income securities, but to compensate, they’re typically priced to offer other advantages, such as higher current yields.

Importantly, when a preferred share is trading at a high current yield relative to the market yield, the investor receives a measure of protection from the impact of rising interest rates (or, if we’re focused on real returns, the impact of rising inflation). If interest rates rise, one of two things will happen, both of which are attractive to the shareholder. Either the shares will not be called in, and she will actually get to earn that high current yield over time (which she would not have otherwise gotten to earn), or the shares will be called in, and she will get pulled out of the security, at which point she will be able to take her money and go invest in a better deal.

Preferred Stocks: Assessing the Valuations

The following chart shows the average yield-to-worst (YTW) of preferred stocks alongside the average YTWs of other fixed income asset classes from January 31, 1997 to January 31, 2017, the latest date for which preferred YTW information is available:

(“Preferred” = BAML US Preferred, Bank Capital, and Capital Securities index, “HY Corp” = Barclays US Corporate High-Yield Index, “IG Corp” = Barclays US Corporate Index, “EM USD” = Barclays Emerging Market USD Index, “10 Yr Tsy” = 10-Year Treasury Constant Maturity Rate, FRED: DGS10)

Some might challenge this chart on the grounds that preferred stocks are perpetual securities that shouldn’t be compared to bonds, which have maturity dates. The point would be valid if we were evaluating preferred stocks on their current yields. But we’re not. We’re looking specifically at yields-to-worst, which assume that all preferred stocks trading above par get called in on some future date (typically inside of a 5 year period). On that assumption, preferred stocks as a group are not perpetual, but have some average finite term, like bonds. Note that if we were to treat preferred stocks as perpetual securities, the yields shown in the chart would be current yields, which are meaningfully higher than YTWs. For perspective, as of January 31, the current yield for preferreds was 5.53%, versus the 4.78% YTW shown in the chart.

That said, the chart is admittedly susceptible to distortions associated with the fact that the average durations and average credit qualities of the different asset classes may have changed over time, impacting what would be an “appropriate” yield for each of them in any given period. There’s no easy way to eliminate that susceptibility, but I would argue that any potential distortion is likely to be small enough to allow the chart to still offer a general picture of where valuations are.

Let’s look more closely at spreads between preferreds and other fixed-income asset classes. The following two charts show YTW spreads of high-yield and EM USD debt over preferreds. As you can see, spreads have come down substantially and are now well below the average for the period, indicating that preferreds have become cheaper on a relative basis:

The following charts show YTW spreads of preferreds over investment-grade corporates and US treasuries. As you can see, spreads over corporates have increased and are slightly higher than the average, again indicating that preferreds have become cheaper on a relative basis. Versus treasuries, spreads are roughly on the average (with the average having been pushed up significantly by the temporary spike that occurred in 2008).

The above data is summarized in the following table:

The conclusion, then, is that US preferred stocks are priced attractively relative to the rest of the fixed income space. They aren’t screaming bargains by any means, but they look better than the other options. They also look better than US equities, which are trading at nosebleed levels, already well above the peak valuations of the prior cycle.

Now, in comparing yields on these asset classes, we’ve failed to consider an important detail. Preferred dividends are paid out of corporate profits that have already been taxed by the federal government at the corporate level. They are therefore eligible for qualified federal dividend tax rates —15% for most investors, and 23.8% for the top bracket of earners. Bond income, in contrast, is deducted from corporate revenues as interest expense, and therefore does not get taxed by the federal government at the corporate level. It’s therefore taxed at the ordinary income rate–28% for most investors, and 43.4% for the top bracket. Though often missed in comparisons between bond and preferred income, this difference is huge .

The following table shows the current tax-equivalent YTW of preferred shares versus the YTWs of the other fixed income categories. For top earners, the tax advantage gives preferred shares an additional 166 bps in pre-tax yield; for normal earners, an additional 86 bps.

The significance of this advantage should not be understated. With pension assets included, over 60% of all U.S. household financial assets are exposed to income taxation (source: FRB Z.1 L.117.24/L.101.1). Of that 60%, a very large majority is owned by high-net-worth individuals that pay taxes at the top rates. Preferreds effectively allow them to cut those rates in half.

Right now, there’s no shortage of people highlighting the fact that U.S. common equity, represented by the S&P 500 index, is extremely expensive, trading at valuations that are multiple standard-deviations above historical averages. But here’s an interesting piece of information. With respect to preferred equity, the situation is somewhat reversed . In past eras, particularly the period from 1937 to 1964, preferreds traded at very low yields. Today’s yields can easily beat those yields, especially when the tax-advantage, which only came into place in 2003, is taken into account. Prior to 2003, dividends were taxed at normal income rates, including during those periods when capital gains were taxed preferentially.

The following chart shows preferred yields of NYSE stocks from 1910 to 1964 (source: FRED M13048USM156NNBR).

Today’s tax-equivalent yield range of 5.64% to 6.44% is above the 5.05% average from 1910 to 1964, and significantly above the 4.2% average seen from 1937 to 1964, the latter half of the period. I’ve seen many investors pine over the attractive equity valuations seen in the 1940s and 1950s, wishing it were possible to buy at those valuations today. The good news, of course, is that it is possible, provided we’re talking about preferred equity! 😉

Advantages of Financial Preferred Stocks

In market antiquity, preferred shares were very popular. For a fun illustration of their popularity, consider the following advertisement taken from a financial magazine published in 1928. The recommended allocation to preferred stocks is 30%, the same as the bond allocation. Today, financial advisors tend to recommend a much smaller preferred allocation, if they recommend any at all.

The only entities in the current market with any real reason to issue preferred shares are depositary financial institutions–i.e., banks. Preferred shares are attractive to banks because they count as Tier 1 capital under Basel rules. Banks can use them to raise Tier 1 capital and meet minimum Tier 1 capital requirements without having to dilute common shareholders. From a regulatory perspective, the reason preferred shares are treated as capital, and not as debt liabilities, is that a failure to make good on their promised payments will not trigger a default, an event with the potential to destabilize the banking system. Rather, a failure on the part of a bank to pay its preferred shareholders will simply mean that its common shareholders can’t be paid anything. The activation of that constraint will surely matter to common shareholders, but it need not matter to anyone else in the system.

From a shareholder’s perspective, financial preferred shares have a number of unique features that make them attractive. These include:

(1) Counterbalancing Sources of Risk : The credit risk and interest rate risk in a financial preferred share, particularly one issued by a conventional bank, tend to act inversely to each other. To illustrate:

Increased Interest Rate Risk –> Reduced Credit Risk : When interest rates go up, preferred shares face downward price pressure. But, at the same time, higher interest rates tend to increase bank profitability, particularly when the catalyst is an expanding economy. Higher bank profitability, in turn, means a reduction in the risk that banks won’t be able to pay, i.e., a reduction in the credit risk of preferred shares.

Increased Credit Risk –> Reduced Interest Rate Risk : In those situations where credit risk in preferred shares rises–situations, for example, where the banking sector faces losses associated with a weakening economy–interest rates will tend to fall. Considered in isolation, falling interest rates put upward pressure on preferred prices, given that they’re fixed income securities.

Admittedly, in the current environment, one could argue that this effect has already been “maxed out”–i.e., that financial preferred securities are not currently viewed as carrying meaningful credit risk, and that they therefore aren’t likely to see much upward pressure in response to the credit risk “relief” that would come from an improving economy. Regardless of whether or not that’s true, the general point still holds: credit and interest rate risks in financial preferred shares tend to work in opposite directions. We saw that clearly in earlier phases of the current cycle, when credit risk was considered to be meaningful. The shares experienced upward price pressure in response to economic improvement, and were able to rise even as long-term interest rates were rising.

(2) Increased Regulation : With the passage of Dodd-Frank, banks face increased regulation. Increased regulation reduces bank profitability and therefore acts as a drag on the value of common shares. However, it boosts the value of preferred shares, because it makes their risk-reward proposition more attractive.

As a preferred shareholder in a bank, your biggest risk comes from the possibility that the bank might take on too much risk and fail. That risk, if it’s realized, has the potential to bring the value of your investment all the way down to zero. At the same time, your upside in the shares is limited–the most you can realistically expect to make in them over the long-term is the fixed yield that they’re paying you. That yield has no way to increase in response to the profit growth that successful bank risk-taking can produce. This means that if banks are taking on added risk to increase their profitability, you’re exposed to all of the losses and none of the gains–a losing proposition. But in an environment like the current one, where bank risk-taking is closely regulated, and where the regulations are not so onerous as to completely eliminate bank profitability, you end up winning. You continue to earn your promised income, while banks are prevented from putting your investment principal at risk.

Right now, there seems to be a consensus in the market that the election of Donald Trump will lead to significant changes to Dodd-Frank. But that’s hardly a given. Any legislative initiative will have to make it through congress, which is not an easy process. Even if meaningful changes do make it into law, it’s unlikely that the regulatory framework will regress back to what it was pre-crisis. All parties agree that banks need to be regulated to a greater extent than they were during that period.

(3) Strong Balance Sheets : To comply with the upcoming transition to Basel III, banks in the U.S. have had to significantly fortify their balance sheets. Today, their balance sheets are in better shape than they’ve been in several decades. In particular, the relative amount of common equity in U.S. banks, which serves as a potential cushion against preferred losses, is at its highest level since WW2. That means reduced credit risk for bank preferreds.

The best metric to use in quantifying the amount of cushion that bank preferred shareholders have from losses is the tangible common equity ratio. We take a bank’s tangible common equity (tangible assets minus all liabilities minus preferred equity at par) and divide by its tangible assets. The result tells us how much of the bank’s tangible asset base is fully owned by common shareholders. The portion of the balance sheet fully owned by common shareholders is the portion that preferred shareholders will be able to draw from to recover their principal in a liquidation.

The following chart shows the tangible common equity ratios of the big four U.S. banks: JP Morgan Chase, Wells Fargo, Bank of America, and Citigroup. As you can see, the ratios have improved significantly.

Now, to be fair, “bank equity” can be illusory. Even when it maps to something real, it can disappear very quickly during crises. That said, having a a lot of it is still better than having a little, which means that bank preferred shareholders are in a much better position today than they were in prior periods.

(4) Too-Big-To-Fail : Regardless of what anyone might say, “too big to fail” is still a reality. It serves as a backstop on the creditworthiness of bank preferred shares, especially preferred shares issued by the big four money center banks: JP Morgan, Wells Fargo, Bank of America, and Citigroup. We can think of these banks as heavily-regulated, government-backed utilities– ideal candidates for a preferred investment.

$WFC-L and $BAC-L: Two Unique Preferred Issues

Let’s now look at the two securities that will form the focus of the rest of the piece. The first security is a Wells Fargo 7.50% Series L convertible preferred issue (prospectus), ticker $WFC-L, or $WFC-PL, or $WFC/PRL, depending on the quote platform being used. The shares were originally issued as Wachovia shares in the early months of 2008. They became full-fledged Wells Fargo shares, ranking on par with all other Wells Fargo preferred issues, upon Wells Fargo’s acquisition of Wachovia in December of that year (8-K). The par value of each share is $1000, with each share paying out $18.75 per quarter in dividends, or $75 per year, 7.5%. The current market price is around $1220, which equates to a current yield (and YTW) of roughly 6.15%.

The shares are particularly unique–indeed, precious, in my opinion–because unlike almost all other preferred shares trading in the market right now, they are not callable by the company. Instead, they’re convertible . They come with a broad conversion option for the shareholder, and a limited conversion option for the company. For the shareholder, she can convert each share into 6.38 shares of Wells Fargo common stock at any time and for any reason. For the company, if the common shares of Wells Fargo appreciate substantially, it can force that conversion to occur. More specifically, if Wells Fargo common shares, currently priced around $58, exceed a market price of $203.8 (technically: $1000/6.83 * 130%) for 20 days in any 30 day consecutive trading period, then the company can force each preferred share to be converted into common at a 6.38 ratio. If that were to happen, shareholders would get 6.38 common shares, each worth $203.8 in the market, which amounts to a total market value per share of $1300, 130% of par.

It goes without saying that the company is unlikely to be able to convert the shares and get out of the deal any time soon. The market price of Wells Fargo common stock would need to more than triple from its current peak-cycle level. Even if we make optimistic assumptions about the future price growth of such a huge bank–say, 6% per year from current levels–a tripling will take at least another twenty years to occur. That’s great news for owners of the preferred shares–it means that they can expect to receive a tax-advantaged 6.15% yield for at least another 20 years. Additionally, if or when the conversion price is eventually reached, it’s not going to create a loss for current buyers. It’s actually going to create a small gain, because the shares are currently trading at a price below the $1300 that they would effectively be converted into monetarily.

The second security is a Bank of America 7.25% Series L convertible preferred issue (prospectus), ticker $BAC-L, or $BAC-PL, or $BAC/PRL. Like the Wells Fargo shares, these shares were issued in the early months of ’08, at a time when funding for financial institutions was become increasingly tight. In terms of their structure, they’re essentially identical to the Wells Fargo Series L shares, except for the numeric details, shown below:

Now, let’s look more closely at the risk-reward proposition in the shares at current prices.

In terms of reward , the investor will earn a tax-advantaged 6.15% yield (tax-equivalent: 7.26% for 28% earners, 8.28% for top bracket earners) for some unspecified number of years, potentially up to infinity, plus a one-time 5% to 10% gain on a potential conversion decades out. Importantly, because the shares are not callable, they offer the potential for substantial price appreciation–as might occur, for example, if long-term interest rates fall, or if the market discovers additional value in the shares and re-rates their prices. Note that the vast majority of preferred shares in the market are callable, and therefore do not offer investors the same price appreciation potential. As their prices rise, their implied call losses rise, causing their YTWs to quickly drop.

In terms of risk , the shares carry the same risk that any security carries, which is the risk that the market price might fall, for any number of reasons, the most basic of which would be more selling than buying.

Thinking about the risk in fundamental terms, the shares carry the credit risk that Wells Fargo or Bank of America will not be able to pay the promised preferred dividends. In quantifying that risk, Moody’s and S&P have given Wells Fargo preferred shares a BBB rating and a Baa2 rating, respectively, and Bank of America preferred shares a BB+ and Ba2 rating, respectively. Note that these ratings are distinct from the credit ratings of the debt securities of these banks, which obviously have a higher rating.

Personally, I believe the credit risk in the preferred shares of any large money center bank to be very low, for the reasons already stated. But to gauge that risk, we don’t need to rely on speculation. We have an actual historical test case that we can examine: the financial crisis of ’08, which represented the epitome of a worst-case scenario. Notably, the two securities existed before the worst of the ’08 crisis unfolded. Both came through it in perfect health, with all promised dividends paid. Like everything else in the sector, the securities suffered large price drops, but their prices fully recovered.

In addition to credit risk, the shares carry the same risk that any long-term fixed income security carries, which is the risk that long-term interest rates will meaningfully rise, forcing prices to adjust downward to create competitive yields. But these securities, at their current prices, offer three features that can help mitigate that risk, at least partially.

First, at 6.15% (tax-equivalent: 7.26%, 8.28%), their yields and YTWs are already very high, higher than essentially any other similarly rated fixed income security in the market. Conceivably, in a rising rate environment, their prices won’t need to fall by as much in order for their yields to get in line with other opportunities.

Second, if their prices do end up falling over time, they’ll be accumulating a healthy 6.15% yield during the process, helping to offset the losses. That’s much more than the 2.5% to 3% that long-term treasuries will be accumulating.

Third, as discussed earlier, increases in long-term interest rates will tend to increase the profitability of Wells Fargo and Bank of America. The realization of interest rate risk in the shares will therefore have the counterbalancing effect of reducing their credit risk. Granted, the market might not see the shares as carrying any meaningful credit risk right now, and therefore the credit risk “relief” that comes with improved profitability might not help prices very much. But if the shares do not carry any meaningful credit risk, then why are they trading at a yield of 6.15% (tax-equivalent: 7.26%, 8.28%)? Is that the kind of yield that risk-free securities normally trade at in this market? Obviously not.

Another risk worth mentioning is the risk of forced liquidation. When you buy a preferred security above par, and the underlying company is forced to liquidate, the most you can hope to recover in the liquidation is par, $1000. Buyers at current prices would therefore incur a loss on forced liquidation down to that level. Personally, I don’t see the forced liquidation of either these banks as representing a realistic scenario.

$WFC-L and $BAC-L: Understanding the Valuation Anomaly

With the risks and rewards identified, we can now look more closely at the valuations of the shares. Currently, $WFC-L and $BAC-L are offering current yields and YTWs of 6.15% (the yields and YTWs are the same). That’s 62 bps higher than the 5.53% average current yield of preferred stocks as a group, and 137 bps higher than the 4.78% average YTW of preferred stocks as a group. Unlike the vast majority of shares in the preferred space, however, $WFC-L and $BAC-L aren’t callable, which gives them upside potential that the rest of the space lacks. That difference should cause them to trade at lower yields than the rest of the space–yet we find them trading at higher ones.

Ultimately, there’s no way to make sense of the higher yields. They represent a plain market inefficiency. For conclusive proof of that inefficiency, we can compare the valuations of $WFC-L and $BAC-L to the valuations of other preferred shares from the same issuers. In an efficient market, absent relevant differences in the structures of the shares, the valuations should all be roughly the same, given that the shares represent claims on the same company and rank on par with each other. But that’s not what we’re going to find–they’re all different.

The following table shows all of the currently outstanding fixed rate preferred stock issues of Wells Fargo, each of which ranks on par with every other. Prices are intraday as of February 27, 2017:

As you can see in the above chart, we find the same inefficiencies within the space of Wells Fargo shares. $WFC-L is offering a higher YTW than all of the other issues, and a higher current yield than every other issue except for $WFC-J (a legacy Wachovia issue that has an 8% coupon and that’s essentially guaranteed to be called in at the end of this year, given its high cost to the company–it therefore deserves to be treated differently). Instead of trading at a higher yield than the rest of the space, $WFC-L should be trading at a lower yield, because it’s the only security that’s non-callable, and therefore the only security that has the potential to reward shareholders with a long-term stream of future dividends, as well as meaningful price appreciation as interest rates fall.

Getting inside the head of the market here, I would guess that the thought process being used to justify lower yields for the other shares looks something like this. The other shares can be called, therefore they have lower effective durations, therefore they deserve to trade at lower yields. But this logic misses the crucial fact that the call option belongs to the company, not to the shareholder. It’s only going to be used if using it is in the company’s interests, which is to say, if using it is counter to the interests of the shareholder, the company’s counterparty. There is no scenario in which the existence of the call option will ever be capable of increasing the value of the shares, just as there’s no scenario in which giving someone else a free call option on positions you own could ever make those positions more valuable.

It’s true that in a falling rate scenario, the duration of a callable security will go down. But that’s precisely the kind of scenario where an investor will want to be owning longer-duration securities–securities like $WFC-L that provide a guaranteed stream of dividends out into the future and that are therefore capable of appreciating meaningfully in price.

To see the inefficiency more clearly, let’s compare $WFC-L to $WFC-O. We see the from that table that $WFC-O is offering a 5.23% yield, almost 100 bps lower than $WFC-L’s 6.15% yield. It has a coupon yield of only 5.13%, which is at the absolute low end of what Wells Fargo has been able to issue over the last several years. Because it’s extremely cheap for Wells Fargo to finance, it’s unlikely to ever get called in. The market agrees, which is why it’s trading below par, despite having a call date only 6 months away. Because it’s unlikely to ever get called, we can treat it as a perpetual security. Is 5.23% an appropriate yield for a perpetual security? Maybe, but not with the equally-ranked WFC-L, also a perpetual security, yielding 6.15%!

Now, assume that over the next several years, interest rates go down, breaking below the lows of last summer. $WFC-O will not be able to appreciate in such a scenario because the call option will already be exerciseable. Any move above par ($25) will expose buyers to immediate call losses. Moreover, the company will want to call the security in, because it will be able to refinance at better yields in the market. The situation with respect to $WFC-L, however, is different. It is set to pay a solid stream of sizeable dividends decades out into the future. Given the lack of a call feature, unless the common stock triples, there’s nothing that the company can do to get out of paying those dividends. For that reason, $WFC-L has a full runway on which to appreciate in price should interest rates come down. So while $WFC-O would be stuck at $25 in the scenario, $WFC-L would be able to rise by several hundred points, if not more.

To summarize, then, you have a perpetual security that’s offering a contingent (callable) dividend stream with no price appreciation potential ($WFC-O) trading at a yield almost 100 bps lower than a perpetual security with an equal ranking from the exact same issuer ($WFC-L) that’s offering a guaranteed (non-callable) dividend stream with substantial price appreciation potential. If you’re looking for a case study to disprove the efficient market hypothesis, you have one right there.

Moving on to Bank of America, the following table shows the company’s currently outstanding fixed rate preferred stock issues, each of which ranks on par with every other:

Again, we see the same types of inefficiencies. BAC-L has the highest YTWs, even though, as a non-callable security, it deserves to have the lowest.

Now, as considerate value investors, we need to ask the question. Why are $WFC-L and $BAC-L priced so much more attractively than the rest of the preferred share market? Are we missing something?

The simple answer to the question is that the market for preferred shares contains a large cohort of unsophisticated investors. For that reason, it frequently produces mispricings. In fairness, for all we know, common equity markets–i.e., the regular stock market–may also produce frequent mispricings. But the mispricings would be much harder to conclusively prove, given that there are so many confounding variables associated with that type of investing.

To illustrate, ask yourself, right now, is $AMZN mispriced relative to $AAPL? You can’t know for sure, because you don’t have a reliable way to estimate the likely future cash flows of either company, nor a reliable way to quantify the many risks associated with those cash flows. The question therefore can’t be resolved, except in hindsight, at which point an efficient market guru can easily say, “The market was correctly pricing the securities based on the available information at the time. Hindsight obviously changes the picture.”

With preferred shares, however, we can look at par securities from the exact same issuer, and watch them trade at substantially different yields. Without a justification somewhere in the structure of either security, the mispricings become undeniable. Unfortunately, mispricings in the preferred space cannot be readily corrected through arbitrage (i.e., buying the underpriced shares and shorting the overpriced shares) because the borrow costs on the overpriced shares tend to be prohibitively high. The borrow cost on $WFC-O, for example, is between 10% and 11% annualized, so if you wanted to collect 100 bps annually by shorting $WFC-O and going long $WFC-L, the carrying cost of the trade will end up being 10X that amount.

Now, back to the unanswered question of why the market is currently mispricing these securities. I can think of at least three possible reasons:

Reason 1: Callability Neglect and Par Anchoring

As I insinuated earlier, not everyone participating in the preferred share space understands or properly accounts for the impact of callability. There are uninformed investors who will buy based simply on seeing a high yield, ignoring considerations related to callability. As evidence of that claim, consider two interesting debacles that occured last year in the bank preferred space–the case of Merrill Lynch 6.45% trust preferreds, ticker $MER-M, and the case of Bank of America 6% trust preferreds, ticker $BAC-Z. Last summer, both of these high-cost shares were lazily trading well above their par values, even though they had become callable. The excess in price over par was far greater than any individual future dividend payment could have made up for, yet investors in the space were willing coming in each day and buying them. When the shares did get called in, the net result was bloodshed:

So there you have one likely explanation for why investors might be mispricing the securities–they aren’t paying attention. They go in, for example, and pick $BAC-I over $BAC-L simply because it offers a higher yield, never mind the fact that it becomes callable in a few months and has a current YTW that’s negative.

Another likely explanation is that there are investors that wrongly interpret callability to be a beneficial feature of preferreds, a feature that lowers duration and reduces interest rate risk. Because $WFC-L is not callable, it’s conceptualized as having a higher duration and as being more exposed to interest rate risk. But that’s completely wrong. $WFC-L is no more exposed to interest rate risk than any of the other callable securities (with the limited exception of $WFC-J, which is all but guaranteed to be called in, given its 8% cost to the company). As I emphasized earlier, callability doesn’t protect investors from rising rates because securities don’t get called in when rates are rising (i.e., when corporate financing costs are going up). They get called in when rates are falling (i.e., when corporate financing costs are going down), which is precisely when an investor will not want them to be called in.

We can imagine an unsophisticated investor thinking to himself–“This stock has a call date 3 yrs from now, which isn’t very far away. There’s a decent chance I’ll get my back then, regardless of what Mr. Market decides to do. It’s not a 100 year security, so it’s not like I’m going to be stuck holding it forever.” The problem, of course, is that the security is going to turn into a 100 year security in exactly the kinds of situations where the investor will wish it was a 3 year security. And it’s going to shift back into a 3 year security in exactly the kinds of situations where the investor will wish it was a 100 year security. The investor does not own the option, and therefore the investor should not expect to receive any benefit from it.

On a similar note, I’ve noticed that when the price of a security–say, $WFC-O–trades steadily near or below par, investors tend become more comfortable with it, even when they shouldn’t be. It’s as if they anchor to “par” as a reliable standard of normalcy, fairness, appropriateness–a price that can be trusted. This tendency may help explain why $WFC-L trades so cheaply relative to other $WFC issues. To trade at a fair price relative to the rest of the space, it would have to trade upwards of 50% above par, at $1500, a price that feels excessive, even though it could easily be justified on the basis of relative value.

To be clear, par may be a normal, fair, appropriate, trustworthy price for a security on the date of its issuance –it’s the price, after all, that other presumably intelligent people agreed to pay when they made the initial investment. But once that date passes, and conditions change, the question of how close or far a given price is to or from it is entirely irrelevant.

Reason 2: Large Outstanding Market Supply

The point I’m going to make here is more complex, but also more interesting, so you’re going to have to be patient and bear with me.

All else equal, a larger outstanding market supply of a security (price times share count) will tend to put downward pressure on its price. This fact helps explain why $WFC-L and $BAC-L trade so cheaply on a relative basis. As shown in the earlier tables, their outstanding market supplies–measured in dollar terms at $5B and $7B, respectively–are extremely large relative to the outstanding market supplies of the other preferred issues.

To understand why supply matters, recall that as you increase the outstanding market supply of a security–for example, by issuing large quantities of new shares–you are necessarily increasing the total “amount” of the security floating around in the market, and therefore the total “amount” sitting in investor portfolios, because every issued share has to it someone’s portfolio at all times. Trivially, by increasing the total “amount” of the security contained in investor portfolios, you are also increasing the total “amount” of it that investors will randomly attempt to sell in any given period of time (and here the selling can be for any reason: because the investor is concerned, because a better investment has been found, because the cash is needed to fund some other activity–whatever, it doesn’t matter). The point is strictly intuitive–more outstanding units of a security in investor portfolios means more units that get randomly sold every day, and every hour, and every minute, as investors move their portfolios around in response to their own whims and fancies.

That selling is a flow quantity, so we refer to it as attempted selling flow; all else equal, it increases whenever supply increases. Now, it’s a truism of markets that, for a price equilibrium to be reached, attempted buying flow in a security has to match attempted selling flow in that security. If attempted buying flow is less than attempted selling flow, prices will not stay put. They will get pushed lower.

So ask yourself this question. As the outstanding market supply of a security goes up, and therefore as the amount of attempted selling flow in that security goes up, does the amount of attempted buying flow also go up–automatically, spontaneously, simply to stay even with what’s happening elsewhere? No. There’s no reason for attempted buying flow to go up simply in response to an increase in the outstanding market supply of a security. But that flow has to go up, otherwise the attempted flows will not match, and prices will fall. So what happens? Prices fall. The security trades more cheaply. By trading more cheaply, it draws in interest from investors, resulting in an increase in attempted buying flow to match the increased attempted selling flow and return the price to an equilibrium at some new lower level.

Empirically, we see that big behemoth companies, with large supplies of market equity for investors to hold in their portfolios, tend to trade more cheaply than smaller ones, all else equal. You can look look at $AAPL, with its massive $716B market value, as a good example–investors lament its cheapness all the time: “It has a P/E of 10 ex-cash!” But why do big behemoth companies like $AAPL trade more cheaply? Some would say it’s because their potential future growth is constrained–but that can’t be the only reason. In my view, a significant contributor is the sheer size of their market capitalizations, the enormous outstanding dollar amounts of their equity that investors have to willingly take into portfolios. The the interest to do that–i.e., take in that large supply of equity as a position in a portfolio–isn’t always going to be there, which is why big behemoths sometimes have to become cheap, so that they they can attract more willing buyers and more willing owners.

As a company like $AAPL grows in market capitalization, it becomes a larger and larger portion of investor portfolios. A larger dollar amount of it is attempted to be sold every day. But does the growing market capitalization also cause a larger amount of it to be attempted to be bought every day? No. The buy side of the equation isn’t affected by supply–it has no way to know that supply is increasing. And so the security sees more selling demand than buying demand, until it becomes cheap enough to attract sufficient buying demand to correct the imbalance. That’s the dynamic. Now, to be fair, as a company like $AAPL grows in size, reaching ever higher market capitalizations, it will typically become more popular, more talked about, more visible to market participants, and so on. More people will hear about it, know about it, and therefore more people will wake up in the morning and randomly decide “Hey, I want to own that stock.” That effect–the increase in popularity and visibility that occurs alongside equity growth–can bring with it an increase in attempted buying flow, an increase that can help quench the increased attempted selling flow that will naturally arise out of the increased market supply of the equity. If that happens, the company, as a big behemoth, may not need to become as cheap, or cheap at all.

But when we’re talking about two obscure preferred stock issues that very few people even know about, preferred stock issues that didn’t arrive at their current market sizes through the growth of an underlying business, but that were instead dumped on the market en masse during a crisis-era fundraising effort, their attempted buying flow isn’t going to be able to rise to the necessary levels in the same way, i.e., by an increase in popularity or visibility or whatever else comes with growth. The only way they’ll see sufficient attempted buying flow to match the large attempted selling flow that they’ll naturally face is if they trade more cheaply, cheap enough to come up more frequently on value screens and attract attention from bargain-seeking investors. And that’s exactly how we see $WFC-L and $BAC-L trade–cheap enough to draw interest from those looking for a deal.

For a fascinating illustration of supply effects working in the other direction, driving prices to irrationally high levels, consider the curious case of Kansas City Southern non-cumulative 4% preferred shares, which have a par value of $25 and trade on the NYSE as $KSU-, $KSU-P or $KSU/PR. A total of 649,736 of the shares were issued in a $16.24MM IPO that took place in November of 1962, at a time when preferred shares tended to trade at very low yields. Shortly thereafter, around 400,000 of the shares were eliminated in a tender offer, leaving 242,170 shares leftover. At par, those shares represent a total dollar market supply of $6.05MM–a tiny supply by any measure. Because they were issued with no call feature, they still trade in the market to this day. They have no way to leave the market, because they don’t mature, convert, or have a call feature.

Now, recall that unlike common dividends, preferred share dividends and preferred share prices don’t have the potential to grow with the economy over time. Consequently, without new issuance, their outstanding market supplies (price times share count) can’t grow with the economy over time. For that reason, the market supply of $KSU preferreds has stayed constant at roughly $6.05MM for over 50 years , even as the market value of the rest of the asset universe, to include the economy’s money supply, has increased by a factor more than 30X. The end result is that $KSU preferreds have become the “Honus Wagner T206” of the preferred share market. They are unique preferred shares that, through a quirk, have been rendered incredibly scarce. Their scarcity causes them to trade at irrationally high prices.

One would think that in the current environment, at only a 4% coupon, the shares would trade significantly below par. But, for reasons that make no rational sense whatsoever, they trade at a strong premium to par, at price of 28.75 and a yield of 3.45%. For perspective, that’s only 45 bps above 30-yr treasuries, for a perpetual fixed income security that’s subordinate to BBB- rated corporate debt!

So you have $WFC-L preferreds, rated BBB, offering a yield of 6.15%, and then you have $KSU- preferreds, with no rating, issued by a company whose senior debt is rated BBB-, offering a yield of 3.45%, 260 bps lower–in the same market, on the same exchange. The clearest available explanation for this crazy price outcome is supply: the total dollar amount of market value in $WFC-L, an amount that has to find a home in someone’s portfolio at all times, is roughly 1000X larger than the total amount of $KSU- to be held. Granted, there could be other unmentioned forces at work–$KSU- might have a few very large shareholders who refuse to sell and who contribute to an even tighter shortage. But those forces are highly-likely to somehow involve supply considerations as well, given that no fundamental information about the shares could justify such a ridiculous valuation.

Reason 3: $1000 Par Value, Convertibility, Index Exclusion

A third reason for the potential cheapness of $WFC-L and $BAC-L is the fact that the shares exhibit unique properties that make them less likely to see buying demand from the usual sources. The shares trade at an unusually high par value, $1000, versus the normal $25. They have a complicated conversion-to-common feature, one that can be difficult to clearly decipher from the legalese in the prospectus. These factors might steer certain investors away from them–in particular, income-seeking retail investors, who constitute a significant portion of the preferred market.

More importantly, because of their differences from normal preferred securities ($1000 par, convertible, etc.), they are excluded from most preferred stock indices. As a consequence, you don’t see them represented in popular preferred stock ETFs. $PSK, $PGX, and $PGF, for example, all exclude them. I’ve gone through all of the popular preferred stock mutual funds, and at least as of last year, only one of them owned either of the two shares–in that case, it was $WFC-L. The largest preferred ETF index–$PFF–also owns $WFC-L, but doesn’t own $BAC-L. Note that if it did own $BAC-L at the right index ratio, the shares would be roughly a 4.25% position, the largest in the index, given the large market supply of $BAC-L outstanding.

When we consider these three factors together–first, the possibility that investors might be ignoring the call feature or misinterpreting it as some kind of a duration-related advantage, second, the fact that, in relative terms, there’s a very large outstanding market supply of the securities to be held, weighing down on their prices, and third, the fact that the securities have unique features that make them less likely to see interest from the usual sources of preferred buying interest–the depressed valuations start to make more sense. Admittedly, there’s no obvious catalyst to remove the factors and lift the valuation–but no catalyst is needed. Investors can earn an attractive return in the securities by simply owning them and collecting their outsized yields, paying no mind to whether the market price ever catches up.

Conclusion

In conclusion, preferred stocks are reasonably valued relative to the rest of the market and relative to their own past history, especially when their special tax advantages are taken into consideration. Within the preferred stock space, two unique securities–$WFC-L and $BAC-L–represent very attractive value propositions: 6.15% yields (tax-equivalent to 7.26% and 8.28% for 28% and top bracket earners, respectively), very little credit risk, no call risk, meaningful price appreciation potential, and decades worth of dividends still to pay. In an investment environment like the one we’re living in, where almost everything looks terrible, you have to take what you can get.

Disclosure: I am long $WFC-L and $BAC-L. Nothing in this piece should be interpreted as a recommendation to buy or sell any security. I make no warranty as to the accuracy or completeness of any of the information or analysis presented.