A Yen for Yield

There's a little-known corner of the securities market that could help brokers win kudos from clients who have exhausted safe domestic sources of good yield: foreign preferred stock. Most of these shares, which trade like ordinary U.S. shares and are listed in newspapers, are investment-grade securities offering current yields of around 8 percent and higher. Not bad, considering mortgage-backed securities are yielding 5.7 percent and medium-quality corporate bonds are paying just 50 to 60 basis points more.

The U.K.'s second-largest bank, the Royal Bank of Scotland, has a series of A1-rated preferreds with current yields in the mid-8 percent range. Spain's largest bank, BSCH, has several A2-rated preferreds paying around 8 percent. And from Down Under, A1-rated National Australian Bank and A2-rated Westpac have issues currently offering yields around 7.8 percent.

So, what's the catch? There isn't any.

As Daniel Campbell, managing director of global capital products at Deutsche Bank in New York, explains, “You just have to realize that the power of domestic preference can lead to market inefficiencies and opportunity for the broker and investor willing to look outside the domestic box. This means that you can find foreign preferreds paying 100 to 200 basis points more than U.S. issues of the same quality with the same risk profile.”

Foreign companies, particularly financial institutions, issue preferred shares in the U.S. for several reasons. First, noncumulative preferred shares are classified by banking regulators as Tier 1 capital. Banks must maintain a minimum level of such assets to operate effectively. And as William Scapell, a director in Merrill Lynch's fixed income strategy group observes, “Preferreds are a relatively cheap way to raise this core capital without diluting earnings numbers and key ratios. It also helps secure investment-grade ratings, which reduces the overall costs of borrowing.”

Second, raising capital outside home markets enables firms to diversify their borrowing sources, further increasing the stability of their operations. It also increases a company's name recognition in the world's largest securities market, which could prove valuable for subsequent financial ventures.

Third, because these securities are denominated in U.S. dollars, they provide foreign firms with a natural currency hedge against their home currency. This helps firms balance their U.S. debt exposure, thereby offsetting currency risks. And finally, foreign companies can use proceeds to help pay for U.S. acquisitions.

For U.S. investors, the preferreds generally do not provide currency hedging or risk. This makes them distinct from their ADR common share brethren, which are proxies of a company's home market shares and reflect changes in the home currency. For example, if the euro strengthens, the value of a Spanish or Irish ADR will decline, even if the price of the shares in the home market doesn't change.

The primary way foreign exchange could affect investment in a foreign preferred is if a company's underlying currency moved so dramatically as to materially hurt operations. In a worst-case scenario, a company could be forced to suspend payments of certain obligations, such as dividends. But currency issues alone are not likely to cause payment failure.

Four countries have come to dominate the foreign preferred market in the U.S.: the U.K., Spain, Australia and Canada (see table). Financial issuers dominate this list. However, energy companies also make use of these instruments as a means of raising long-term capital without diluting their shares.

Whether you're buying domestic or foreign preferreds, the basics of investing in these securities remain the same. Strong, stable credit ratings are essential, because preferreds trade much like bonds. Ratings are typically two notches below senior unsecured debt.

This parallel with bonds proved a boon for preferreds when interest rates declined in 2000 and 2001. Prices of many issues soared by 20 percent to 30 percent. Like bonds, when interest rates rise, prices of preferreds will decline.

Also like bonds, preferreds may come with a call date — when the issuer has the right to retire the security at a specific price. Because many preferreds were issued when interest rates were higher, their current prices have risen above par, which in most instances is also the call price. Therefore, it's essential to calculate the worst-case scenario — the yield to call.

Brokers, for instance, should not be enticed by the Royal Bank of Scotland's preferred “B” issue and its current yield of 10.25 percent. The security was trading at $27.29 toward the end of October. But the bank has the right to call it at any time at $25.

Merrill's Scapell generally advises investing in preferreds with BBB+/Baa1 ratings or better, that are trading close to their call price, and are at a minimum of one and a half years away from their call dates.

What will you find in that cohort? Westpac, one of Australia's largest banks has a preferred “A” issue that was trading at $25.80 in mid-November with a current yield of 7.75 percent. It enjoys an A2 rating and is not callable before July 2004. If it were called — a decision largely determined by what the cost of refinancing will be at that time — the preferred's annualized yield would be 6.37 percent.

Even more enticing are RBS' preferred “E” shares. The current yield is about 8.4 percent. Its original coupon of 9 percent has sent its share price rising to a recent $26.60. But with a call date that's nearly four years away, the share still has an attractive yield-to-call of 7.31 percent.

It is important to remind clients that preferreds can fail to make dividend payments without being in default (unlike when bonds fail to make interest payments). The protection that preferred shares offer over common shares is that they are one rung higher on the priority scale when it comes to payments and in the liquidation of assets (again, this may be cold comfort).

A few countries may subject payments to withholding taxes. For example, the U.K. government withholds one-ninth or 11.1 percent of the dividend on certain domestic issues. When this occurs, U.S. investors can receive a tax credit. To determine eligibility and amount, investors need to consult with their tax advisors.

Listed foreign preferreds are registered with the SEC and are designed primarily for retail investors. Another crop of foreign preferreds, issued under Section 144A of the 1933 Securities and Exchange Act, require less documentation and disclosure and are traded over the counter. They can only be purchased by qualified high-net-worth individuals or corporations. If your clients qualify, these issues may be attractive. “These preferreds can often offer yields 100 to 200 basis points more than comparably rated registered preferreds, with no additional risk,” says Deutsche Bank's Campbell. “The market simply demands higher returns from unregistered nonexchange-traded securities, even from a company that issues both versions.”

Take the big French bank Crédit Lyonnais; it has a 9.5 percent issue that's rated A3. It has a call date of July 2003 and recently fetched around $25.63 a share, just above its call price, producing a current yield of 9.27 percent and a yield-to-call of 6.80 percent. This return compares with equivalently rated, SEC-registered preferreds that are currently yielding 7.5 to 8 percent and which are callable in one year.

The Spanish financial firm Banesto, a subsidiary of Banco Espanol de Credito (which itself is a subsidiary of BSCH), has an A2-rated 10.5 preferred that's trading at around $26.50. That produces a current yield of 9.9 percent. With a call date of June 2012, qualified investors could lock into a 9.68 percent yield for a decade. This return contrasts with the current yield of 8.23 percent from A2/BBB-rated BSCH series “Q” preferred that's callable in October 2005.

Yielding Impressive Results