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2 High-Yield Preferred Shares with Upside Potential
Stock Analysis & Ideas

2 High-Yield Preferred Shares with Upside Potential

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JPMorgan and Bank of America offer significant upside on some of their preferred shares if interest rates turn lower. Combining preferred and common shares offers diversification benefits. Of the two, BofA offers higher upside potential but also higher risk.

Most preferred bank shares with a fixed dividend rate have taken a beating this year thanks to higher rates across the board. This comes against the backdrop of solid capital positions for the banks. What’s more, the higher-than-expected rates created an earnings boost that will continue into 2023, albeit with the expectations of rates going back down later next year. In this article, I will highlight two preferred shares which look like good buys, especially if rates come down as expected, starting in late 2023.

JPMorgan (NYSE:JPM) Preferred Shares

One of the biggest beneficiaries among JPMorgan’s preferred share classes for a return to a long-term neutral 2.5% FED funds rate should be its 4.625% non-cumulative preferred stock, series LL (NYSE:JPM/PL). Back in 2021, these were trading around the par value of $25 while the 10-year U.S. government bond yield was ~1.6%. In essence, the yield premium of the preferred shares was 3%, with a FED funds rate stuck at zero, albeit with expectations for rate hikes.

Source: TradingView

Nowadays, the expectations are that the FED will raise rates somewhat further before eventually cutting them to the long-term neutral rate of 2.5%. While the current yield of 5.8% on the preferred shares represents just a 2.1% premium over the 3.7% 10-year U.S. government yield, I think that the 10-year U.S. yield should end up in the 2.5-3% range in the long term, providing upside on the preferred shares.

Thus, I reckon the series LL has a good chance to move in the $21-23 range, or some 5-15% higher than the current sub-$20 price. What’s more, starting on June 1, 2026, the preferred shares are callable at $25, providing a total upside of 25% should the FED cut rates in the event of a recession. In the meantime, you can collect a 5.8% yield, which is almost double that of JPMorgan’s common stock, although I expect the bank to resume dividend hikes in the latter part of 2023 once its capital position has been strengthened.

Bank of America (NYSE:BAC) Preferred Shares

The thinking behind the opportunity for BofA’s 4.25% non-cumulative preferred stock, Series QQ (NYSE: BAC/PQ), has great similarities with the thesis outlined above for JPMorgan. While the current yield of around 6% is almost identical to the one offered by JPMorgan, I think BofA’s Series QQ shares offer higher total-return potential if the Federal Reserve lowers rates. The upside to $25 is close to 40%, given the sub-$18 price the shares trade at (see below).

Source: TradingView

Another thing to highlight is that Bank of America is active in buying back its preferred shares, up to $1.5 billion worth. Given the discount the shares trade at, that is very value-accretive for the bank.

As we know, there is no free lunch. Case in point, under the standardized approach, BofA’s CET1 ratio (a liquidity ratio — the higher, the better) is 11%, below the 12.5% reported by JPMorgan. Thus, as always, the higher return opportunity comes with an extra bit of risk, although as far as the preferred payments are concerned, both banks are in an ideal position to weather a jump in credit losses. Finally, the first call date for the Series QQ is┬áNovember 17, 2026, a few months later than the JPMorgan equivalent.

Preferred Shares Provide Diversification Benefits

While year-to-date preferred share returns have tracked the common shares lower, there is reason to believe their performance should diverge somewhat in the future. Firstly, the current starting point is different. At the beginning of the year, both of the above-mentioned preferred shares were trading at par, in essence offering limited upside if rates went lower. Nowadays, if rates do indeed drift lower, there is room for the shares to return to par. Of course, the current market expectations may prove to be wrong, and rates could end up even higher than currently anticipated, pushing the preferred shares even lower in price.

I think combining preferred shares with common bank shares will improve risk-adjusted returns since the common shares will likely suffer if rates move to the downside, unlike the preferred ones. Investors may even use moves in interest rates to rotate from one share class to another.

Conclusion: Preferred Shares Can Benefit from Lower Rates Eventually

Despite interest rate tailwinds, both common and preferred bank shares have suffered double-digit losses in 2022. Investors remain worried about a 2023 recession. If rates turn lower as expected, the preferred shares should stage a recovery in price, potentially outperforming the common ones.

The capital position of BofA is weaker, and all else equal, it may have to suspend preferred dividend payments before JPMorgan. However, given the current repurchase offer, I view this scenario as highly unlikely.

Finally, in a sideways market, the preferred shares should outperform, given their higher cash yield (the difference is greatest at Bank of America). Investors may also use income-generating options strategies such as selling covered calls on price strength to enhance their current cash return.

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