Bank Of America: Busted Preferred Shares Still Yield 5.85% (NYSE:BAC)

Introduction

Last December, I argued Bank of America (NYSE:BAC) irrevocable preferred stock was a good idea to speculate on a rate cut (and on falling interest rates in the financial markets). So far, the investment has made what I expected him to do. Bank of America has continued to make quarterly preferred dividend payments, while the stock price is currently about 10% higher, for a total return of about 15% over the past eight months. As Bank of America recently released its second quarter results, I wanted to make sure my investment thesis for Series L Preferred Stock still holds.

Bank of America obviously remained very profitable

Whenever I look at the preferred stock, I want to double check that the preferred dividend still enjoys a great coverage ratio.

As you can see in image below, Bank of America reported slightly lower net interest income compared to the same quarter a year ago, while there was also a slight quarter-over-quarter decline. That said, the bank’s noninterest income increased by more than $600 million on a year-over-year basis, while total non-interest expense increased by just over $270 million and this almost entirely offset lower net interest income.

That said, Bank of America’s pretax income was lower than in the same quarter last year, mainly because the bank increased the amount it set aside for loan loss provisions. As you can see, the total amount has increased by about $400 million, and while some other authors may sound very “alarmist” on these matters, it is pretty much the normal course of doing business for banks. In tougher economic times, it makes sense to see higher provisions, and once the dust settles, it’s quite common for banks to be able to recoup some of the provisions they made.

In any case, Bank of America posted a net profit of nearly $6.9 billion, and after taking into account preferred dividends of $315 million, the net profit attributable to common shareholders was just under 6, 6 billion dollars. This indicates that the preferred dividends are very well covered as the bank needed less than 5% of net income to cover the preferred dividends.

Series L preferred shares live up to expectations

As explained in previous articles, the L series, which trades with (NYSE:BAC.PR.L) as a ticker symbol, is a so-called “busted” favorite that cannot be called by Bank of America. The owner of the preferred stock has the option to convert the stock into 20 shares of common stock, and if the underlying stock trades at $65/share, Bank of America can force the conversion.

But since the common stock trades at about $40/share, the likelihood of a forced conversion happening in the next few years is pretty low (the stock price would need to rise more than 60% from the current stock price). And even if that were to happen, preferred stock owners would receive at least $1,300 in common stock ($20 times $65) from Bank of America. Given that the preferred stock is currently trading at about $1,240, there would be a capital gain of about 5% if that were to happen, so it’s certainly not a dire scenario.

Meanwhile, those preferred shares offer a preferred dividend of 7.25% based on the $1,000 principal value of the security. This means that at the current share price of approximately $1240, this series of preferred shares yields approximately 5.85%. That’s about 203 bps above the 10-year US Treasury note (which, of course, is an arbitrary comparable since there’s no definitive maturity date for preferred stocks).

investment thesis

Bank of America’s Series L fixed-rate preferred stock is doing exactly what I expected it to do: Due to lower interest rates in the financial markets and the likelihood of seeing further rate cuts (which should lead to even lower interest rates in the markets), the stock is already trading about 10% higher than last December.

I have a long position in Wells Fargo’s “broken” preferred stock and Bank of America’s Series L preferred stock because I like the dual exposure to both income and the potential to generate capital gains.