Banks' Preferred Option

	Roger Conrad Utility Forecaster.com
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Preferred stocks of regional banks offer lofty yields and solid safety out of the public eye.

In a low interest rate environment, good yields are tough to come by--unless you go a little off the beaten path. Since last fall, we've featured preferred stocks of real estate investment trusts (REITs) as an overlooked option for yield seekers. In this issue, we highlight regional banks preferred stocks.

Like the REIT preferreds, including the Income Portfolio's Chelsea 8 3/8 Percent Preferred, regional bank preferreds are in tight supply. Once you buy, you rarely give them up. Although some will sell, it takes real patience to buy--particularly if you have the necessary discipline to get the right price.

The good news is that like any exclusive club, once you're in, you're in. With securities issued by solid banks, there are few, if any, credit concerns. Even rising interest rates won't do much damage, since traders generally stay away and the preferreds have coupon yields well above market rates.

The Chelsea Preferreds, for example, held firmly during the spring rate spike. Below, we explore general rules for buying preferreds, as well as tracking both their performance and their issuers' health.

The Right Regionals

The first step is selecting the right bank. The issuers in the table XXX were selected based on the following eight criteria:

• Below Average Efficiency Ratio--This measures how effectively a bank's assets are being used. The lower the ratio the better.
• Net Interest Margin of 3 percent or higher--This is essentially the difference between the return on money the bank loans versus what it pays to lenders and particularly depositors. Higher is better.
• Non-performing Assets Ratio of less than 0.5 percent.
• Return on Assets at least 1 percent, preferably higher.
• Return on Equity at least 14 percent.
• Reserves for losses cover non-performing assets.
• Positive growth in loans.
• Positive growth in deposits.

Taken together, these financial measures give a pretty good indication of whether a bank is healthy or sick.

Of the banks on our list, First Busey Corp, Independent Bank Corp, MB Financial, Prosperity Bankshares and Sterling Bancorp meet all of these criteria with room to spare and are consequently extremely healthy. Also, with relatively high price-to-book values, there's less risk of a takeover by a larger but financially weaker bank.

The other seven banks fell short in one category or another, but scored highly enough to offset any weaknesses.

Doral Financial, for example, shows a weak net interest margin of a little more than 2 percent. But it also has an excellent 31 percent efficiency ratio, a more than 3 percent return on assets, 32.7 percent return on equity (ROE) and 35 percent-plus loan and deposit growth.

Great Southern Bancorp has a high 1.04 percent of assets that was non-performing at last count. However, the bank has reserved a more-than-adequate 1.87 percent of assets for losses. And it has a low efficiency ratio, high return on assets and equity and solid growth of deposits and loans.

National Commerce Financial and Zions Bancorporation show low ROE of 11.4 percent and 13.8 percent, respectively. But National's ROE is offset by very low non-performing assets at 0.28 percent, a solid 1.4 percent return on assets and strong efficiency and growth measures. The same is for Zions, which also has a strong net interest margin of 4.6 percent.

Income Portfolio pick Regions Financial's results will likely be skewed to the downside over the next several quarters as it absorbs newly merged Union Planters. But the multi-state bank continues to stack up generally well on our criteria.

Its efficiency ratio of 63 percent has some room to come down. But its return on assets is solid at 1.4 percent as is its ROE at 15 percent. That's a fairly good indication of management's skill in absorbing new assets over the long haul.

National Commerce Capital also showed a marginal efficiency ratio of 63 percent. But it has solid returns on assets and equity, low and well-reserved non-performing assets and its deposit and loan growth are running at 29 and 26 percent, respectively.

Most of the banks on our list are publicly held corporations. The exception is First Banks Inc of St. Louis--Personal Finance and By George editor Neil George's favorite.

Rather than issue equity to finance its growth, First Banks has issued preferred stock, which pays a high yield but has no voting rights. The bank's health is strong, attested by a 77 percent boost in second quarter earnings over last year's levels.

Inside the big number, the company reported a sizzling net interest margin and, though hurt by problem loans, reduced non-performing assets in the second quarter. 1.43 percent return on assets and 18.2 percent ROE are also positives. So is the 57.9 percent efficiency ratio, which was vastly improved from 64 percent a year ago.

Buying Wisely

For prospective preferred stock buyers, the most important lesson to glean from this fundamental analysis is that all of these banks have what it takes to be in business for a long time.

We're not as concerned about how their common stocks perform. But the underlying businesses are in good shape: We can count on their stability to pay us dividends over the long haul.

That's only half the battle, though. Getting the most from bank preferreds also depends on buying them the right way.

For starters, the typical broker in most cases hasn't heard of them and they're not listed in your local paper's financial pages. Any broker, however, can buy them with a minimal amount of legwork. They're available for purchase with online accounts as well.

As we've seen from the action (or inaction) in the Income Portfolio's Chelsea Preferred, the prices of these securities aren't apt to vary much. But quotes are readily available from a wide range of sources.

For those of you with Internet access, you can look them up on Yahoo Finance. Other information is available on the free Web site www.quantumonline.com, which also features basic information on a range of other income investments that are slightly off Wall Street.

Because investors don't usually sell these preferreds, it doesn't take much demand to move their prices sharply higher, though these moves are inevitably retraced. Thus, it's important to either use an official limit order when you buy or else watch them carefully and only strike when the ask or offer price is below a certain level.

In the case of the 12 preferreds in the table, it's critical you don't pay more than $1 to $2 above the prices listed. That's especially true for those trading above their call prices.

As we've explained in previous issues of PF, "premium" securities (like these) almost always pay you a higher "yield to maturity"--the dividend minus the price erosion to the call price. This is because investors are irrationally afraid of paying above call, even if the call date is years away.

In addition, premium securities pay you more cash before maturity or call, which tends to reduce their interest rate swings vulnerability. But if you pay too much above call, the yield to maturity will drop off sharply.

Taxation is a third concern for these preferreds. Except for the Doral and First Bank securities, these are "trust" preferreds--meaning dividends are taxed as ordinary income, rather than at the preferential 15 percent.

You may also have to file special tax forms if you hold them within an IRA. That may be disconcerting to those who prefer simplicity.

But if you're willing to take the extra step, they're a great way to add some yield to your portfolio, without great risk. That's a feat in any environment, especially one like this.

Roger Conrad will be available for questions until Monday, September 27. Don't miss this chance to ask your questions using the below form.