Bank of America: Grab 6.5% Yield Preferreds! (NYSE:BAC.PR.L)

Most U.S. investors will have encountered Bank of America (BAC) stock at some point in their investing journey. It has the second most branches of any bank in the United States, and a very large brokerage business. It’s only natural to think of investing in your personal bank, so BAC’s common stock is likely familiar to most readers of this article.

The preferreds, however, are a different story.

Bank of America has a number of different preferred shares on offer to investors. One of them, which is called the “7.25% Non-Cumulative Perpetual Convertible Preferred Series L” (BAC.PR.L) has a 6.5% yield. It’s a pretty high yield–much higher than BAC’s equity–although it isn’t quite as high as the yield when the stock was issued, as it has risen in price.

BAC.PR.L was issued with $1,000 of par value and a $72.50 coupon. The price rose to $1,112.21, causing the yield to shrink to 6.5%. It’s still a high yield, without a doubt, but not as high as when the preferreds were issued.

Bank of America preferreds are an interesting alternative to investing in BAC equity. Preferred shares have a priority claim on earnings above common shares. This means that if BAC shares were to ever suffer a profitability problem that caused the dividend to be cut, the preferred shares could still get paid.

The downside is that with these preferreds, the dividend never increases. Earlier this year, Bank of America upped its dividend payout by 9%. That doesn’t happen with the preferreds. Granted, the preferreds still have a much higher yield than BAC does, but BAC may have a higher yield-on-cost in 10 years.

In this article, I will make the case that Bank of America series L preferred shares are a good alternative to BAC for risk-averse investors. Although they don’t have the upside potential that the equity has, they have a very safe and well covered yield. Even if a Spring 2023-style banking crisis were to occur, Bank of America’s preferreds would likely be very safe. So, these preferreds are a good choice for the risk-averse investor.

Bank of America: Competitive Position

Before looking at Bank of America’s BAC.PR.L preferreds, we need to look at the company’s overall strength. That way, we can get a feel for the enterprise which issued these preferreds.

Bank of America is the second biggest bank in the United States. It has the second most branches out of all the banks in the nation. It has high brand recognition. Finally, it’s the #1 bank in North America for risk management. So, Bank of America has a high market share to begin with, and it has a lot of advantages that argue it will maintain it. The risk management point is especially important: it’s a bank’s risk management practices that determine whether it will survive a banking crisis like the one in Spring 2023. BAC survived the crisis, a testimony to its sound risk management.

This point is more relevant to common shareholders than preferred shareholders. Preferred shares have priority over common shares, so common dividends would be cut before preferreds would. It would take a really severe crisis for Bank of America to stop paying its preferred share dividends.

Macro

One factor that is uniquely important to Bank of America is macro. As a high interest rate sensitive bank, its fortunes are partially determined by Fed policy and the bond market. You may have heard that “banks borrow short and lend long.” This means that their short term deposit interest is based on short term bond yields, while mortgage interest earned is based on long term bonds. Interest rate hikes that are parallel across the yield curve is good for banks, as they increase the interest banks collect off of renewed loans and variable rate loans. However, if the yield curve inverts, bank margins come under pressure. Because banks “borrow on the short end and lend on the long end” of the curve, they earn less profit when short term bonds fall in price (i.e. rise in yield) compared to long term bonds. In theory, anyway. In 2023, profits at the big banks have been rising. For example, in the second quarter, BAC earned:

• $25.2 billion in revenue, up 11%.

• $7.4 billion in net income, up 19%.

• $1.7 in net interest income, up 14%.

• $1.1 billion in provisions for credit losses (“PCL”), up 120%.

• $765 million in non-interest income, up 5%.

Overall, it was a pretty good showing for Bank of America. Revenue and earnings grew significantly. The earnings growth was particularly impressive given the large PCL build–a rise in reserves causes a charge to be taken off of net income. Finally, investment banking fees increased 7% year over year to $1.2 billion. That’s an important milestone because investment banking fees had been declining across the industry prior to the second quarter. Perhaps investment banking is about to stage a comeback! Although BAC has said that fee growth will be negative again in the third quarter, the magnitude of the decline will not be as great as what was seen in 2022, so the trend is improving.

Valuation

Next up, we have valuation. Although BAC.PR.L is not the same as BAC, its shares are convertible to BAC shares at $50. Therefore, we can look at BAC.PR.L as a “potential” BAC share, that pays a 6.6% yield in the meantime.

At today’s prices, BAC trades at:

• 7.8 times earnings.

• 2.3 times sales.

• 0.85 times book value.

• 4.9 times operating cash flow.

It’s a pretty cheap stock, even for the banking sector. Granted, the price/book ratio is not as low as it looks. As I wrote in a recent article, it rises to about 1.6 when you adjust the held to maturity securities down to book value. That’s still not scarily expensive, and the other multiples I just listed are actually low.

BAC.PR.L shares can be converted to BAC stock at a price of $50 (the cost to the exerciser becomes $55 after accounting for the rise in BAC.PR.L’s market price). The conversion rights can’t be exercised now, and it wouldn’t be desirable to do so: if you turned one BAC.PR.L into 20 BAC shares, you’d be paying $55 per share for a $27.38 stock. So the 7.8 P/E ratio would effectively become 15.6! There may come a point in the future when exercising the conversion option on BAC.PR.L makes sense, however, and the 6.5% yield you get on the preferreds is already desirable.

Risks and Challenges

As We’ve Seen, BAC.PR.L are some very high yielding preferreds, and they even come with an option to convert to BAC stock. It’s a pretty enticing picture, however, this situation comes with some risks too, including:

• Interest rate risk. BAC.PR.L is a fixed coupon instrument, meaning it should react to interest rates much like bonds do: it should decline when they go up and rise when they go down. Bank of America’s preferreds have in fact behaved this way: they rose all through the easy monetary policy period of 2020-2021, and fell when the Fed started hiking in 2022. Currently, oil prices are above $90, and inflation was at 4% as of the last reading. These signs tend to indicate that the Fed may have another hike or two left up its sleeve, so there’s a chance that BAC.PR.L will decline on higher interest rates.

• Liquidity risk. Bank of America’s preferreds aren’t as exposed to liquidity risk as its common shares are, but it’s still exposed. “Liquidity risk” refers to the risk of a bank not paying its obligations. In the Spring 2023 banding crisis, several banks, including Silicon Valley Bank and First Republic, lacked the liquidity needed to pay depositors off when they made runs on these banks. Bank of America, with its highly liquid assets comprising about 50% of the deposit base, is fairly liquid. However, if its held to maturity securities decline in price even further, then its liquidity situation will deteriorate. The 10-year treasury yield has been rising in recent weeks, so it does look like Bank of America’s liquidity will deteriorate somewhat in the period ahead.

These risks and challenges are serious enough to bear in mind. Bank stocks can be risky, and Bank of America does face some issues pertaining to its unrealized losses on held to maturity securities. The preferreds get paid before the common shares do, though, so the former is less risky than the latter. On the whole, I’d say that Bank of America’s 6.5% yield preferreds are a solid income bet.