Bank Of America: I Chose A 6% Yielding Preferred Share Over A 5.4% Yield (NYSE:BAC)

Introduction

Bank of America (NYSE:BAC) is one of the largest financial institutions in the United States, and this banking giant with worldwide presence likely doesn’t need a lengthy introduction. While the common shares are well covered here on Seeking Alpha by a myriad of authors, I have been keeping an eye on the preferred equity issued by Bank of America to improve the yield in my portfolio. In this article, I will explain that although the preferred dividends are very well covered, it doesn’t mean you should buy just any preferred share issue.

Despite the turmoil in 2023, the preferred dividends are still well covered

My main concern is obviously to be absolutely certain the bank can meet all of its commitments related to the preferred shares. The dividend coverage ratio is an important metric, as it shows what percentage of its net income the bank has to spend on the preferred dividends (which are paid out before any compensation to the common shareholders is issued).

As you can see below, the bank reported a substantially lower net profit in the fourth quarter of 2023 due to some exceptional items. The income statement shows the bank has been able to keep the impact of the volatile interest rates relatively minimal and although the net interest income decreased by approximately 3% (or just over $400M), the reported net interest income was still very reasonable.

The main reason for the disappointing bottom line result can be found in the net non-interest expense category. We see much lower market making income ($998M compared to a result that’s consistently above $3B in the previous few quarters, the lower result is caused by a new accounting interpretation) while the “other general operating costs” roughly tripled compared to the previous quarters.

The “other general operating” costs are related to the FDIC special assessment rule for the uninsured deposits of failed banks. This had a profound negative impact of $2.1B on BAC’s Q4 results. On an adjusted basis, Bank of America’s Q4 net income would have been $5.9B, which is approximately 90% higher than the reported net income.

We also know the bank had to pay $306M in preferred dividends during the quarter, while the average quarterly preferred dividend payments are just over $400M. Based on the adjusted net profit of $5.9B, Bank of America needed less than 7% to cover its preferred dividend payments.

A closer look at one of the preferred share issues

I’m mainly interested in preferred shares with a fixed preferred dividend, and as I currently have a long position in the Series L preferred shares (BAC.PR.L), I wanted to have a look at other potential investment possibilities. The Series QQ trades with (BAC.PR.Q) as its ticker symbol and offers a preferred dividend of 4.25% based on the principal value of $25 per preferred share.

As the interest rates on the financial markets have increased in the past few years, these preferred shares are currently trading at a discount and at the current share price of $19.69 per share, the $1.0625 annual dividend (payable in four equal quarterly tranches) represents a preferred dividend yield of approximately 5.4%.

As the share price chart above shows, the preferred share price has recovered well since October, when worries about interest rates peaked on the financial markets. Back in October, these preferred shares were yielding approximately 6.6% due to the 36% discount vs. the $25 principal share price.

Investment thesis

As the preferred dividends are very well covered by the bank’s earnings, the main question now is “are they still sufficiently attractive to add to a portfolio.” And there are two schools of thought here.

Looking at an absolute return, you could argue that for the Series Q the current yield of 5.40% is a little bit on the lower end of the spectrum. While it still provides a mark-up of 122 bp and 120 bp on the five-year and 10-year US Treasuries, and that’s not particularly high. On the other hand, the fixed rate preferred securities could be a good instrument to speculate on lower interest rates on the financial markets, but then you also need to be pretty certain the mark-up won’t increase. After all, a 50 bp decrease in Treasuries does not necessarily mean the market’s required yield for Bank of America will decrease on a 1:1 basis.

And that’s why I think a “sell” is a fair assessment for the aforementioned series of preferred shares. This doesn’t mean the prefs are a “must buy now” type of investment, but it could definitely be interesting to keep an eye on some of Bank of America’s preferred issues. I currently have no position in the Series Q, but I have a long position in the Series L preferred shares (BAC.PR.L). The yield on the latter is still in excess of 6% and the $72.5 annual coupon is fixed as well, so I wouldn’t know why I would accept a 5.4% yield over a 6% yield. Investors should carefully select which fixed rate preferred share they’d like to invest in, as not all returns are equal.

That being said, I’m bullish on the common shares, but I have no position in Bank of America’s common stock. I have been writing put options on Bank of America’s common shares, but none of the options have ended up in the money so far.