Potential Double Digit Returns With First Horizon Preferred Stock

Introduction

First Horizon Corporation (NYSE:FHN) is a bank holding company for First Horizon Bank providing general banking services to retail, commercial, and government clients in the US. First Horizon also provides underwriting for bank eligible securities and other fixed income securities from financial firms, sells loans and their derivatives, and offers advisory services. FHN is based in Memphis, TN and First Horizon Bank has over 400 locations in the southeast through Texas with one location in New York State. FHN carries an investment grade credit rating from Fitch of BBB. While some investors may focus on the common shares currently offering a 4.9% forward yield, I’m more interested in the three preferred series.

FHN Preferred Stock

First Horizon has three fixed to floating preferred stock series, Series B, C, and D. A summary of the current pricing, yield, and terms is provided in the chart below.

All three series are non-cumulative, which is typical for banks, pay preferentially taxed qualified dividends, and FHN announced all three will transition from 3 mo LIBOR to CME 3 mo SOFR base rates. To ensure everyone is on the same footing, the less than obvious terms in the top row of the chart are defined below.

Fixed Payment – The original and current annual dividend.

Yield – The original par value yield calculated as (Fixed Payment/$25) x 100

First Call Date – The date FHN can call the series which is also the date for transition to a floating rate.

Price – Market price as of Friday, August 25, 2023.

Yield to Call – Annual effective yield including capital appreciation to par value plus dividends paid.

Reset Rate – The coupon rate at transition to floating on the First Call Date.

Yield On Cost – The investor’s yield assuming a cost basis equal to the Price (close on 8/25/23).

3 mo LIBOR – Current synthetic 3 mo LIBOR based on CME 3 mo SOFR + 26.16 pbs.

Investors have choices to make with the three FHN preferred stock series. NYSE:FHN.PR.D clearly provides the highest potential near term return with an annual YTC of nearly 25.6% over 8 months. Total return over those 8 months consists of 3 dividend payments (3 x $0.38125) plus the price difference to par ($25 – $22.28) for a total of $3.864 giving a total return of 17.3%.

FHN.PR.B provides a lower YTC because the return is over approximately 23 months of almost 15%. The total return over those 23 months is significantly higher because the investor, assuming they hold for the entire period, will receive 8 dividend payments (2 x $1.656) plus the price difference to par ($3.29) for a total of $6.602 giving a total return of 30.4% over 23 months.

FHN.PR.C provides the lowest YTC of 13.4% but the highest total return of 38.0% over the approximately 32 months between now and the first call date. The math for the series C is left up to the reader.

Readers should note that there is an inherent assumption in the above calculations of YTC and the total returns of all three series. That is, each of the three series (B, C, D) will “tether” to their $25 par value as each approaches its first call date. I started accumulating exchange traded debt (Baby Bonds) and FtF rate preferred shares almost exactly one year ago. I accumulated 25 different securities with four of those having passed their first call date and converted to floating rates. All four issues are currently priced above their $25 par value by up to 1.2%. So, unless the Federal Reserve gets a little nuts and gets aggressive again with raising interest rates, I fully expect the FfF securities I hold will approach their $25 par value as they get close to their respective first call date.

The choice of whether to focus on near term high YTC or longer term total return depends on an investor’s goals and where you think the interest rates will be in 2025 and 2026. My particular choice is to focus on FHN.PR.D and I started accumulating shares slowly last week. My rationale for focusing on the series D is that my interest rate crystal ball gets more cloudy as I go out in time. I’m pretty certain interest rates will remain elevated through early 2024 but less certain for 2025. My view on rates in 2026 is that it is a coin toss. I plan to retain the series B and C on my preferred share watch list and if/when my series D holdings get called, I’ll consider deploying that money in the series B or C securities. That decision will depend on the trajectory of interest rates at that time.

If FHN Calls The Series D Preferred

Because May 1, 2024 is also the first call date and the 9.50% coupon rate is a much higher rate than the current 6.85%, I fully expect FHN.PR.D will be trading around its $25 par value at that time. So, investors who initiate a position before the next ex-dividend date, October 16, 2023, will receive three quarterly dividends plus the difference between the investor’s cost basis and FHN.PR.D’s $25 par value. As noted above, that works out to a YTC of 25.6%.

If FHN Does Not Call The Series D Preferred

I believe the FHN.PR.D preferred shares will be called on or shortly after May 1, 2024. However, we should look at all credible potential outcomes before investing. As noted above, the series D shares will very likely be trading near their $25 par value as we approach the May 1, 2024 call date. If FHN does not call the preferred, investors have two options. The first option is that investors can sell their shares to realize the capital gain between their cost basis and FHN.PR.D’s $25 par value. In this case, total returns will be similar to those estimated above.

The second option available to investors is to hold their shares of FHN.PR.D and collect the increased dividend payout after the security converts to a floating rate. The decision to continue to hold the preferred shares will depend on the current interest rate policy of the Federal Reserve. I’ve lost count of the times I’ve heard the Federal Reserve chair or bank presidents state we expect to have interest rates higher for longer. If the Federal Reserve is in the mood to hold rates steady beyond May 1, 2024, holding the series D preferred shares and collecting a roughly 9.5% dividend is a very viable option. Those investors that pay attention to Yield on Cost (YOC) should note that, at an entry cost of $22.28, that 9.5% coupon rate provides a YOC of 10.7%. Investors always have the option of cashing out if the Federal Reserve decides it is time to loosen up on monetary policy.

What Are The Risks

The credible potential risks I come up with are few and unlikely. There are a few folks in the business and members of Seeking Alpha that believe we could have another banking crisis similar to what we saw in 2008/9. I don’t believe we have today nor are we likely to have in the near future, conditions similar to those that resulted in the 2008 banking crisis. Bank minimum capital requirements are higher today than in 2008. Home prices have been much more “sticky” in today’s environment; we don’t have large numbers of residential mortgages significantly underwater. While commercial real estate (CRE) loans are under some pressure due to falling valuations of some office properties, this is also not a wide spread problem. In particular, FHN’s CRE loans are well diversified geographically as well as by type. Keep in mind that not all CRE loans are created equal. The charts below from the FHN second quarter 2023 earnings presentation show the level of diversification.

Only 3% of FHN’s CRE loans are in non-medical office properties. It should also be noted that 89% of FHN’s CRE loans are in the south so there is little exposure to office vacancies NYC and other large cities along the east coast and California. Bottom line, I’m not worried about a general banking crisis nor specific impacts to FHN’s CRE exposure.

The only other potential risk I can envision is a 180 shift in the Federal Reserve monetary policy. Rapidly lowering interest rates would material change the calculus for investment in any FtF security. As noted earlier, the Federal Reserve has been beating the “higher for longer” drum at every opportunity. May 1, 2024 is only 8 months away. I’m doubtful that the Federal Reserve is going to do a 180 on monetary policy and drive interest rates rapidly downward between now and May 1.

In Summary

First Horizon is a traditional, midsized regional bank with a solid retail deposit base and low exposure to office type CRE loans and an investment grade credit rating. The FHN preferred shares offer investors the opportunity to collect a large total returns between now and May, 1, 2026 with very low risk and a high degree of certainty. While there are other investments that may provide higher returns, those higher returns typically come with higher risk and less certainty. The FHN preferred series B, C, and D preferred shares offer double digit returns with less risk and a high degree of certainty.