Thursday, January 1, 2009

Regular Preferred and Trust Preferred

I also have a Gateway Post on my discussions about Trust Preferred securities and other issues that may be of interest to readers of this post: Trust Preferred Securities: Links in One Post

I also have a post discussing the advantages and disadvantages of equity preferred or traditional preferred stocks: Advantages and Disadvantages of Equity Preferred Floating Rate Securities

As a result of the financial reform legislation passed in 2010, banks with assets greater than $15 billion as of 12/31/09 will have to phase out the use of trust preferred securities as equity capital.  Trust Preferred Securities & Financial Reform; Section 171(b)(4)(C) of Dodd-Frank law found at page 153 of docs.house.gov .pdf; page 5 www.paulhastings.com/.pdf)  This is causing a significant number of redemptions by those banks who have to phase out such use.  (e.g. KTV and Wells Fargo Notice of Redemption of Certain of its TPs

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ADDED 5/19/09/Modified with Additional Material 6/2/2010:

Junior v. Senior Bonds: The distinction between regular (also called equity) and trust preferred issues is an important distinction for U.S. taxpayers, since most equity preferred issues (other than REITS whose dividend classification has many categories) pay qualified dividends and QuantumOnline has compiled a list. Preferreds eligible for the 15% Tax Rate Table - QuantumOnline.com From an investor's viewpoint, Trust Preferred issues are, in effect, bonds, and their distributions will be taxed as interest. The TP security represents a beneficial interest in a junior bond. (if the TP meets all of the requirements of the Federal Reserve, it can be considered part of the bank's Tier 1 capital for regulatory purposes (studentorgs.law.unc.edu.pdf), and are similar to the European hybrids in this respect, see Aegon Hybrids; ING Hybrids)

The regular preferred is a form of equity and will be found listed with common stock in the firm's balance sheet. Any form of equity will be inferior to any bond in the priority chain in the event of bankruptcy, with the lowest rung occupied by common stock, then equity preferred, then junior bonds such as Trust Preferred securities, then senior and then secured debt. But, if I am holding both a bank's equity preferred stock and a Trust Preferred when the FDIC seizes it, I would expect both pieces of paper to be worthless particularly given the priority of uninsured depositors in such an event in the FDIC's scheme of priority. The priority distinction may make a difference in a bankruptcy of a non-bank firm that has both classes of securities outstanding, such as an electric utility.

For me there is another important distinction between junior and senior bonds that always needs to be emphasized other than just priority. Senior bond covenants do not allow for deferral. If the company misses a payment, it is in default and it would be helpful to just read some of those provisions to see the difference compared to the junior bond. In all of these Trust Preferred issues that I have read, the issuer has very liberal deferral rights, and that is why you have cumulative provisions. It is common for the issuer to have the right to defer payment for up to five years for any reason, as long as no payment is made to a holder of a junior security. If the firm first eliminates the common and equity preferred dividend, then it would have the right to defer the trust preferred interest payment, which will accumulate, frequently with interest, and would remain a legal obligation short of bankruptcy.

But, my point is that any institution which is so desperate to eliminate both common and preferred dividends, and to postpone junior debt payments, is already skating on very thin ice, and the market will smash the price of such junior debt issues. This will not be due just to a fear of deferral, which would be bad enough, but out of a legitimate concern that the security itself will become worthless. So, as a result, I generally prefer buying senior debt and my exposure to junior debt issues is minimal. For Trust Preferred issues, I will delve more deeply into the non-bank issues and have been a selective and opportunistic buyer of bank Trust Preferred issues, which have shown extreme levels of volatility over the past 9 months, due to the concerns expressed above. That volatility presents the investor with a profile of enhance risk and opportunity, which needs to be managed even for those willing to venture into this area.



*****************Original Post

This will be an extremely boring post. Most will not want to read it. But, when you become older and realize that a bond is not the name of some old man's disease that you do not want to hear about, and when you start to listen for the first time in your life to Frank Sinatra, wondering where Frank had been all of your life, then the following may have some interest. I wanted to draw some distinctions between what I call standard or traditional preferred stocks and Trust Preferred stocks, and highlight some of the differences and the many similarities.

An accountant would say the standard preferred stocks is part of a company's equity and has preference rights only over common stock. This is what most investors would classify as a preferred stock. The Trust Preferred (TP) security is in essence a junior debt issue, mostly issued by banks. (In a typical bank Trust Preferred issue, the TP shares are sold to the public by a Delaware Trust whose common shares are owned by the bank, and the trust buys a subordinated bond from the bank. The TP represents an undivided interest in the junior bonds owned by the trust.) 

For me as a buyer of both types of securities, I regard this to be a distinction without much of a meaningful difference except to ones who have an interest in trying to sell the distinction, although others disagree with me including many financial journalists. The features of both are more bond than equity. 

Possibly, there could be an issue of preference rights where a bank has issued common, preferred stock, Trust Preferred, senior and secured debt, where the Trust Preferred would come before the regular preferred stock (Compare BACPRE and BACPRA, cited below) This is probably not going to be relevant when a bank is in such bad shape that it has to be seized by the FDIC. If you expect anything after a FDIC seizure for either preferred stock type, then you are certainly an optimist. I would never expect much if anything to be left after a FDIC seizure for any holder of a preferred security irrespective of the identifying tag placed on them by lawyers and accountants.

I mentioned in an earlier post that I under-weighted Trust Preferred issues for a number of reasons including their very liberal deferral of interest rate provisions. Both Fannie and Freddie could defer payment on their preferred stocks for up to five years and the payments were not cumulative. This made them unattractive investments. Many other traditional preferred stocks issued by financial companies can be deferred as long as no common stock dividends are paid, and the skipped payment do not accumulate. Please examine the prospectus of both the BACPRE and METPRA, two floating rate preferred stocks as examples of this category (see,e.g, pages S-4 & S--5 of the BACPRE filing at Bank of America Corporation and page S-64 of the METPRA prospectus: METLIFE INC )

I classify this type of security as permitting a deferral PROVIDED no common stock dividend is being paid. You will see similar provisions in a Trust Preferred prospectus. If the common dividend is eliminated, there would be no meaningful restraint on the elimination of the preferred dividend in these traditional non-cumulative preferred issues, and the preferred dividends are non-cumulative for both METPRA, BACPRE and many other standard preferred stocks (other than REIT preferred stocks, which to my knowledge, always have cumulative provisions.) Others do allow for accumulation such as the REIT preferred stocks and some non-bank financial preferreds. 

Thus, for a non-cumulative preferred issue, a missed payment results in no legal obligation to pay in the future which places the preferred shareholder in exactly the same position as the common shareholder which is not good. The preferred shareholder really just has the dividend. If the business is sold at a big profit, the preferred shareholder does not receive that money. The accountants may call it equity but there is no equity interest in the business. Sometimes the preferred shareholder will not only receive nothing in the event of a buy out, but will be in a far worse position where the acquiring company loads up the acquired company with debt to finance the transaction.

Most Trust Preferred stocks issued by banks have very liberal provisions about deferral of interest payments but will often provide that skipped payments accumulate. I probably should not be making statements, as I am prone to do, that all Trust Preferred stocks are similar, since I have not examined the filings on every one of them. Some allow for suspended dividends to accumulate, which is all that I should say about it-meaning the ones that I have looked at and can now remember . Unlike the regular preferred stocks, they do have a maturity date. Frequently, the maturity date is way out into the future, say fifty years whereas others may be closer to 30 years. The maturity date always needs to be checked. I took a sample from a Citigroup prospectus for CPRS to show what to look for in a prospectus:

"Deferral of Distributions. Citigroup has the right under the indenture to
defer interest payments on the junior subordinated debt securities for an
extension period not exceeding 20 consecutive quarterly interest periods during
which no interest shall be due and payable. A deferral of interest payments
cannot extend, however, beyond the maturity of the junior subordinated debt
securities. As a consequence of Citigroup's extension of the interest payment
period, quarterly distributions on the capital securities would be deferred
during any such extended interest payment period. During an extension period,
the amount of distributions due to you would continue to accumulate and such
deferred distributions will themselves accrue interest." at page 13



I interpret this to mean a five year deferral of interest payments is expressly allowed with just one meaningful limitation. The dividends so suspended will continue to accumulate. This is Citigroup's explanation of the tax consequences to a holder of CPRS in the event of such deferral:

"If distributions on the capital securities are deferred, you will be
required to recognize interest income for United States federal income tax
purposes in respect of your ratable share of the interest on the junior
subordinated debt securities held by Citigroup Capital before you receive any
cash distributions relating to this interest."

Paying taxes on income not received, possibly never, is generally not a good thing. This same kind of provision is found in every Prospectus that I have read permitting deferral of a cumulative dividend. The debt is classified as junior subordinated, which is ranked below senior debt in priority. The coupon is 6%. The maturity date is 2/14/2033. Since this is a bank, the FDIC preference laws come into play in the event of a seizure. It is my understanding that uninsured deposits at a bank now have preference rights over this junior debt in the event of a FDIC seizure which adds another layer of concern.

I thought that I would take another example from one issued by Bank of America, BACPRA, Bank of America Capital Trust X:

"We will have the right to defer interest payments on the junior subordinated notes for up to 20 consecutive quarters, but not beyond the maturity date. After we make all interest payments that we have deferred, including any accrued interest on the deferred interest payments, we can defer interest payments again for up to another 20 consecutive quarters, provided that the deferral period does not extend beyond the maturity date.

If we defer interest payments on the junior subordinated notes, the Trust will defer distributions on the capital securities for the same period. During any deferral period, distributions on the capital securities will continue to accumulate at an annual rate of 6 1/4% of the



$25 liquidation amount per capital security. In addition, the deferred distributions will accrue additional interest, to the extent permitted by applicable law, at an annual rate of 6 1/4%, compounded quarterly.
While we defer interest payments on the junior subordinated notes, we generally will not be permitted to take certain actions. See “Description of Junior Subordinated Notes—Option to Extend Interest Payment Period” on page S-25 for a more detailed discussion.
If we defer interest payments on the junior subordinated notes, during the deferral period the capital securities will be treated for United States federal income tax purposes as having been issued with original issue discount. This means that you will be required to include accrued interest in your income for United States federal income tax purposes before you receive any cash distributions. Please see “United States Federal Income Taxation” on page 40 of the attached prospectus for a more complete discussion. "



Page 30 of the prospectus contains what I consider to be the only real limitation on the Citigroup's deferral right, the existence of a dividend on a junior security:

"If (1) we shall have exercised our right to defer payments of interest on a series of junior subordinated notes, as described above under the heading “—Option to Defer Interest Payments,” or (2) junior subordinated notes of a series are held by a Trust and remain
outstanding and either (a) there shall have occurred and be continuing an event of default under the junior subordinated indenture, or any payment failure, or (b) we shall be in default relating to our payment of any obligations under the guarantees relating to that Trust, then we will not:
declare or pay any dividend on, make any distributions with respect to, or redeem, purchase, acquire, or make a liquidation payment with respect to, any shares of our capital stock or make any guarantee payment with respect to the foregoing (other than (1) purchases or acquisitions of our shares of common stock in connection with the satisfaction of our obligations under
any employee benefit plans, (2) as a result of a reclassification of our capital stock or the exchange or conversion of one class or series of our capital stock for another class or series of our capital stock, or (3) the purchase of fractional interests in shares of our capital stock in connection with an acquisition or the conversion or exchange provisions of our capital stock or the security being converted or exchanged); or ..."



Many investors will buy one of these issues without understanding these provisions. Once you understand it and know what to look for, then the investor will be in a better position to evaluate whether or not to own one, some or none of them.

In summary, the Trust Preferred stocks have maturity dates which makes them better on that point than standard preferred stocks and many are cumulative as are the REIT preferred stocks. However, they have liberal deferral of interest provisions where the only effective limitation on a suspension of payments is the continued payment on a junior security which makes them more similar to a regular preferred. This is not much protection these days. There are also unique issues related to a FDIC seizure and preference rights. The ones that have maturity dates beyond 30 years renders the maturity date practically useless to someone my age. 

A REIT preferred may have other types of limitations on the ability to defer a dividend. For example, to maintain its tax status, common dividends have to paid on income. If a common dividend is paid, then the preferred dividend has to be paid. It would be theoretically possible for a bank to eliminate the common, defer the Trust Preferred dividend and still have some income. So, at least for me, the disadvantages of the Trust Preferred stocks make them slightly less attractive to me than a cumulative preferred stock issued by a REIT as a general rule. Some REIT preferred stocks that I own may have far worse credit profiles but much higher yields. 

With some REIT preferred stocks, I might actually receive something in a bankruptcy which I believe would be highly unlikely in the event of a FDIC seizure of a bank. I view their tax status as providing another layer of protection, as discussed above, that is not applicable to the Trust Preferred issues. I do invest in both categories. But given my view of the Trust Preferred bank securities, I pick the ones maturing in 20 years or less and then only on an opportunistic basis. An example of what I mean by opportunistic is the quick buy and sell of KEYPRA, a trust preferred issued by Key Bank (KEY)

Some examples of perpetual preferred stocks that I have discussed include INZ: www.sec.gov. That security is actually a European hybrid, part bond and part stock. It is part of equity for regulatory purposes but is a junior bond for balance sheet purposes.

Th INZ prospectus discusses required and optional deferments, at p S-25, where interest is paid on an optional deferment only at the coupon rate of 7.2%. I interpret this to mean that a dividend which is deferred on an optional basis is cumulative and interest has to be paid at the coupon rate on the deferred interest payment. Then, you would find similar prohibitions or restrictions about paying a dividend on a junior security while attempting to defer payment on a more senior security. I keep these prospectuses on file. I recently discussed some of the Aegon perpetual preferred stocks and this is a link to one, AEH, that has a 6.375% coupon:

In that one, the mandatory deferral is expressly linked to a solvency event, which is probably an order from a regulator to cease payment due to capital inadequacy problems. This one has a provision allowing for payment of a deferred dividend in shares (see p. S-20).

I WOULD ADD ONE CAVEAT. Most of my buys in preferred stocks have been REIT cumulative preferred securities, which is an outgrowth of being a real estate investor, and in floating rate perpetual preferred securities. Both of those categories are not important in my overall asset allocation and I believe that I understand them well enough to invest some money in them. I have traditionally paid little attention to regular fixed rate perpetual preferred stocks and Trust Preferred issues unless the dividend rate was abnormally high due to a precipitous fall in price, which started to happen for the first time in October 2008, when many of them reached yields well into the double digits. All of these preferred stock issues, with the possible exception of floating rate preferred stocks which fill an asset niche, are trades rather than long term investments. If I am going to make a long term investment in a bond, it needs to be a senior bond, with the only exception made by me to date is the junior Aon bond contained in Trust Certificates that I own.