Preferred Securities

Today, preferred securities take many forms. In general, there are four types of preferred securities: traditional perpetual preferreds, trust preferred securities, restructured preferreds, and junior subordinated debt securities. The market for these securities has become the fastest growing segment of the market for capital securities.

Investment Highlights

• Steady Income – Preferred securities offer predictable and fixed periodic payments.
• Competitive Returns – Preferred securities may offer attractive yields compared to other fixed income investments.
• Liquidity – Most issues are traded on the major exchanges.
• Term – Most preferred securities carry a predictable investment time frame; however, some issues are perpetual. Usually, the investor has call protection for 5 years from the issue date although extraordinary calls may exist.
• Diversification – A diversified portfolio including preferred securities may help to reduce risk and mitigate the effects of market volatility.
• Quality – Preferred issues are generally rated by the rating agencies depending on the credit quality of the issuer. As a general rule, higher yields are associated with lower quality issuers.
• Denomination – Most issues are offered in $25 par value denominations.

Suitability

Preferred securities are most suitable for investors with a long-term time horizon who are interested in a fixed rate of return. Income is taxable in the year it is received. Certain issues allow the issuer to defer income payments and may pose additional taxation issues.

Features and Considerations

• Income – All preferred securities have an income feature based upon par value that is paid monthly, quarterly, or semi-annually. Traditional preferred stock pays dividends. Today, a more commonly available structure is the ‘trust preferred’. Some ‘trust preferred’ securities carry a deferrable interest feature, which allows the issuer to defer income payments for a period up to 10 years or longer. In this case, security holders may have a tax liability (a.k.a. phantom income) for the amount of deferred income. In most cases with trust preferreds, any income payments not made by the issuer become cumulative.
• Term of Investment – Most preferred securities carry maturities of 20 - 49 years from the original issue date, but some are perpetual. While most preferred securities are callable after a period of call protection, certain extraordinary events may further alter the term of investment. Special event calls may be in place to allow the issuer to call the securities early. These events may include a tax law change, a change in the defined status of the issuer to that of Investment Company or a call on the underlying collateral. Further, a few issues with a defined maturity date may have provisions for maturity extension. These features are discussed in the prospectus.
• Quality – Income oriented investors should consider preferreds that carry investment grade ratings. Preferred securities provide the investor with a higher priority of claim on the assets than common stock holders should the issuer be liquidated. The priority is as follows: (1) secured debt holders (2) unsecured debt holders (3) unsecured subordinated debt (4) trust preferred securities (5) traditional preferred stock (6) common stock.
• Credit Risk – The yields offered will depend upon the credit quality of the issuer. In general, lower quality issuers will require higher yields to compensate the investor for credit risk. If the credit quality of the issuer changes, the value of the security could be affected as well.
• Liquidity – Most preferred issues are traded on a major national exchange, which allows more flexibility in managing a portfolio, and quoted in most major newspapers with a “pf” following the underlying stock symbol. With all other variables being equal, prices will fluctuate based on the prevailing interest rates.
• Interest Rate Risk – Preferred shares are fixed income securities which, like bonds, have values that will rise and fall in response to interest rate changes. Principal is subject to market fluctuations and sale proceeds may be more or less than the original purchase price. As preferred securities have long term maturities, an increase in interest rates will have a considerable impact on the principal value. If rates rise, preferred prices decline because the income rate is less attractive relative to new issues of similar preferred securities. However, when interest rates decline, the income rate available on a previously issued preferred becomes more attractive and demand drives the price up. However, because the securities are callable, a decrease in interest rates will not have as much impact. This is due to the fact that issuers are more likely to call securities in a decreasing interest rate environment. In addition, preferred securities trade at a price that includes income accruals. All other variables being equal, the preferred price should increase accordingly to reflect the accrued income. Other factors affecting the price include supply, demand, and perceived credit risk.
• Dividend Received Deduction – Only traditional preferred stocks carry this provision, under which ‘qualified’ domestic corporations receive a tax advantage. In the market place today, there are very few traditional preferred stocks. For other preferred securities, there is no tax-advantage for ‘qualified’ domestic corporations.

Structure of Trust Preferred Securities

To those familiar with fixed income markets, trust preferred securities are a hybrid of a corporate bond, which carries a stated maturity, gives the holder a claim on issuer assets that is above both common and traditional preferred shareholders, and trades with accrued income; and a preferred stock, which is issued with a $25 par value, provides the investor with the liquidity associated with an exchange listing, and trades at a flat but aggregate price that includes market or par value and accrued income.

The issuers of trust preferred securities are often the same companies that issue other traditional debt instruments such as bonds. Trust preferred securities may be issued by the same company that is obligated on the underlying security or by a third party. Third party trust preferred issues do not have the underlying issuer’s guarantee, and may also be subject to call provisions at a price less than par.

Some commonly used acronyms for trust preferreds: CBTCS™(Corporate Backed Trust Certificates), CORTS™ (Corporate Backed Trust Security), MIPS ^SM (Monthly Income Preferred Shares) MIDS ^SM (Monthly Income Debt Securities), PCARS (Public Credit and Repackaged Securities) QUICS ^SM (Quarterly Income Capital Securities) QUIDS ^SM (Quarterly Income Debt Securities) QUIPS ^SM (Quarterly Income Preferred Securities) TOPrS™ (Trust Originated Preferred Securities) TRUPS (Trust Preferred Securities). (^SM = service mark, ™ = trade mark)

Structure of Traditional Preferreds

Traditional preferred stocks are stock shares that represent a portion of ownership in a company, with the shares normally carrying fixed dividends. Sometimes the shares have voting rights, but not generally. Typically issued with a $25 par value, they provide the investor with the liquidity associated with an exchange listing, and trade flat but at an aggregate price that includes market value and accrued income.

Evaluation of Preferred Securities & Traditional Preferreds

• To evaluate the attributes of preferred securities, an investor must be able to understand the pricing mechanism. These securities trade at a price that can include up to three components: par value, accrued dividend or income from the last payment date and market premium or discount.
• These securities have a number of different features that may alter the term of the investment. Consequently, a number of different yields may be quoted and used in determining the relative value of the particular security. In any case, the yield to the worst case scenario should be the primary means of evaluation.
1. Callable Securities – The yield to the first call date should be a consideration when callable securities trade at a premium. When these securities trade at a discount, yield to the stated maturity and/or current yield should be considered.
2. Securities with an Indeterminate Maturity – In the event that the final maturity is indeterminate, as would be the case with perpetual or with extendable securities, then the current yield or the yield to call, if the security is trading at a premium, could provide the basis for evaluation.
3. Currently Callable Securities – The current yield and the yield to call may be used when evaluating securities trading at a premium while being currently callable at $25 par value.
• In the case of deferrable preferred securities, if the issuer chooses to stop or defer interest, it is expected that the securities will trade at a discount and the price might be the only means of evaluation.

Possibility of capital gains/losses

A holder of preferred securities will generally recognize a gain or loss on the sale or other disposition of the securities. The resulting capital gain or loss will depend on the difference between the cost basis and net sale proceeds. In the case of trust and debt preferred securities, purchase and sale prices may have to be adjusted to account for accrued income that may have been included. Please consult your tax advisor for details.

Calculation of Adjusted Cost Basis for Trust or Debt Structure Preferred Securities*

*This is a hypothetical example presented for illustrative purposes only. It does not relate to any specific security.

Although both transactions occurred above the stated par value of $25, one reflects a possible market premium and the other reflects a market discount.

The Raymond James Advantage

Professional advice and, in many cases, professional management, are key elements of successful financial planning. Our Financial Advisors assist investors in creating diversified fixed income portfolios designed to perform well in unpredictable market environments while addressing the specific objectives of the investor.

To find out more about strategies utilizing preferred securities and other fixed income services offered by Raymond James, please contact your Raymond James financial advisor or use the office locator to find an advisor near you. Additional information is available by requesting Securities Industry and Financial Markets Association brochure, “Fixed-Rate Capital Securities.”