Preferred securities are widely held segments of the capital securities market. At appealing yields, they catch the attention of many investors. In a well-diversified portfolio, preferred securities may provide income and attractive returns.
Today, preferred securities take many forms. In general, there are three types of preferred securities: traditional perpetual preferreds, trust preferreds and debt securities. Potential investors should examine the characteristics of each issue to determine that the investment meets their expectations and risk tolerance. They should understand the capital structure for priority of claims, study call provisions and know the circumstances under which the issuer can stop paying out income as well as what the consequences are:
Preferred securities are most suitable for investors with long-term time horizons who are interested in a fixed rate of return. As new structures continue coming to the market, not all issues may be suitable for a particular investor. The following explanations should be used in conjunction with a prospectus, as features may differ from issue to issue. The explanations below should assist investors in determining personal suitability and the risks and rewards of investing in preferreds.
Features, Considerations and Risks
As discussed above, the deferrable feature on certain trust preferred shares may have an unfavorable impact on investor’s tax liability. On trust preferreds or capital trust structures, the issuer may defer payments up to five years, ten years or longer without causing a default event. If payments are deferred, the holder is liable for tax on income accrued but not received.
|Traditional Preferred||Trust Preferred Security||Debt Security|
|Priority of claim||Junior to all debt, senior only to common equity||Junior to all debt, senior to traditional preferred and common equity||Senior to trust & traditional preferreds and common equity|
declared by the Board of Directors
|Cumulative or non-cumulative||Cumulative or non-cumulative;
some issuers may defer payments up to ten years or longer without causing a default event, but holder may continue to incur tax liability and the issue may have provisions for alternative payment mechanism
|Few permit deferral of income but at some point the event may cause default|
|Paid out of after-tax earnings||Paid out of pretax earnings||Paid out of pretax earnings|
|Term||Perpetual||Usually 30 years or longer
some issue have extendable feature
|Usually 30 years or longer|
|Usually five years non-call from issue date||Usually five years non-call from issue date||Usually five years non-call from issue date|
|Special calls may exist||Special calls may exist||Special calls may exist|
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 are usually collateralized with the assets of another issuer and do not have the underlying issuer’s guarantee. They may also be subject to call provisions at a price less than par. Some commonly used acronyms for these repackaged trust preferreds follow: CBTCS™(Corporate Backed Trust Certificates), CORTS™ (Corporate Backed Trust Security), MIPSSM (Monthly Income Preferred Shares), MIDSSM (Monthly Income Debt Securities), PCARS (Public Credit and Repackaged Securities), PPLUSSM (Preferred Plus Trust), QUICSSM (Quarterly Income Capital Securities), QUIDSSM (Quarterly Income Debt Securities), QUIPSSM (Quarterly Income Preferred Securities), TOPrS™ (Trust Originated Preferred Securities), TRUPS (Trust Preferred Securities). (SM = service mark, ™ = trademark)
On June 7, 2012 the Federal Reserve’s Board of Governors met to approve three Notices of Proposed Rulemaking (NPR) in regards to Basel III and selected features of the Dodd-Frank Act passed by Congress in July of 2010. One of the Notices addresses the “Collins Amendment” of the Dodd-Frank Act and will likely impact many Trust Preferred Securities (TruPS) and hybrid preferreds. The amendment states that financial institutions with assets over certain levels lost a portion of the Tier 1 capital treatment status on these securities beginning Jan. 1 2013. This change is being phased in over a four year period with the Tier 1 treatment being reduced by 25% each year.
This action by the Fed can be interpreted as a Capital Treatment Event (CTE) which may allow banks to redeem most of their outstanding TruPS at par plus any accrued interest within a 90-day period. The term CTE has been open to some interpretation with certain banks interpreting the initial passage of Dodd-Frank as a CTE; others could view this release of NPR as a CTE, while some may view the actual implementation beginning 2013 as a CTE. Taking this into consideration, it is difficult to determine when or why an issuer may call its securities.
Tier 1 capital is considered one of the most permanent forms of capital by bank regulators. According to both the Dodd-Frank legislation and Basel III, Tier 1 capital cannot have a stated maturity and dividend payments must be non-cumulative. The two most common forms of Tier 1 equity capital are common stock and non-cumulative perpetual preferred securities. TruPS on the other hand, generally have a maturity and the issuer can defer payments for a specified period with these deferred payments typically being cumulative. The possibility of special event calls is disclosed in the original offering documents for these preferred securities.
|Transaction # 1||Transaction # 2|
|Accrued Income||$ - 0.40||$ - 0.40|
|Adjusted Cost Basis||$25.25||$24.85|
|Security Par Value||-$25.00||-$25.00|
|Market Premium(Discount)||$ 0.25||-$ 0.15|
*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.
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 investors’ specific objectives.
To find out more about strategies employing 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.
Alternative Payment Mechanism/Mandatory Payment Provision/Payment Securities – The issuer is obligated to pay deferred payments with proceeds from the payment securities as provided in the prospectus (such as stocks and warrants).
Capital Replacement Covenant – Prior to maturity, the issuer may call capital securities with proceeds of like junior securities and as long as it does not impact senior security holders in priority of claim. In certain cases, prior regulatory approval may be required. This may occur at any time, for example, if the issue no longer qualifies for Tier 1 capital.
Dividend Stopper – Unless the issuer has paid the cumulative deferred interest, the issuer will not take action to make payments on junior securities.
Investment Company Event – Change of regulation that requires the issuer of a preferred to be considered an investment company that must be registered under the Investment Company Act of 1940.
Make Whole Call – A provision that allows the issuer to prepay the issue at the greater of par or par plus a designated spread over a Treasury.
Mandatory Deferral of Interest – Issuer is required to defer interest payments in the event of inability to pay debts to senior creditors, if liabilities exceed assets, or in case of a regulatory minimum capitalization event, supervisory event, or wind-up due to liquidation. Interest will not be cumulative in these instances, and thus will present no tax liability to the holder.
Optional Deferral of Interest – Issuer may choose to defer payments – but payments will be cumulative. Holders will be liable for tax on income accrued but not received (phantom income). Under these circumstances, the issuer will not make payments on junior securities. After a given period, typically five years or longer, the issuer may be required to sell designated assets such as common stock or warrants to make deferred payments. Any deferral of payments may cause the shares to trade at a significantly lower price. In most instances, the issuer has the right to defer payments for 10 years without causing an event of default.
Rating Agency Event – A change in the rating agency treatment of capital securities may trigger a call.
Tax Event Call – Upon occurrence of certain tax events, such as a change that would impose tax on the issuer, the issuer may be able to convert or exchange for a like security or call the entire issue. Usually the entire issue would be called and it can be done prior to the traditional five-year non-call period.
Voting Rights – Preferred securities do not generally have voting rights except in special circumstances.
A credit rating of a security is not a recommendation to buy, sell or hold securities and may be subject to review, revisions, suspension, reduction or withdrawal at any time by the assigning rating agency.