Financial reform bodes well for TruPS

One likely outcome of the Dodd-Frank financial-reform legislation is that it will rally the TruPS. Trust-issued preferred securities, or TruPS, are among a broad range of preferred-stock hybrids issued by companies to raise capital. For years, banks have relied heavily on TruPS to boost capital reserves — thereby increasing their ability to lend.

Typically, a bank creates an off-balance-sheet trust, which then issues preferred stock. The trust then uses the proceeds from the sale of the preferred shares to purchase subordinated debt from the bank, a strategy that essentially turns preferred stock into debt.

That’s advantageous to a bank from a tax standpoint because unlike the dividends paid on preferred stock, the interest paid on bonds sold to the trust is tax-deductible.

Today, the average trust-issued preferred security is trading at 18% below its issuing price and is paying annual dividends of between 8% and 10%. The entire TruPS market is estimated to be valued at about $50 billion.

A rule change in the reform package aimed at forcing banks to strengthen their capital requirements will likely trigger billions of dollars in calls on TruPS over the next five years. Specifically, banks with more than $15 billion in assets will no longer be allowed to use TruPS in their capital calculations.

The banks have five years to replace TruPS with common stock or other securities that count as capital.

As a result, many holders of the securities will receive full, or par, value, in addition to the dividend income.

Small banks will be grandfathered, meaning that they are allowed to hold on to existing TruPS, but prohibited from issuing new ones.

At this point, it’s unclear how much of the TruPS market will be in play over the next five years. But some financial advisers are already homing in on what they view as a rare opportunity to harvest income and capital gains through a relatively secure investment vehicle.

“It’s a true opportunity because by 2016, all TruPS will be diverted out of the capital reserve,” said Mark Lookabill, an adviser with Carson Wealth Management Group, a $2.2 billion investment advisory firm. “We view it as a buying opportunity and an attractive investment option.”

A couple of recent examples of TruPS trading below their issuing price are Citigroup Inc.’s Citigroup Capital VI 6 7/8% Capital Securities (TruPS) Preferred Stock, which pays a 6% dividend and is trading at a 12% discount to par, and Bank of America Corp.’s Fleet Capital Trust IX, which pays a 6% dividend and is also trading at a 12% discount.

Of course, there is always the risk that banks will find other strategies to meet their reserve requirements that could reduce the chances of the securities’ being called at par on schedule.

But considering banks’ financial state these days, it seems unlikely they will be come up with a long list of capital-raising alternatives.

Then there’s also the matter of why many TruPS are trading at steep discounts.

“The initial risk is whether the TruPS are any good to begin with, because if this is a preferred stock issued by a top-tier bank that is trading below par, you need to ask why it is trading below par,” said Mark Bowman, an adviser with Archer Private Financial Group LLC, an accounting and advisory firm.

Mr. Lookabill acknowledges that the market is discounting the securities, but he still likes the degree of risk relative to the yield and capital gains potential.

No matter what, money managers have long used preferred stock in both growth and income portfolios for the attractive and dependable dividend yields, plus the relative security of being just behind bonds on a company’s capital structure.

“In some cases, preferreds will pay better yields than bonds issued by the same company, and they give us added flexibility in building out a fixed-income portfolio,” said Kenneth Winans, president of Winans International Investment Management & Research, which manages $138 million.

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].