Trust Preferred Securities: A Core Holding for Defensive Growth Portfolios

Investors have been faced with a unique dilemma over the last few years. Volatility in stocks pushed many people out of the market. At the same time, with interest rates near zero, traditional cash and fixed income havens did not (and still do not) provide meaningful returns, in most cases. Because of this plight, we have focused on the surprisingly attractive and predictable returns of trust preferred securities.

Many investors still linger in cash, CDs, or other fixed income securities which pay little or no return. Today, our Trust Preferred portfolios currently yield over 7 percent. Trust preferred securities were created by banks as a way to achieve favorable tax treatment on preferred dividends, while increasing the capital structure of the banks. These publicly-traded securities are issued at a par value of $25 and have a very long term, 30 or more years, before maturing at par.

To issue the security, a bank creates a wholly-owned trust company. The trust company issues the preferred shares to investors, thus the name trust preferred. The bank borrows the amount of money raised by its trust company. The bank, then, makes interest payments to the trust company, which passes the payment along to the trust preferred shareholders as a dividend. As a result, the bank can treat the preferred “dividend” as an interest expense, whereas a normal preferred dividend is not treated as an expense for tax purposes. Thus, the bank has less income subject to taxation and can raise regulatory capital more cheaply.

The Dodd-Frank Wall Street Reform Act provides an interesting twist for trust preferred securities. The Act stipulates that large banks (over $15 billion in assets) phase out the use of trust preferreds as regulatory capital, over three years, beginning in 2013. Because the banks will not want to pay such a high dividend rate on securities that will not count as capital, we expect banks will redeem the securities during the three-year period.

Trust preferreds can only be called, or redeemed, by the banks at the par value of $25 per share. Most of the trust preferreds we buy are trading at or below par and pay an annual dividend of over 7 percent. Therefore, in this strategy, we are able to lock-in a compelling annual dividend plus moderate appreciation over the next five years. Our search for yield has uncovered no investment that has anything near this total return for a relatively low level of risk

*The information contained in this commentary is not investment advice for any person. It is presented only for informational purposes to assist in explaining factors that may have had an impact in the past or may have an impact in the future on client portfolios or composites. All expressions of opinion reflect the judgment of the firm on this date and are subject to change. Included information has been obtained from sources considered reliable, but we do not guarantee that the foregoing materials are accurate or complete. Clients or prospective clients should contact Ulland Investment Advisors for individualized information prior to deciding to participate in any portfolio or making any investment decision. Ulland Investment Advisors does not provide tax advice. All clients are strongly urged to consult with their tax advisors regarding any potential investment. Past performance does not guarantee future results; there is always a possibility of loss.