My guess is you haven't brought the Restoring American Financial Stability Act (the official name of the just-passed financial reform act) to the lake with you this summer.
At 2,300 pages and filled with 100-word sentences written in complex legalese, the bill — signed into law with much fanfare by President Obama on July 21st — is not exactly light reading.
However, buried in this legislation is Section 171, the Collins Amendment. And this single amendment dramatically impacts income investors. It completely alters the status of one of the more popular high-yield investments.
The good news is that this change will give savvy investors who know where to look the ability to lock in attractive 6-7% yields, investment-grade safety and the potential for capital gains within three to five years.
But this opportunity will not be around for long. The rule changes are already in place. The window is open now, but begins to close in 2013 and shuts completely at the end of 2015.
The high-yield opportunity I'm talking about lies with trust preferred stock, also called trust unit preferred shares or “TruPS.” Banks are usually associated with these shares… but that may be changing. (If you own the preferreds of a bank, they stand a good chance of being trust preferreds.)
You see, TruPS aren't issued directly by the bank. Instead, the bank sets up a new company or off-balance sheet trust. When TruPS are issued, the trust receives the offering proceeds, not the bank. However, the trust then turns around and loans the proceeds to the bank. This convoluted financing was worth it because banks were allowed to count TruPS toward Tier 1 capital — a basic measure of a bank's financial strength. During the height of the financial crisis, banks issued $149 billion of trust preferred stock, according to the Federal Reserve Bank of Philadelphia.
But the financial reform act changes all that. In the future, banks won't be able to include TruPS in Tier 1 capital. The phase out period begins January 1, 2013 and will be complete by December 31, 2015.
This change has major implications for income investors. The biggest is that some banks may choose to redeem their TruPS during the next three to five years. Today, however, these TruPS carry high coupons associated with 30-year investments.
Since TruPS will no longer serve their original purpose of counting as Tier 1 capital, banks will have no reason to hold them. The additional costs of setting up and maintaining the issuing TruPS are unattractive, as well.
That leaves three possible outcomes. First, some banks will choose to do nothing and simply allow their TruPS to mature and not issue any more. Most mature by 2030. Other banks may choose to issue traditional preferred or common stock to shore up Tier 1 capital and then offer TruPS holders the option of converting to these issues.
A third outcome is redemption… and that's where the opportunity lies.
Banks could begin calling TruPS as early as October of this year. If you buy TruPS below their par value (typically $25), this will lead to potential capital gains if the security is called. Of course, that is in addition to the high yields they pay while you wait. Remember that these securities were issued with a long-term outlook, so the yields they pay are associated with 30-50 year bonds instead of the 3-5 year outlook before the law changes.
Action to Take –> If you want to do some hunting for trust preferred securities on your own, I'd recommend QuantumOnline.com. The website has a list of current TruPS on the market that you may want to investigate. (It's free, with registration. Look under than “Income Tables” tab.) Remember, not all TruPS will be called, so you have to be selective. Be on the lookout for those trading below par value and backed by investment-grade credit ratings.
– Carla Pasternak