Trust Preferreds - An Opportunity?

In our era of pathetic yields, investors search high and low for extra yield. Most are well aware that more yield generally means more risk. The biggest challenge is to ensure that the incremental yield compensates for the risk and that overall risk is managed.

A segment of the market many are investing in to obtain incremental yield is trust preferreds.

Trust Preferreds

Trust preferreds are a hybrid between stocks and bonds. They are actually preferred stock issues. Most have a long maturity (typically 30 years and longer), are callable at par, and have the ability to suspend dividends. In fact, the bells and whistles attached to specific issues are part of the challenge in assessing trust preferreds.

The attractive feature for investors is the yield. Today that yield is on the order of 6 or 7% for most issues.

To manage the risk, DIY Investor recommends that most investors confine this sector to 5% of total investable assets. For one thing, banks are big players in the market and, thus, these issues get hit when the banking sector weakens. Other risks are mentioned below.

To start with, consider PFF, a well diversified trust preferred exchange traded fund, indexed to the S&P Trust Preferred Index. It is presently priced to yield 7.19% and pays a dividend at the beginning of each month. The dividend record is available at the iShares site:

(Source: iShares) CLICK TO ENLARGE.

It is also worth keeping an eye on individual holdings. These are available as well at the iShares site:

(Source: iShares) CLICK TO ENLARGE
The holdings list is a good place to start for those interested in investing in individual issues. To analyze specific issues, investors may want to go to QuantumOnline.com .

How Trust Preferreds Trade
First off, those that are issued by banks will trade in line with the perceived strength or weakness of the banking sector. You can see this by going back and examining their price history during the 2008 debacle. Keep in mind that issuance of trust preferreds is a low cost source of bank capital and to the extent that policy makers are interested in keeping the banking sector viable they will tend to bend over backwards to see that dividends are paid etc.

The suspension of dividends is a big issue and, although not something to obsess over, should be watched. The risk of dividend suspension is why the yield is so attractive just as the possible default of a corporate bond issuer is why corporate bond yields exceed Treasury yields (although admittedly this is getting a bit convoluted to say the least.:)

The financial improvement of the banking sector is a positive and generally has helped this sector. With a positive yield curve (1 year T-bill 0.15% and 10 year Treasury note yield 2.94%) banks have excellent opportunities to borrow at low rates and lend at considerably higher rates to earn an attractive spread.

In the event that rates fall, as they have recently, Trust Preferreds can be expected to underperform a bit because of their callability feature. For this reason DIY Investor only buys below par. For the PFF etf mentioned above, $40 is par value. Before the recent drop in rates it had been above par but now is a bit below and thus, more attractive.

At the other end of the spectrum, if rates climb sharply, trust preferreds will extend in maturity and thus likely underperform.

In this regard they are a bit like mortgages that are refinanced when rates drop but tend to last considerably longer when rates rise. For these types of securities the investor does best when yields stay within a range.

DISCLOSURE: This post is intended for educational purposes only and is not a recommendation. I hold PFF in my personal account as well as client accounts. Individuals should do their own research or consult with a professional before investing.