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.

Searching For Mr. Yield

Are you a do-it-yourself investor searching for yield? Jump in the boat with everybody else. Let's take a look at trust preferreds. Trust preferred yields today exceed 6.5%.

Trust preferreds are equities with fixed income characteristics. They pay dividends quarterly, have a par value, typically are callable, and are rated by the major rating agencies. Their dividends can be cumulative or non-cumulative. The best resource for getting information on trust preferreds is at Quantum Online. CLICK TO ENLARGE THE GRAPHIC and you'll see information on a trust preferred issue for Ford. This page was brought up by typing F-S (a small irritant is that different financial sites have different ticker symbols for trust preferred issues) into the ticker symbol box. If you scroll down the page at the site, you'll see the ratings and other information. As you can see, there is a lot of information. You'll want to note when the issue is callable and at what price. Whether or not the dividend is qualified may be important to you. Do your homework!

If you scroll down, you'll see a link that will take you to a price graph where you can view the 12-month price chart. Today the shares are trading around $47/share, and last year this time they were bouncing along around $30/share - there is some volatility.

Worth Considering
You may be asking yourself whether it is worthwhile taking on such a risky position for more yield. First off, we know the continuing back story on Ford and GM. If you believe a double dip is imminent, you may want to hold off a bit until the haze clears. If you subscribe to the slow recovery view, some exposure may be worthwhile. No matter what- putting more than 5% in an issue like this is asking for trouble. Furthermore, for Ford and other widely held issues, you would want to make sure it is not held in other places in your portfolio. Always keep diversification in mind.

A way to get around the individual issue constraint is to buy an exchange traded fund that is indexed to this market. A candidate is PFF. If you go to Yahoo Finance, put in its ticker symbol and click "holdings" on the left. You'll see:


Note that Ford is the second largest holding. Again, do some research. Check out the price action. This ETF has been highly volatile. On 3/9/09 it traded at $15/share. Today it is around $40. You'll recall that 3/9/09 was the time of maximum pessimism in the market. Fears of dividend cuts and suspensions were widespread. It is not surprising that trust preferreds were hit especially hard.

I believe that those who have a decent risk tolerance might consider up to 5% of total assets in a fund of this type. Combined with a short-term corporate fund (example: CSJ), it can contribute meaningfully to overall portfolio yield. Understand that risk with any type of higher yielding issues needs to be carefully managed.

As always, investors should do their own homework or consult a professional to ascertain the appropriateness of investments for their specific situation.