Trust Ford's Trust Preferred Shares

In the last week, Ford Motor Company (F) took significant steps to shore up its capital position. Ford:

• Reached agreement with the United Auto Workers that allows Ford to lower its hourly labor costs and use common stock to pay up as much as $6.6 billion of its future payments to the Voluntary Employee Beneficiary Association health care trust;
• Offered to convert its 4.25% Senior Convertible Notes due in 2036 into common stock for a cash premium;
• Launched a $1.3 billion cash tender offer for unsecured debt, and a separate $500 million cash tender offer for Ford's senior secured term loan debt; and
• Indefinitely Deferred dividend payments on the Capital Trust II 6.50% Cumulative Trust Preferred (F-PS).

Taken together, the company has taken meaningful steps towards survival. In addition to the $6.6 billion the company owes for retiree health care, if the company’s debt conversion offers are maximized (which is questionable), the company will shed about 40% of its debt and save at least $600 million in interest payments annually, according to news stories. In addition, the deferral of the trust preferred payments will allow the company to conserve an additional $190 million per year.

The trust preferred is now quite interesting. Lee Eugene Munson and Patrick Kirts wrote that “there is certainly no reason to buy” this issue, but I disagree. The attributes of this security, namely that it’s cumulative and convertible, have very specific impacts on its current and potential value, making it a legitimate investment option in certain circumstances.

First, some details. Following the announcement of the dividend deferment, F-S dropped 25%, following a 20% downward move already this year. The nominal yield at Monday’s close of $5.22 is 41.3%. The company may defer payments to this trust for up to 5 years, at which point all deferred payments and interest (which continues to accrue) are due. So, if the company survives, the dividends will be paid – though it may take five years. In the meantime, holders must pay tax on the accrued dividends as if they had been paid.

Monday, the common closed at $1.85, and F-PS closed at $5.22, or 2.822 times the common share price. This means that buying the preferred is exactly like buying the common, with the potential dividend benefits thrown in for free. Well, not for free – taxes are due as dividends accrue.

This leads to the first circumstance where buying this stock is logical. Committed holders of Ford’s common probably should swap into this preferred, with the conversion rate virtually identical to the current price differential. It’s like getting the potential dividend payment - which you have to believe will be paid if you’re a committed common holder - for free. The cost of this swap is the cost of money related to paying accrued (but unpaid) dividends; however, if you’re selling the common you’re likely taking a capital loss that probably would more than offset the dividend taxes.

Note that the preferred is unlikely to fall faster than the common at this point, because if it did arbitragers could buy the preferred, convert it into common, and sell for a profit.

This fact brings the second logical buying rationale: arbitrage. Selling 2.825 common shares for each preferred share purchased eliminates downside price risk. Remaining are three elements:

1. The cost of money associated with paying taxes on accrued unpaid dividends, and the carrying cost of the position.
2. Potential dividends of 41%.
3. Potential appreciation of the preferred relative to the common. If the company survives and begins paying the dividend again, the preferred will appreciate, driving the yield down.

The cost of the position is the opportunity cost of committing capital and the that of paying taxes on accrued but unpaid dividends. The potential gain occurs (a) if the company survives intact, (b) in no more than five years, and (c) is the amount of the dividend payment plus the appreciation of the preferred in excess of the common due to the dividend resumption. This kind of opportunity also exists in many of the financial preferreds.

It's worth noting that the differential between F and F-PS was this narrow once before, on December 8. By January 8 the preferred had gained 27% compared to the common, and on February 10 its gain peaked at 46% before narrowing as F-PS lost 45% in the last weeks up to Monday.

The first logical buying circumstance is basically the same as the third: if the holder simply believes the company will survive to pay the dividend. Though I’m in this camp, it’s a small position and risk is high, and as a result of this quick analysis I may expand and hedge it.

Incidentally, because of the debt-to-common conversion, the position of the Trust Preferred in the capital structure is improved markedly, with as much as $10B of capital moving from above to below. I don’t think this significantly increases the likelihood of the trust preferred getting anything from a bankruptcy, but it does improve the chances of avoiding bankruptcy.

Disclosure: Long F-PS.

Comments

[epeon:]

If it has the union label, don't buy it.

Mar 11 07:22 PM

[jdmballm:]

Could you explain why a preferred holder would have to pay tax on the dividend if it wasn't paid?? I would think that as a cash basis taxpayer, you wouldn't recognize income until it is actually paid. What would change a individual from a cash basis taxpayer to (apparently) an accrual basis taxpayer for this purpose?? Thanks.

Mar 11 07:37 PM

[richandmer:]

Ford also has several Exchange Traded Debt Securities, including F-A, FCZ and FCJ. All are trading at huge discounts with yields of approx 25 to 30%. I would think that Ford will only stop payments on their debts if and when they go bankrupt.

So if the preferreds are considered a good investment, then how about these 3 securities?

Mar 11 09:30 PM

[Brian Grad:]

You are right on with this idea although I am not sure that the taxes are due on phantom income. Right now, there is no borrow on Ford as the exchange offer for the convertible bonds is soaking up the borrow. If you can find some, it is costing over 20% per year to hold the short. I expect that if the majority of the 4.25%'s get exchanged, the borrow will free up massively and this will be a very good trade anywhere near parity. Put it on 100% and forget about it.

Ford may also opt to offer a premium exchange for this security down the road as well. They retired 1/2 the issue in just such a deal about two years ago.

Two ways to win.

Mar 11 09:39 PM

[David Clayton:]

My submitted title was "Trust Ford's Less Preferred Trust Preferreds?" Too cute, I guess.

epeon - today's news about the union accepting reduced compensation is really a great indicator that the union recognizes the seriousness of the problems, and is truly taking steps to help keep Ford out of bankruptcy.

jdmballm - I'm not an accountant, and I haven't looked into the "why," but it is certainly the case that tax is due on these dividends as they accrue, whether they are paid then or later (it's plainly stated in the prospectus). I'm guessing it's all part of the favorable tax treatment the company gets in payments to the trust preferreds - because the trust issues debt to the company, the company's payments are interest and therefore pre-tax.

richandmer - I haven't investigated any of Ford's securities beyond those that have been in the news lately.

Brian - You clearly have better information on the trading nuts and bolts than I do. I'd be much obliged for any information sources.

Mar 11 10:37 PM

[JBond:]

One issue about the alleged tax on the accrued interest:
if one pays the tax each year for the next 5yrs, for example, and F declares bankruptcy...and holder gets nothing back including the deferred payments, then one has to file amended tax returns...and if longer than 3yrs..than SOL?

Mar 11 11:47 PM

[gregdodge:]

I own my preferred in a Roth account, so the tax issue won't affect me. Others may want to consider doing the same.

Mar 11 11:54 PM

[Wren337:]

If you search for "OID security" you'll find a few sites that explain it. F-S is now like a zero coupon that has some future value but no yearly dividend. The govt. requires you to pay taxes on a pro-rated slice of that future value every year; in the case of F-S, that value is the unpaid dividend value. When you pay the tax, the 3.25 will be added to the cost basis of the preferred; when you're eventually cashed out you can deduct this increased cost basis from the return and not show a tax gain. The tricky part is what happens if they go under. As I understand it, if you paid $5 for F-S today, and in 1 year they go under, you'd have a cost basis of $8.25 a share and a value of zero. Exactly like if you'd paid $8.25 for a share of stock that went to zero. So you could write the whole thing off against gains, but I don't believe you could refile and get your money back. If you're buying f-s in a tax free account or planning to convert it, I say have fun. I would not hold this in a taxable account myself. Too much hassle, too much risk.


On Mar 11 11:47 PM JBond wrote:

> One issue about the alleged tax on the accrued interest:
> if one pays the tax each year for the next 5yrs, for example, and
> F declares bankruptcy...and holder gets nothing back including the
> deferred payments, then one has to file amended tax returns...and
> if longer than 3yrs..than SOL?

Mar 12 10:14 AM

[Wren337:]

Another thing to consider. I would expect a lot of people are going to be very surprised in a year to get a 1099-OID and to owe taxes. Over the next 5 years you'll see a lot of these converted into common just to get out of the tax consequences. That is a huge advantage for Ford in deferring these payments - how many of these preferred will just go away over the next 5 years?

Mar 12 11:03 AM

[STASH48126:]

If I held on to my Ford preferred for another year, then I sell it. I know that I have to pay on the dividend income, but when and if Ford pays the dividend, will I receive the dividend income that I paid taxes on or does it accrue to the stock and payable to the last holder of the stock as of ex dividend date.

Mar 20 01:40 PM

[UpsideHunter:]

STASH, I just called Ford and asked that question, and they didn't know the answer -- said they'd have to call me back on it!

Mar 24 06:30 PM

[David Clayton:]

A commenter at my latest article pointed out that I've been miscalculating the nominal yield. The dividend is $3.25 per share. So when this was $5.22, the nominal yield was 62.3%. At today's close of $8.33, it's 39%.

Mar 24 09:45 PM

[David Clayton:]

@STASH48126:

You would not collect any dividend. Prospectus page S-52: "On the interest payment date occurring at the end of each deferral period, Ford shall pay to the holders of the debentures of record on the record date for such interest payment date (regardless of who the holders of record may have been on other dates during the deferral period) all accrued and unpaid interest on the debentures, together with interest thereon at the rate specified for the debentures."

As for the taxes paid, I assume you would then be able to write off any accrued dividends paid, but would consult a tax professional for guidance.

> If I held on to my Ford preferred for another year, then I sell it.
> I know that I have to pay on the dividend income, but when and if
> Ford pays the dividend, will I receive the dividend income that I
> paid taxes on or does it accrue to the stock and payable to the last
> holder of the stock as of ex dividend date.

Mar 24 09:50 PM

[David Clayton:]

Prospectus:

www.sec.gov/Archives/e...

Mar 24 09:50 PM

[UpsideHunter:]

Thanks David -- I missed that in the prospectus -- and the Ford contact at Computershare had no idea...

Mar 25 11:33 AM

[drbrake:]

I don't think this is correct.
I had Chrysler cumulative prefferred back in 1980 and sold it befor the x-dividend date when the cumulative dividends where going to be paid. All the dividend value was in the share price so I took it at long term capital gain.

I just read through U.S. Tax publication 550 and did only talks about stripped prefferred stock with is not the same as this preferred.
I do not believe you have to pay taxes on the defferred dividends until they are actually paid.

On Mar 11 07:37 PM jdmballm wrote:

> Could you explain why a preferred holder would have to pay tax on
> the dividend if it wasn't paid?? I would think that as a cash basis
> taxpayer, you wouldn't recognize income until it is actually paid.
> What would change a individual from a cash basis taxpayer to (apparently)
> an accrual basis taxpayer for this purpose?? Thanks.

Mar 28 09:47 AM

[User 385245:]

I hold some of these securities and have found all of your comments quite enlightening. To the average person who does not follow these things very closely, they come as quite a shock. To summarize (to make sure I have all of this correct) Ford is no longer paying on this security and is in a defferal mode - holders of the security will still have to pay taxes on income not received during the deferral period- if the security comes out of deferral, then the current holder of the security gets all of the back payments that are due (someone could buy in right before the deferral period ends and get ALL of the back payments due ?).
When are you considered to own the security (for taxing purposes and entitlement to the interese payment- on the scheduled payment date or the 15th of the preceding month ? or ? If you bought this on,say, March 20th 2009 and sold it on April 10, 2009 - would you be considered to have owned it ?
Appreciate your comments.

Mar 29 02:50 PM