Before being purchased by Bank of America (BAC), Merrill Lynch was a big fan of issuing preferred securities to raise capital. When BAC took over ML in the aftermath of the financial crisis BAC inherited many preferred issues that were formerly Merrill vintages. One such example is the Merrill Lynch Capital Trust I, 6.45% TruPS (MER-K, could differ depending on your broker). In this article we'll take a closer look at this TruPS and see if this issue is a potential win for income investors.
This TruPS was issued by Merrill Lynch when it was an independent company near the beginning of 2007. Under the terms of the TruPS, shares have a liquidation preference of $25 and pay an annual coupon of 6.45%. At the liquidation preference that works out to an annualized dividend, paid in quarterly installments, of $1.6125 per share. This TruPS is set to mature in December of 2066 but the maturity can be extended at BAC's option for up to an additional 20 years. In addition to the set expiration date on this TruPS BAC can now call it whenever it chooses; beginning in 2011, BAC can redeem this TruPS at any time. With the current price hovering near the liquidation preference the current yield is very close to the coupon rate at 6.49%.
So we've established this TruPS pays a great dividend yield but there are some risks involved as well. First, the dividends on this TruPS are non-cumulative. This means that if BAC misses dividend payments it is under no obligation to pay them in arrears. Given that BAC's fundamental improvements have strengthened the bank immeasurably since the financial crisis I think the risk of missed payments is likely very close to zero. However, if BAC were to have financial trouble, and I'm talking serious trouble, it may defer dividend payments on certain preferreds in order to preserve capital. If BAC ever wanted to access the capital markets ever again it wouldn't want to do this because once investor trust is gone, it's very difficult to regain. Again, I don't consider this a serious possibility but it is something to consider with this TruPS.
In addition, this TruPS, and any other interest-bearing security, inherently has some interest rate risk associated with it. As interest rates rise, all else equal, the prices on interest-bearing securities will fall in order to meet the rise in other rates. This means that a TruPS such as this one should theoretically be worth less in a rising rate environment than a stable or falling rate environment. However, this TruPS has shown tremendous resiliency over the past year even when rates were being whipsawed by taper talk from the Fed. This TruPS has sported a very narrow 52 week range of only 6%, from $24.26 to $25.49. So as far as interest rate risk goes, while this TruPS is certainly not immune, it does seem less susceptible than you may think at first glance.
Given BAC's propensity to reduce interest expense over the past couple of years I'd suggest that the reason this issue is trading so close to its liquidation value is that market participants expect that it may be called any time now. While this could be a bit undesirable if you're looking to be a long term holder I would also suggest that this is a great way to protect your principal and the reason why shares have been so much less volatile than other comparable issues. In other words, you're trading some potential longevity in holding this TruPS in exchange for a price that is likely higher than it otherwise would be if it weren't eligible to be called yet. And keep in mind, there is nothing saying BAC has to redeem this preferred; it could simply continue to let it ride for decades to come.
While this particular issue isn't my favorite from BAC, given its non-cumulative nature and what I believe to be an artificially high price, it still has many positives for income investors. First, the borrower is rock solid in BAC; the company's fundamental improvements have taken all payment risk out of the equation for me. Second, the yield is still quite high at 6.5% when the SPY is paying less than one-third that amount. Third, the price of these shares has proven very steady even in the face of interest rate movements and I believe it is due to market participants' belief this issue may be called relatively soon.
While this combination of factors may not be for you, if you're looking for a short term, high yield holding, you could do much worse than the MER-K. Think of it as a CD with an unknown maturity date and the upside bonus of the possibility BAC chooses not to call it. If BAC calls it, you will have earned an annualized 6.5% yield and a small capital gain and if not, you can continue to watch the dividends roll in.