Bank Of America: 7% Yield And Principal Protection

Dec. 3.13 | About: Bank of (BAC)

Bank of America (NYSE:BAC) inherited a lot when it acquired Merrill Lynch a few years ago. It inherited a world class wealth management firm but along with that, BAC also acquired Merrill's legal troubles and debts. One such security that BAC took over with the Merrill acquisition is the Merrill Lynch Preferred Capital Trust III 7.00% Trust Originated Preferred Security (MER.D, may differ depending on your broker). This preferred offers investors a tremendous combination of principal stability and safe income and it is the subject of this article. The D is the perfect combination of income and stability and we'll take a look at why and what it can do for your portfolio now.

The D is a perpetual, cumulative issue that pays a $1.75 annualized dividend on a quarterly basis on each share with a $25 liquidation preference. What does all of this mean? The perpetual part means that this issue has no maturity date. Unlike debt issues that have a stated date in the future when they will be redeemed, this security has no such date. Thus, if BAC chooses not to call this issue, it will persist forever.

The cumulative characteristic means that if BAC misses a dividend payment it must make up that dividend payment in the future. This is a huge advantage in a preferred security because many such securities have clauses that allow the payer to simply miss dividend payments and never make them up. For an income investor that is buying a preferred simply for the income, that is a disaster. Investors needn't worry about that happening with the D because BAC is obligated to make all missed dividend payments, should that arise. However, the risk of BAC missing dividend payments is as close to zero as it can get at this point given BAC's tremendous fundamental improvements since the financial crisis. But even if that does happen, your dividends are safe, they may just be a little late.

Speaking of the dividend, it is very strong at $1.75 annually, good for a 7.00% yield on the liquidation preference. As shares are currently trading for a very small premium at $25.25, the current yield is very slightly lower but still robust at 6.94%.

This brings us to one risk of this preferred issue and that is the fact that BAC could call this issue at any time. Starting in March of 2008 Merrill (and now BAC) has had the option to call this preferred for the liquidation preference of $25. Should that happen, investors will miss out on any future dividends after the preferred is called and will also suffer a 1% capital loss, assuming a purchase at today's market price. That is a very small risk as just one quarter's dividend will more than make up for the potential capital loss and the fact that BAC hasn't called this issue yet may suggest it has no current plans to do so. However, it is something you must keep in mind if you are looking at the D as it could be called at any time.

The other risks that are inherent in any preferred, missed payments and capital losses due to interest rate spikes, are quite muted for the D in my opinion. First, BAC is a very strong payer and as I said, has made tremendous strides towards sustained profitability over the past couple of years. This means that BAC is going to be around for a long time and as such, as long as it doesn't call this issue, I think you can receive dividends from the D for a long time as well. Finally, interest rate risk, which wreaks havoc on many interest-bearing securities, doesn't really affect the D's price. For instance, even as rates have moved violently over the past eight months due to taper talk from the Fed, the D has a 52 week range of only 88 cents, from $24.88 to $25.76. In other words, interest rates don't affect this security the way they do with others and I believe it is due to the combination of the payer's strength, the fact that it is callable and the fact that it is cumulative. This means that your principal is likely as safe as it can be when investing with this particular preferred.

The MER.D offers income investors a terrific blend of yield and safety with the additional principal protection of the issue not moving with the whims of the interest rate market. If you can stomach a potential 1% capital loss upon BAC calling this issue, it can provide you with large amounts of income for a very long time and let you rest easy regardless of what's happening in the stock market.

Disclosure: I am long BAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.