A 7.1% Yield From This Dow Component

 |  Includes: BAC
by: Josh Arnold

When Bank of America (NYSE:BAC) bought the ailing Merrill Lynch during the financial crisis it inherited a world class brokerage and, among other things, Merrill's debt and preferred financing vehicles. These instruments represent opportunities for income investors to take a position in BAC without having to wait for common stock dividends to come, which have thus far been elusive. In this article, we'll take a look at the Merrill Lynch Preferred Capital Trust 7.12% Preferred Security (MER-E, may differ depending on your broker) to see if it is a good fit for your portfolio.

MER-E is a trust preferred security, which in my experience, is normally backed by some kind of debt issue. However, this trust preferred is actually backed by a preferred security so it has an important difference from many other trust preferreds; it has no stated maturity date. When a trust preferred is backed by a debt issue it typically matures on the maturity date of the debt issue. However, since MER-E is based on a perpetual preferred issue, no such date exists.

It does have a call date, or a date at which BAC can redeem it at its option, and that date was in 2008 at the point where BAC purchased Merrill. Therefore, at any time from now on BAC can redeem MER-E and holders will be forced to sell. However, if such an event occurs, holders will receive $25 per share and as shares are currently trading just 16 cents higher than that as of this writing, anyone who purchases today may be subject to a very small capital loss. Just know that if BAC were to call this issue, holders would be entitled to $25 per share.

MER-E pays annualized interest payments of $1.78 per share in quarterly installments, good for a 7.12% coupon yield. As shares are trading at a slight premium to their issue price the current yield is just a bit lower at 7.07%. However, since this is a trust preferred security and not a traditional preferred, the distributions from MER-E are not eligible for the favorable dividend tax treatment. This means that holders in a taxable account will potentially have a significantly lower after-tax yield than a similar traditional preferred issue that is eligible for the favorable treatment. This wouldn't matter in a retirement account but those holding MER-E in a taxable account must take their individual tax situation into consideration before initiating a position in MER-E.

Bank of America has made it a corporate mission to redeem expensive sources of funding and while no one can know if MER-E is on the chopping block, being called is a very real possibility. I suspect that is why the price of MER-E has a 52-week range of less than 75 cents; market participants must believe BAC is going to call this issue. However, market participants have been wrong before and as such, I believe you can own MER-E with a muted risk of interest rate movements. Interest rates have moved decently since taper talk began last May and despite this, MER-E has barely budged but continues to pay its distributions. This is a positive in my view as it means that the worst that can happen is that you lose 16 cents if the issue is called but in the mean time, you get added price stability.

MER-E is also cumulative which means that, while BAC has the option to defer distributions for up to six quarters, it must make all scheduled distributions eventually. This is a large positive as many preferred issues are non-cumulative and distributions are not guaranteed. In this case, the distributions are implicitly guaranteed and offer the added sense of security, particularly from a very high quality payer like BAC.

Overall, I think MER-E offers investors, particularly those in retirement accounts, to own a very high quality preferred issue with a nice coupon and the added capital protection of the market's apparent expectation this issue will be called. If you were to purchase today you'd receive a greater than 7% yield until such time BAC called the issue for a 16 cent capital loss per share or, until you decided to sell. Either way, the risk is skewed to the upside in the form of robust distributions and not towards interest rate risk and potential capital losses.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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. I may initiate a position in MER-E at any time.