A 9.5% Yield From Taylor Capital Group

Jan.14.14 | About: Taylor Capital (TAYC)

Taylor Capital Group (NASDAQ:TAYC) is a bank holding company that is based in Illinois, operating Cole Taylor Bank. The common stock has had a very nice run over the past year but for income investors, TAYC doesn't pay a dividend on its common stock. However, there is a way for investors to take advantage of the strength of TAYC's business and in this article, we'll take a look at the company's Capital Trust I, 9.75% Trust Preferred Securities (TAYCP) to see if it is a good fit for your income portfolio.

We'll begin by defining exactly what we're dealing with. TAYCP is a trust preferred security, not a traditional preferred. They behave much the same way to holders but there are some important differences to be aware of. First, trust preferreds are based on debt issues whereas traditional preferreds aren't. In the case of TAYCP, the company issued shares in a trust, the trust bought the 9.75% Junior Subordinated Deferrable Interest Debentures due 2037 and funnels interest payments from the company to holders of the trust preferred securities. That complicated legal mess essentially means that by owning TAYCP, you own Taylor Capital Group debt; you receive interest payments just like a traditional debt holder.

Astute readers will notice I used the term "interest payments" instead of "dividends" and that is because trust preferred securities, being based on debt issues, do not distribute dividends and thus, are not eligible for the favorable dividend tax treatment. Any distributions received from TAYCP are treated as interest payments for tax purposes and as such, holders of TAYCP in a taxable account could receive a materially lower after-tax yield than if it were eligible for the preferential treatment. If you are holding TAYCP in a retirement account it doesn't matter but if you plan to hold it in a taxable account, make sure you understand the consequences for your particular tax situation.

As I mentioned earlier the underlying debenture for this trust preferred is set to mature in 2037. Thus, when the debenture matures, TAYCP will also mature, just like it would if you had purchased the debenture outright. However, the company has had the option since October of 2007 to call this issue and hasn't done so. This does mean that Taylor could redeem this issue any time it pleases from now until the maturity date so it is something to be aware of.

TAYCP was issued in $25 increments and pays an annualized distribution of $2.4375 in quarterly installments, good for a 9.75% coupon yield. Shares are trading at a three percent premium to that price right now so the current yield is actually a bit lower at 9.5%. This still represents a terrific yield and a three percent premium, while not ideal, is not a large price to pay for the kind of income you can accrue from TAYCP.

TAYCP does have a clause that allows Taylor to defer interest payments for up to 20 consecutive quarters. This means that Taylor could potentially stop interest payments on TAYCP for five years before resuming distributions. Nobody wants to see that happen but this is a pretty common clause in trust preferreds and given Taylor's earnings and balance sheet strength, I don't think it will ever be invoked. However, if you own TAYCP you must keep an eye on Taylor's financial situation to ensure it remains safe to own TAYCP.

In addition, TAYCP is cumulative which means that even if Taylor were to miss interest payments on TAYCP it is obligated to make them up. Thus, if Taylor deferred interest for five years on TAYCP it would need to make a $12.1875 per share payment to make up the missed distributions. What this boils down to is that your interest payments are guaranteed as long as Taylor continues to operate. In a bankruptcy situation these debentures are very low down on the totem pole and as such, you'd likely not receive all of your principal back. But if you're worried about Taylor going out of business you probably don't want to own TAYCP in the first place; you must be comfortable with Taylor's business in order to own this issue. Taylor is a strong bank and I'm not worried about repayment risk at this point but that is something you must decide for yourself.

Apart from the inherent risk in Taylor's business that is present with any security purchase, TAYCP is subject to interest rate risk. Any income security is going to pose some risk to the holder from fluctuations in interest rates and TAYCP is no exception. As interest rates move up and down over time the price of TAYCP is likely to follow suit. If we see a spike in interest rates we could see TAYCP move down sharply in price, leaving holders with capital losses. Of course, as interest rates move up the opposite will happen and holders will have capital gains. The point is that TAYCP is not a trading vehicle; this is something you buy and hold to collect income and seeing fluctuations in the value of your holdings is something that is going to happen over time. If you can't stomach that then TAYCP probably isn't for you. If you can, you should be able to collect a very strong yield for years to come.

TAYCP represents an opportunity to own a very high yielding security from a small but profitable bank. The company has been in existence since the Great Depression and is run by very competent managers. However, since Cole Taylor Bank isn't exactly a household name I'd encourage you to do your own due diligence on the bank before pulling the trigger on TAYCP to make sure you feel comfortable with it. If Taylor passes the due diligence test and you can make peace with the potential price fluctuations, TAYCP could be a nice boost to your income portfolio. Given that it is taxable as interest, I'd suggest holding TAYCP in a retirement account but for certain taxpayers, the interest designation may not be a material negative and could still be a solid addition to your income portfolio.

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.

Additional disclosure: I am long TAYCP