Preferred stock and trust preferred issues are often overlooked by investors due to lack of liquidity, information or basic understanding of what the securities are and what they provide. However, for many investors, preferreds are a terrific option for stable, predictable income. In this article, we'll take a look at an issue from Bank of America (BAC) that could be a great addition to your retirement portfolio.
The issue in question isn't a traditional preferred stock; rather, it is a trust preferred security. What this means is that a trust was formed and issued shares, the proceeds of which were used to buy debt from the issuer. In this case, the issuer was Merrill Lynch but since BAC purchased ML, it inherited this trust preferred. Essentially, a trust preferred is structured such that holders of the trust's securities, in this case, the Merrill Lynch Capital Trust III (MER-P, may differ depending on your broker), are indirectly holding the issuer's debt. You can think of it that way with a trust preferred; you hold shares in an entity that holds the issuer's debt and thus, you are entitled to receive the payments on the debt.
MER-P was issued at $25 per share and pays annualized distributions of $1.84375 in quarterly installments. This means the coupon yield of the issue is 7.375%, which is very strong indeed and in particular, from a gigantic global issuer like ML (now BAC). As of this writing shares are trading at a moderate premium to their issue price at $25.60 so the current yield is a bit lower at 7.2%. That is still a robust yield and many investors would be happy with that, but I'll make one cautious statement regarding that.
With the price at a premium to the issue and call price of $25, in the event of a call by BAC, holders would be subject to a capital loss of 60 cents. Since the call date passed in 2012, BAC can call this issue anytime it pleases and it only needs to pay $25 per share. Thus, with the call date having passed I would wait to buy this preferred security until it is trading near or below $25 to avoid any potential capital loss situation. Of course, you can purchase today maybe BAC will never call this issue but the prospect of losing more than 2% on a call isn't enticing to most income investors and as such, I'd recommend waiting until the price falls a couple of percent before pulling the trigger.
The underlying debt issue for this trust preferred matures in 2062 with the option for BAC to extend it to 2087. Thus, this issue is going to trade like a perpetual preferred for a long time until the maturity date becomes a lot closer than it is now. Again, this is desirable for some but undesirable for others; it simply depends on your preferences. Something with a maturity this far out is going to be more sensitive to interest rate changes, good or bad, and that is something you must be aware of before you step in and buy. The kicker is the call date having passed as this issue could be redeemed at any time or not at all, it simply depends on what BAC wants to do. If it chooses not to redeem MER-P you could potentially hold this security "forever" as it doesn't mature for nearly 50 years.
Unfortunately, since this security isn't a traditional preferred, it doesn't offer the preferential dividend tax treatment. This means that distributions are interest payments and not dividends and are then subject to higher taxation, all else equal. Of course, everyone's tax situation is unique and you should understand the consequences of owning this issue before you buy. Ideally, you'd own MER-P in a retirement account and the taxation status wouldn't matter.
MER-P offers investors a chance to essentially own BAC debt that pays more than 7% in interest yearly for potentially a very long time. If you can stomach the nearly 50 years until maturity and hold this in a retirement account to avoid the taxation issue, MER-P could be a great addition to your retirement portfolio. BAC is getting stronger everyday and the likelihood of some kind of default event is quite remote. Thus, I think the strength of BAC and the terrific yield of this issue make it a great choice for those seeking stable income.