Bank of America (NYSE:BAC) announced on Tuesday that it had issued a total of $3 billion in perpetual preferred stock in two tranches. The first tranche of $2 billion, which can be called after 10 years, yields 6.25% until the call date when the rate begins to float. The second, which is a traditional preferred stock, has a coupon of 6.625% and can be called after five years. The bigger of the issues has a par value of $1,000 and will likely have far less volume if it gets listed on an exchange but the smaller issue, which has a par value of $25, should have much better volume and access for smaller investors.
This is good news for investors that want exposure to BAC but don't want to own the common stock because of the common's subpar yield. Investors can swap out some of their common stock for the new preferred and boost the yield on their overall position. As far as the merits of investing in the preferred stock, that is a choice for individual investors. Obviously, I think BAC will fulfill all of its obligations with the preferreds but interest rate risk is real and the yields are on the lower end for preferreds. The lower yield makes sense given that it is from BAC, a very strong mega bank, but interest rate risk cannot be helped regardless of the issuer. Higher rates in a couple of years could see the preferreds trading at large discounts to their issue prices. Buying when the preferred is trading for its issue price is likely not the best move since everyone and their brother thinks rates are set to rise. However, it is an option if you're interested in being a long-term holder.
More importantly, BAC has strengthened its finances for next year's stress test. This past year, in the 2014 edition of the CCAR exercise, the bank asked for a decent sized dividend increase and a moderate buyback program. Of course, that was before the bank had the well-publicized miscalculation on its capital ratio, causing the bank to inadvertently overstate its capital position to regulators. This, while not an actual issue in my opinion, was seen as evidence that BAC didn't have adequate controls in place. In turn, this caused the bank's regulators, and in particular, the Fed, to look at BAC's capital return plan with a keener eye. This, as you can imagine, is never good as the less a company's regulator is involved, the better.
Fast forward to August and BAC settled with the government over the largest case the banking industry has seen to date. While I've already covered settlement, today's development of a capital raise has made the financial impact of the settlement significantly less damaging. The cash portion of the settlement wiped out nearly a year's worth of earnings and potential capital that could have strengthened the balance sheet or been returned to shareholders. As many investors have shied away from BAC due to its lack of capital returns recently, this is a big deal.
The capital raise has provided the bank with about a quarter's worth of earnings in additional cash that will allow it to pay the fine and deal with its non-cash portion when that bill comes due. But more importantly it shows the Fed that BAC can raise billions in funding without trying very hard. This will come in very handy next year when the Fed makes its determination of whether or not BAC can return the amount of capital that it asks for. And if you think that's a foregone conclusion, ask Citi (NYSE:C) how it can go when you ask the Fed for something.
I don't like BAC having to pay more than 6% for its cash but under the circumstances, it was the right thing to do. This raise came out of left field for me but after understanding the transaction, I'm happy BAC did it. Next year, when it asks the Fed to return billions of dollars to shareholders, it will be able to point to the additional cash on its balance sheet and the fact that it can raise money whenever needed. This speaks volumes to BAC's full recovery from the financial crisis and it paves the way for a smoother future of sustained earnings growth and capital returns for years to come.
Disclosure: The author is long BAC.
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