Seeking Alpha
Profile| Send Message|
( followers)  

by Roger Choudhury

Edward Deicke, a financial advisor at JHS Capital Advisors, oversees over $2 billion in assets. He recently recommended that investors should take on a serious study of trust preferred shares of banks. The basis of his reasoning is that the new regulations under Dodd-Frank will not any longer count such instruments toward a bank's tier 1 capital. Consequently, the banks have incentives to call these away over the next few years. Anyway, the yield was high upon IPO to influence investors to purchase them, so the banks would be glad to clear them off their balance sheets.

In this fashion, US Bank (NYSE:USB) has announced calls for four series of trust preferred securities. The USB Capital VIII 6.35% Trust Preferred Securities and USB Capital X 6.50% Trust Preferred Securities were redeemed on February 22, 2012. The USB Capital XI 6.60% Trust Preferred Securities and USB Capital XII 6.30% Trust Preferred Securities are scheduled to be called on May 10, 2012. The only series that has not been called is the USB Capital IX 6.189% Fixed-to-Floating Rate Normal Income Trust Securities.

Agreeing with Deicke, I would look for shares trading below par value, so that you will have capital appreciation. Along the way, you will collect handsome dividend yields, while CDs and money markets funds are yielding next to nothing. However, these securities do not qualify for the 15% tax rate. I did some digging, and these are what I found.

Merrill Lynch (NYSE:BAC) (Preferred Capital Trust V, 7.28% TOPrS Preferred Securities)

Recent Price

$24.83 per share

Callable?

Yes, at $25 per share, after Sept 14, 2012

Dividends

$0.455 per quarter

Next dividend payment is on Jun 29

Record date is in the final week of Jun

Current yield (after-tax yield)

7.3% (4.7%)

S&P Rating

BB+

Ticker symbol (Yahoo! / Google / Fidelity)

MER-PF / MER-F / MER/PF

Merrill Lynch is a subsidiary of Bank of America. As of 2011, its ratio of earnings to fixed charges and preferred dividends is 0.89. On the surface, this is a bit disconcerting, however, earlier this month, S&P upheld its previous rating of BB+ on the bank's preferreds. Bank of America is in a similar situation to Citigroup (NYSE:C) in 2007, when Citi's ratio was 1.01. Citi continued making dividend distributions back then.

For Bank of America, preferred dividends amount to a mere $211 million annually. Looking at this from a medium-term perspective, Bank of America has slashed interest expense by 58.3% since 2007, or by a whopping $15.7 billion to $19.7 billion. So, I believe that your preferred dividends are safe for the next couple of years.

On some semi-positive news, Bank of America posted a $653 million profit ($0.03 in EPS) in the first quarter. The same quarter from a year ago yielded $2 billion in net income or $0.17 per share. A debit valuation adjustment trimmed profits. Revenues fell to $22.5 billion from $27.1 billion.

However, credit quality improved with net charge-offs declining broadly from 2.61% at the end of March 2011 to 1.80% now. Moreover, provision for credit losses fell by 37% year-on-year to $2.4 billion. The nonperforming loans, leases and foreclosed properties ratio was 3.10%, which is down 30 basis points from the end of the first quarter in 2011.

The mixed results should lead to flat trading for the common shares. As for this preferred stock, over the next couple of weeks, I believe that there may be a slight pullback to below $24.70, as investors move to safer fixed-income. In the long run, I expect this to hover between $24.50 and $25.00, as not-good-enough US economic indicators and the PIIGS debt problems are priced into the shares. Risk aversion and a flight to safety should also keep this trading near those levels. Looking at the 4.7% after-tax yield, I believe that this is a fair opportunity to beat inflation modestly. Nevertheless, only younger income investors should consider this due to the BB+ rating.

Deutsche Bank (NYSE:DB) (Contingent Capital Trust II, 6.55% Trust Preferred Securities)

Recent Price

$23.80 per share

Callable?

Yes, at $25 per share, after May 22, 2017

Dividends

$0.409375 per quarter

Next dividend payment is on May 23

Record date is on May 20

Current yield (after-tax yield)

6.8% (4.4%)

S&P Rating

BBB

Ticker symbol (Yahoo! / Google / Fidelity)

DXB

In 2011, net income surged by 85.6% to $5.7 billion. Deutsche Bank has $16.2 billion worth of trust preferred securities in its liabilities side of the balance sheet. In 2011, it paid out $1.07 billion in dividend distributions on these instruments. Consider that the net interest income was $22.9 billion and that total interest expense is also $22.9 billion, I would say that the preferred dividends are well-covered.

The Wall Street Journal reported that the company is set to issue up to $3.9 billion in stock to improve its capital levels. However, the company immediately denied it. By 2013, the Bank is aiming to meet Basel III capital requirements without a capital increase.

Due to growth headwinds in the EU, one way is to de-risk itself by diversifying revenue sources, in particular by growing its business in Asia. The company cites that 28% of top 500 global corporations have headquarters in Asia. It expects that figure to grow to 40% by 2015.

The aggressive growth agenda of the firm should give you comfort that these preferred shares should stay above $20 over the long run. Yet, over the next few weeks, I expect this to dip below $23.50, as debt and fiscal pressures mount in Spain, Italy, and Greece. Keep in mind that this is a preferred security with an investment grade rating, so that will keep the share price at respectable levels. After all, investors will seek refuge in exactly this sort of financial instrument. I recommend that well-off retirees should consider parking some of their money in this. I hedge here because this is a bank in Germany, and we are all aware of the adverse conditions in Europe.

Wells Fargo (NYSE: (WFC) (Capital VII, 5.85% Trust Preferred Securities)

Recent Price

$25.16 per share

Callable?

Yes, at $25 per share, since May 2008

Dividends

$0.365625 per quarter

Next dividend payment is on Aug 1

Record date is in second week of Jul

Current yield (after-tax yield)

5.8% (3.7%)

S&P Rating

BBB+

Ticker symbol (Yahoo! / Google / Fidelity)

WPK

Wells Fargo's ratio of earnings to fixed charges and preferred dividends is a healthy 4.69. Since 2007, fixed charges fell by 51.3% to $7.013 billion. In 2011, earnings increased by 11.6% to $30.327 billion. The debt to equity ratio is 1.06. All these numbers show that this company is one of the country's strongest financial institutions. I think that it is safe to say that preferred dividend distributions will continue to be made until this is called away in a few years.

I understand that this is trading slightly above par value, but you will make up for the call price after receiving the first dividend payment. Of course, you may opt to put in a limit order below $25, but I think that the best that you can get is around $25.10, based on its three month trading history. In the medium term, I believe that this will go north of $25.50, mainly because of skittish investors searching for better yield and a safer bet. Given the good financial shape of Wells Fargo, I do recommend that older income investors study up on this, assess their financial condition, and purchase this soon.

For three more similar recommendations, view "3 Trust Preferreds to Boost Your Portfolio Now."

Source: 3 Trust Preferred Stocks To Consider Now