Preferred Stock Investors About To Be Cash-Rich Thanks To New Fed Action

Includes: BAC, BBT, C, JPM, KEY, MS, PNC, STI
by: Doug K. Le Du

Beginning on July 11, 2012, and for the 90 days that follow, preferred stock investors are going to see a significant uptick in their brokerage cash account thanks to a Thursday, June 7, 2012 announcement by the Federal Reserve.

The June 7 Fed announcement opened the "premature call window" for 90 days, triggering a multitude of trust preferred stock (TRUPS) redemptions from our publicly traded banks[1]. With the premature call window now open (for the second time since July 2010), all bank-issued TRUPS are now redeemable regardless of the call date that is published in their prospectus.

Current Redemption Status

Companies are required to provide a minimum of 30 days notice when they redeem ("call") a preferred stock. SunTrust (NYSE:STI) was the first to react on Monday, June 11, redeeming its STI-Z TRUPS for July 11, 2012. If you own shares of STI-Z, SunTrust is going to buy your shares back from you on that date, the proceeds showing up in your brokerage cash account.

As itemized in SA Contributor Michael Terry's article on June 11, Citi (NYSE:C) and JP Morgan (NYSE:JPM) were quick to act as well with TRUPS redemptions (see list: Citi | JP Morgan). Citi is redeeming just under $5 billion of their TRUPS while JP Morgan is calling $9 billion worth.

The following day KeyCorp (NYSE:KEY) prematurely called KEY-F ($0.7 billion) for July 12 followed by BB&T Corporation (NYSE:BBT) on Wednesday, June 18 calling BBT-A, BBT-B and BBT-C (valued at $3.1 billion) for July 18. The SA article titled "The Hidden Risk Of Buying Today's Trust Preferred Stocks" from March 5, 2012 alerted SA readers to the risk of these premature calls using BBT-B as a case study.

Bank of America (NYSE:BAC), with over 70 preferred stocks, weighed in on Friday, June 22, calling 11 TRUPS (see list) for July 25, 2012 valued at $3.9 billion in response to the Fed announcement.

Most recently, last Friday PNC Financial (NYSE:PNC) announced the redemption of PNH and NCC-C for July 30, 2012. These two TRUPS redemptions will deliver another $1 billion into the cash accounts of preferred stock investors during July.

What Moody's Downgrades?

You may have noticed that the long-awaited June 21 bank downgrades by Moody's had little, if any, effect on the market prices of most bank TRUPS. In fact, Morgan Stanley's (NYSE:MS) TRUPS actually ticked up a bit in price, rising a few pennies closer to $25 even though these securities had just been downgraded below investment grade.

It was the Fed's June 7 announcement, pre-dating the Moody's downgrades by two weeks, that likely saved a drop in the market prices of many TRUPS during late-June. Preferred stock investors affectively ignored the long-awaited Moody's bank downgrades.

Standard TRUPS prospectus language allows banks to redeem their TRUPS, regardless of their published call dates, within a 90 day period[2] following a "capital treatment event" (which the Fed's June 7 announcement was). Once the market sees that a call is likely, the market price of a preferred stock will tend to move toward the security's par value ($25 in this case). So the much-feared Moody's downgrades, coming after the Fed announcement that made calls likely, was essentially ignored, having little, if any, effect on TRUPS market prices.

TRUPS Redemptions Will Push Up Short-Term Prices

Because these TRUPS redemptions are being triggered by the same June 7, 2012 event, many billions in cash are going to land in the cash accounts of preferred stock investors within the 90 day period beginning on July 11 with STI-Z shareholders.

High quality[3] preferred stock market prices have been relatively high this year, initially caused by several simultaneous redemptions of very widely held REIT-issued preferred stocks.

During the second quarter, investors fleeing eurozone assets added additional upward price pressure on high quality U.S. assets.

Going into the third quarter, the Fed's June 7 announcement is going to create a large group of suddenly cash-rich preferred stock buyers, beginning July 11 and for the 90 days that follow, all looking to replace their redeemed shares simultaneously. Consequently, while it is not possible to know in advance with certainty, preferred stock investors should expect additional short-term upward pressure on the market prices of preferred stocks beginning July 11, 2012 that would not have been there otherwise.

What's A Buyer To Do?

During this period of high prices, preferred stock buyers are frequently faced with having to pay a market price above $25 (PAR) in many cases.

Paying a market price above $25 per share, while increasing the number of alternatives available to pick from, can expose you to the risk of realizing a capital loss in the event of a downstream call (since shareholders will receive $25 from the issuing company in that event).

But what if someone else reimburses you for that risk?

One way to help mitigate the risk of a capital loss that comes with purchasing shares above $25 is to use the "double-dip" technique.

Those holding shares of a redeemed preferred stock receive a final dividend payment for the final quarter through the redemption date. By using the proceeds from the redeemed shares to purchase a preferred stock that has a dividend payment for the same period coming up, the shareholder gets paid twice for the same period on the same principal.

The Seeking Alpha article titled "Preferred Stock Buyers: Double Dividend Opportunity Approaches" provides an example of how to do this.

As TRUPS redemption dates arrive between July 11 and early-October, tens of billions of new dollars are going to be distributed to preferred stock investors. These cash-rich buyers are going to enter the market during the same 90 day period looking to replace their called shares and, hence, put additional upward pressure on preferred stock market prices. By using the double-dip technique, a preferred stock investor can be reimbursed for the risk of a downstream capital loss when purchasing shares above $25.


[1] Source for all preferred stock data in this article: CDx3 Notification Service database, Preferred Stock Investing, Fourth Edition, see Disclaimer: The CDx3 Notification Service is my preferred stock email alert and research newsletter service including data for all preferred stocks and Exchange Traded Debt Securities traded on U.S. stock exchanges.

[2] There are exceptions to the 90 day limitation language. Some banks removed this limitation from their TRUPS prospectuses when the securities were originally issued. TRUPS without the 90 day limitation language in their prospectus become callable, and remain callable, whenever a "capital treatment event" occurs. The SA article titled "The Hidden Risk Of Buying Today's Trust Preferred Stocks" provides examples of the prospectus language to look for.

[3] "High quality" preferred stocks are those that meet the ten risk-lowering selection criteria from chapter 7 of my book, Preferred Stock Investing. For example, high quality preferred stocks have investment grade ratings and the cumulative dividend requirement.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.