Not all securities commonly called preferred stocks are created equal. Some are actual debt which trades (flat) like stocks and pay interest quarterly. Then there are trusts which pass through interest from their sole asset – a bond of the sponsor. And third party trusts (from investment banks) which pass through income from a variety of other preferreds and bonds. Lastly, there are structured products which trade like stocks, tied to the performance of a linked common equity or indexes.
To add to the confusion, only the true equities qualify for the 15% dividend tax rate. Cumulative equity preferreds require undeclared dividends in arrears to be paid before any common dividends are resumed. Back payments for trusts and other more esoteric securities depend on the underlying assets and security structure.
The definitions that I provide below only scratch the surface of the variations that trade on the exchanges. The differentiation in securities was clearly pointed out in American International Group’s (NYSE:AIG) most recent conference call. AIG’s CFO said they would continue paying quarterly “dividends” on AFF and AVF because they are actual exchange-traded debt securities (bonds) – not equities. Hearing this, I bought a small amount of AFF for $2 a share as a speculation during last week’s panic.
Traditional Preferred Stock. This is a true equity and receives the 15% dividend tax rate. Dividend rates can be either fixed or variable, start fixed and turn to variable, or step up. The term can be fixed maturity or perpetual, with or without one or more call dates. The index for variable rates can be treasuries or LIBOR of any term plus or minus a percentage, or almost any other mathematical calculation you can think of. Some traditional preferreds offer voluntary conversion to common stock. Beware of mandatory conversions to common, or “units” that force preferred stockholders to put up cash to buy common stock at time intervals or based on certain conditions.
Trust Preferred Security. This is a hybrid security consisting of a preferred stock and often a junior subordinated bond issued by the same company. The proceeds from the stock sale are used to buy the bond. The bond’s interest flows through to the preferred stockholders as quarterly dividends. These securities do not qualify for the 15% dividend tax rate. The underlying bonds might be structured to skip as many as 20 quarterly payments without defaulting, but all missed payments are due by maturity or earlier depending on the securities structure. Trust preferreds are generally safer than traditional preferreds and generally have a lower yield. Duration, call dates and dividend rates can be as diverse as traditional preferreds, except the maturity is generally fixed.
Exchange-Traded Debt Securities. This is a bond – the real thing. The bonds are often senior unsecured. These securities do not qualify for the 15% dividend tax rate either. Duration, call dates and dividend rates can be as diverse as traditional preferreds, except the maturity is fixed. Investment banks have given these securities multiple proprietary names, such as PINES.
Third Party Trust Preferreds. These hybrid securities are issued by investment banks that purchased the underlying preferreds and bonds, then pass through the dividends and interest. The underlying securities might have been issued as private placements or in large denominations and sold at a discount to the investment bank. The tax treatment would depend on the underlying securities.
Structured Products. These are securities issued by investment banks that trade like stocks, tied to the performance of a specific equity or index. They were issued in increments as low as $10 and have fixed maturity dates. Investing in these is a pure gamble; you can lose principal and receive no interest at maturity.
Disclosure: Author is long AIG and AFF.