Outlook 2013: Financial institutions move to noncumulatives from trust preferreds due to new law

By Stephanie N. Rotondo

Phoenix, Dec. 31 - Under new rules set to be fully implemented on Jan. 1, 2013, trust preferreds issued by financial institutions will no longer be considered as tier I capital.

Because of the amendment - which was part of the Dodd-Frank Act - banks and other financial institutions spent most of 2012 calling their trust preferreds and replacing them with noncumulative perpetual preferreds.

For the most part, investors reacted favorably to the change. Most of the new noncumulative deals did fairly well in the market, despite the new securities having less protection and not being cumulative.

"[The change] was good for issuers," a trader said. Because the new paper was noncumulative, that gives issuers an ability to halt dividend payments and not have to pay back the cumulative dividends.

That being said, the change was "bad for holders that wanted that benefit."

The differences

Trust preferreds, as defined by one trader, is like a "listed piece of debt." The dividends paid on the securities are more like interest payments, he said, which are fully taxable.

However, the paper is also cumulative and offers more protection to holders. For instance, it is more difficult to halt a dividend payment on a trust preferred than it is on a noncumulative piece.

Noncumulative securities, on the other hand, function more like "true preferreds that are paying dividends, not interest." The dividends are taxed at the current dividend rate, which is 15%.

They do not, however, offer as much protection to holders.

Pros and cons

In a downturned economy, investors would be more likely to place their money in trust preferreds, according to a trader, given the higher level of credit protection and the difficulty an issuer would have in turning off a dividend.

But noncumulatives, which act more like "true preferreds," have better tax benefits, given the 15% tax rate.

"Trust prefereds are generally pretty sticky around par because of the call features," the trader noted. Noncumulative perpetuals are a little more susceptible to price fluctuations, especially in the case of an interest rate hike.

Still, noncumulative perpetual preferreds - many of which are now currently yielding about the same as common stock - are not as prone to volatility as the common stock.

Shift to noncumulatives

In the end, investors had little choice as the new rules required banks to rid themselves of the trust preferreds.

"You either completely stay out of the market or you buy [straight] equities and take the risk that we do see a decent equity correction," a trader said.

And the high demand seen for the new noncumulative securities indicates that investors are more interested in reaching for yield, thus are willing to take on a little bit of risk that comes with the noncumulatives.

"They are priced right; otherwise you don't see this high demand that we've seen for [new] issuance that we've seen this year," the trader remarked.

"It is what it is," he said. "It's still one of the higher-yielding asset classes out there."

"It ended up being a net positive," said Kevin Conery, a preferred stock desk analyst at Piper Jaffray.

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