Back to Trusts

Investors are wondering how they can begin to recover from the disastrous market collapse of 2008–2009. In only 16 months, the Dow declined 50 percent from its high in October of 2007 to lows not seen since 1997.

So, what to do? With many portfolios now in cash—earning about 1 percent interest—it may be time to check out the attractive returns of trust-preferred securities.

Trust preferreds were created by banks and insurance companies as a way to get favorable tax treatment while increasing their capital. Preferred dividends paid to investors normally are not deductible as a business expense. But with trust preferreds, a bank is paying interest to a trust company on a subordinated note, and the payment is deductible; the trust company pays out dividends. These publicly traded securities are issued at a par value (meaning the issue price is not linked to its market value) of $25. They have a very long term—30 or more years—before maturing at par. Dividends for trust preferreds are calculated as a percentage of their par value.

Think of trust preferreds as a holding strategy: Investors with a higher risk tolerance can use them as a substitute for cash or a slightly more aggressive fixed-income approach.

While many of the trust-preferred securities were originally issued years ago with a coupon dividend rate between 6 and 8 percent, the securities are now yielding between 9 and 13 percent. The financial panic cut the share price of some of these securities in half. But the dividend payment, which is fixed in its dollar amount relative to the par value of the security, is now double relative to the current share price.

The government’s massive infusion of capital into banks has added a layer of protection to the trust-preferred dividend. This investment took the form of perpetual-preferred shares (which have no maturity) paying a 5 percent dividend. These securities rank below the trust-preferred shares in a bank’s debt structure, meaning that the trust-preferred dividend is paid ahead of the government’s preferred dividend. Both rank ahead of common stock dividends. Dividends from perpetuals are qualified at a 15 percent tax rate, whereas trust preferreds are nonqualified and investors are taxed at their ordinary income tax rate.

Trust-preferred securities are issued by all major U.S. banks. For example, Wayzata-based TCF Bank issued a trust-preferred security last fall that pays 10.75 percent and trades near its par value of $25; U.S. Bank, based in Minneapolis, and Wells Fargo have similar issues in the market, which are yielding between 9 and 11 percent.