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Banks Find New Way to Squeeze Investors

Philip van Doorn |Bank Analyst
Thursday, 2 Aug 2012 | 4:13 PM ET

Fixed-income investors are in the midst of a harsh transition as banks redeem their trust preferred shares.

The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

In June, the Federal Reserve proposed enhanced capital requirements for large banks that exclude most trust preferred shares from regulatory Tier 1 capital.

Since this is considered a "capital treatment event," banks can redeem their trust preferred shares, even before the call date, often at face value, despite any premium the market previously placed on trust preferred shares paying high dividends.

Investors who "went in" over the past several years — while possibly paying premiums for trust preferred shares on top of any commissions paid to their brokers — are not only facing possible capital losses, they face a huge headache in trying to replace as much of their lost income as possible, without greatly increasing their risk.

Investors who traditionally relied on municipal or corporate bonds for income, have faced a difficult choice for nearly two decades as yields have declined, either to accept ever-shrinking yields or broaden their horizons.

Under the Federal Reserve's proposed new capital rules, banks will be able to have noncumulative perpetual preferred stock making up between 1 percent and 1.5 percent of their Tier 1 risk-based capital ratios.

So we're in the midst of a wave of trust preferred redemptions, with some banks and financial services companies also issuing new preferred shares with lower coupons, that are noncumulative, meaning that dividends can be suspended without missed dividends in arrears being paid.

Banks are benefiting greatly from this transition by lowering their interest expenses.

JPMorgan Chase on July 12 redeemed $9 billion in trust preferred shares, including nearly $4.2 billion with coupons higher than 6.5 percent. All the shares were redeemed for face value.

Bank of America on July 25 redeemed $3.9 billion in trust preferred shares, all of which had coupons of 6 percent or higher, with $2.3 billion paying over 7.5 percent. The company paid premium redemption prices for $1.8 billion of the redeemed trust preferreds.

When Bank of America announced its second-quarter results on July 18, the company said that the retirement of trust preferred securities and debt, combined with "additional liability management actions announced for the third quarter of 2012, are expected to benefit quarterly net interest income by approximately $300 million, of which $60 million was recognized in the second quarter of 2012."

Many regional banks are also following the trend, as the regulators have given them no choice, including BB&T of Winston-Salem, N.C., which in July redeemed $3.1 billion in trust preferreds at face value, of which $350 million paid a fixed rate of 8.1 percent, while $575 million paid a fixed rate of 9.6 percent.

Speaking about the current wave of trust preferred redemptions, one veteran Wall Street bond portfolio manager says "people are definitely upset and perplexed, but one way [quality-seeking] investors can try to make up for this, is to buy these new perpetual preferreds, all of which are noncumulative."

The portfolio manager adds that "high-yield spreads are pretty wide, given the relatively good news out there, corporate-wise, at least."

So where do investors go from here?

There are many directions to turn, and investors had better bone-up on the various risks and rewards. Here are a few examples, none of which are recommendations.

You should sit down with your broker and discuss your new income-generating investments at great length, to fully understand all the risks.

BB&T recently issued noncumulative perpetual preferred shares with a coupon of 5.625 percent. This is a decent yield in the current environment, especially when considering that BB&T is in excellent shape, but it is a bitter pill for investors who recently had higher-paying trust preferreds pulled out from under them.

General Electric subsidiary GE Capital in June issued $2.25 billion in subordinated noncumulative preferred stock paying a fixed-rate of 7.125 percent until June 15, 2022, after which the shares will pay a floating rate, based on three-month Libor plus 529.6 basis points.

That's a beautiful deal, with one catch: The minimum investment is $100,000.

GE Capital in July issued another $1.75 billion in subordinated noncumulative preferred — again priced at $100,000 a share — paying a fixed 6.25 percent until Dec. 15, 2022, after which the shares will pay three-month Libor plus 470 basis points. This deal perfectly illustrates the dramatic and painful change in the market for fixed rate paper over the course of a month.

Another quality direction you may choose is energy limited partnership shares. Two lovely examples are Kinder Morgan Energy Partners and AmeriGas Partners.

KMP is mainly a gas pipeline operator. The partnership shares have a yield of 6.15 percent, based on the most recently quarterly distribution of $1.23 and Tuesday's closing price of $80.03.

Kinder Morgan Energy Partners has had a very strong track record for dividend increases over the past several years, and the stock's five-year chart is rather lovely, showing plenty of growth on top of the income:

AmeriGas is a domestic propane distributor. The partnership shares have a yield of 7.58 percent, based on the most recent quarterly distribution of 80 cents, and Tuesday's closing price of $42.19. Like KMP, APU has been a winner over the past five years:

Of course, these are two extreme examples of income-oriented investments that have also brought home strong growth returns for investors.

You may also consider income-oriented ETFs, REITS, and other income-oriented investment vehicles. It is important to look in the mirror and consider your objectives.

Depending on the investment vehicle and the direction of the economy, you could be facing declining share prices when interest rates rise. How will you react?

If your objective really is to find a secure stream of income over a very long-term horizon, the movement of interest rates and share prices should not cause you to panic.

Then again, if you are obsessed with day-to-day price fluctuation, you need to rethink your investment income strategy.

—By TheStreet.com's Philip van Doorn

Additional News: Raymond James Slashes Banks

Additional Views: Banks, Market Set to Soar: Bove

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Disclosures:

TheStreet’s editorial policy prohibits staff editors, reporters, and analysts from holding positions in any individual stocks.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. He previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico.

GE is the minority owner of NBC Universal, the parent of CNBC.

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