July 13, 2010

RE: Risk/Reward vol.7 Busch, John A (14977) Sent: Tuesday, July 13, 2010 1:12 PM T

THIS IS NOT INVESTMENT ADVICE.  IT  IS A PERSONAL REFLECTION.  RELY ON NOTHING STATED HEREIN. My pursuit of enhanced returns has led me to investigate trust preferred stock (TruPS).  This is a hybrid security consisting of a preferred stock bought by the shareholder issued by a captive trust , the sole assets of which are the bonds of the settlor/issuer, typically a bank holding company.  Interest payments on the bonds fund the pass through dividends on the preferred stock.  This mechanism allows banks to deduct the interest expense on the bonds, but to treat the proceeds of the bond sale as Tier 1 capital (equity) because the bank reserves the right to defer payment on the bonds for up to 5 years without being in default.  They are a creature of accounting regulation and tax law.    TruPS are not eligible for the 15% dividend rate because of the pass through nature of the trust (like a REIT or a BDC). From my perspective, because of their right to defer payments for 5 years, TruPS have significantly more risk than exchange traded debt securities (generally failure to pay interest upon constitutes a default, although they too can have special deferral provisions).  Therefore one should receive a premium in return for the added risk---and one does, currently.  Moreover, as a threshhhold the issuer should pay 40 to 50% higher dividends over traditional preferred stock to defray the additional tax burden from not being qualified (currently the difference between 15% and 35%).  Right now one can get over 5% on an A rated  qualified preferred (e.g. ED-A), therefore one should receive 7.25% on a TruPS comparably rated.  This is about where they are trading---see the Deutsche Bank TruPS.  I am still on the fence about these.  The GE play looks so much better even at the 100 to 120 bp reduction in return.  Thoughts? Coulda, shoulda, woulda.   The AIG bonds I bought in May at 102.50 are trading at 104.   The AIG 2018 bonds that I did NOT buy when yielding 9.2% are now yielding 7.2% .   BOO HOO.   As my wife always tells me, you don't lose weight by counting  the calories of the things you didn't eat---only that which you do eat. Bought ARCC and AINV in the 401K since the last newsletter and added to a few positions