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What is a Trust-Preferred Security?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 19 August 2014
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Trust-preferred securities are investments that possess debt and equity attributes. The unique combination of debt and preferred stock is generally considered to be a viable long-term investment, although a trust-preferred security does allow for early redemption by the issuer of the security. Many examples of an investment of this type will also carry the ability to defer interest payments for up to five years after the initial date of issue.

In order to issue a trust-preferred security, a corporation will usually establish a trust to function as the entity that issues the security. The funding is provided by the corporation and is counted as a debt for the new trust. This formula creates a bank holding company, and is subject to the same regulations that govern the establishment of any holding company.

The bank holding company will hold all issued shares of the common stock connected with the security arrangement. Using the common stock as an underlying asset, the holding company issues preferred stock to investors. Any proceeds that are realized by the sale of the preferred stock are transferred back to the corporation. At the same time, the bank holding company will be the entity that guarantees the interest and payments that are issued over the lifetime of the security.

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One of the advantages to the issuer is that a trust-preferred security arrangement provides a number of tax and accounting benefits. Since the security is taxed as a business debt, it is possible to claim a deduction for the interest payments. This is different from the payment of dividends on other securities, which are calculated on after-tax income rather than pre-tax income.

When it comes to accounting, the setup of a trust-preferred security helps to keep the paperwork simple. Trust preferred securities do not have to appear as liabilities on the balance sheet of the corporation. Under the regulations that govern the structure of a bank holding company, a trust-preferred security is considered to be capital rather than a liability.

While there are advantages to a trust-preferred security, there are a couple of disadvantages to consider. One important consideration is the cost involved in establishing and operating the trust to administer the issuance of the preferred stock. The structure of the security also usually includes a high interest rate, owing to the possible of the issuer to claim an early redemption. In addition, the underwriting fees for the venture may be somewhat higher than with other stock options.

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anon256351
Post 3

I have a question: If the isssuer of said security, say a regional bank, loads a trust up with mortgages, are they obligated to buy those mortgages back if they sour and cause defaults within that trust preferred security? Or is the credit risk completely offloaded to the holders of said security?

everetra
Post 2

@SkyWhisperer - What’s weird is that this security can defer interest payments for up to five years.

If they do that, you won’t get any tax deductions until they start issuing the payments. So in my opinion the tax benefits should not be the main reason that you buy into the security. It should be the high yield, providing that you can stomach the risks.

My guess is that a lot of institutional investors buy these securities, but the article doesn’t say that individual investors can’t get in on these investments too.

SkyWhisperer
Post 1

I like the high interest payments that these trust preferred securities offer. While the article doesn’t say I bet the interest is higher than even common preferred stock.

I also like the fact that the interest payments are tax deductible, since this is a hybrid investment that is part debt, part equity. What I don’t like is the fact that the issuer of the security can choose to “redeem” the security at any time.

This means that you may not be able to hold it to maturity. I guess that’s the price you pay for the higher interest – it’s increased risk. I don’t think this is for everyone, that’s for sure. Perhaps a small holding of these instruments, as part of a balanced portfolio, wouldn’t hurt you.

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