Introduction to Trust Preferred Securities

A trust-preferred security attempts to retain the best features of common and preferred stock by behaving like both a debt and an equity. Common stock is an issuance of equity that gives an investor voting rights and repays an investor based on how well the equity grows. Preferred stock is also equity, but it behaves like a debt by offering high dividends but no voting rights. Trust-preferred securities offer fixed payments and a set maturity, making them like a debt as well, but Generally Accepted Accounting Principles (GAAP) allow a company to still consider these securities part of its equity.

Features of a Trust-Preferred Security

The exact features a company chooses to offer on any particular preferred stock is up to the company. However, there are four main features that characterize a trust-preferred security. First, the security is usually held long term; and second, it matures at a specific date. This makes the security more like a bond than a stock. It also makes quarterly fixed interest payments and, four, has early redemption features. The quarterly payments make a trust-preferred security like other preferred stock. Early redemption options, though, make it unique. Rather than converting the stock into common stock, this feature allows an investor to receive a set par value in return.

Bond vs. Stock

All of the features above make a trust-preferred security like a bond. As a result, the IRS treats the issuance like a debt. It uses the fixed rate paid on the security as the interest rate on the debt, and this becomes a tax deductible expense in the year it is paid. One of the major drawbacks of issuing a bond, though, is that the debt will show up on a balance sheet in addition to a tax return. The balance sheet counts the bond as a negative asset, or a debt, and it partly reduces the company's financial standing. A unique feature of a trust-preferred security, though, is the fact that GAAP treats this instrument like any other stock. It counts the asset as positive, and the company actually appears to be in better financial standing having issued the stock.

Purchasing Trust Preferred Securities

As an investor, you benefit from the stability of trust-preferred securities. Like bonds, they have very predictable returns over time, and you will rarely lose the par value you have invested unless the company cannot repay its debts. Like stock, however, the rates on a trust-preferred security tend to be higher than average bond rates. This means you can make a slightly higher dividend payment on the preferred security than you would earn by purchasing a comparable bond. The challenge to this option is typically the cost, however. The company can request a higher payment for the trust-preferred security than for common stock because of the low risk factor. In the end, you may earn more for your dollar on common stock, and the risk of purchasing the common stock will be well worth the reward.

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