In 2003 President Bush
lowered the tax on dividends substantially for individual investors.
Ironically, just as investor demand for preferred stock would have
increased, the supply of preferreds was sparse.
In 1993, the financial
engineers at Goldman created a new type of security that was the “holy
grail” for issuers: a security that could be considered debt for tax
purposes but treated as equity for capital purposes. Texaco issued the
first MIPs (Monthly Income Preferred
Securities). The name is misleading to investors because the MIPs
pay interest, not dividends as they might expect from a preferred stock.
The payments are taxed at the maximum rate not the favorable rate
available to dividends from “real” preferreds.
The issuance of these
“Trust Preferreds” really took off in late 1996 when the Federal
Reserve ruled that these securities would constitute Tier 1 Capital to
Bank Holding Companies. Between the ruling in mid-October and December 31,
1996, forty banks issued $15 billion in “trust preferreds.
In 1997 Enron’s VP of
finance was quoted as saying that
he was hoping their two recent MIPs issues of $350 million “would allow
the company’s rating to be improved from BBB+ to A-“; Enron alone
issued $800 million in “trust preferreds”.
GM offered investors the
opportunity to exchange their GM “real” preferreds for “trust
preferreds”. So did U.S. Steel, McDonalds, SunAmerica and RJR Nabisco.
At least 29 companies issued “trust preferreds” to redeem their
By 2003, $211 billion of
“trust preferreds” were outstanding. At that time the total of all
“preferreds” was only $250 billion; and that total included REIT
preferreds that also do not pay “real” dividends taxed at 15%. Today
there are only about 100 issuers of “real preferreds”.
A little background on
Preferred stocks are below
debt in the event of bankruptcy but are senior in payment to common stock.
Preferreds were invented by the financial engineers of the 1800s. The
first were issued in Britain to raise funds to complete the Canal system.
In 1850, railroads in the U.S. were limited in their borrowing capacity by
government mandate. The equity owners did not want more common stock
issued that would cause dilution and thus the first preferred stocks were
issued in the U.S.
Companies do not get a
deduction for payments of dividends on either common or preferred stock. A
company that replaced a “real” preferred with a “trust” preferred
increased their borrowing cost a bit pre-tax but were now able to deduct
the cost, lowering the after tax cost of the offering. Money raised
through a debt offering (that has to be paid back) is not good capital,
common or preferred stock is. MIPS got the best of both worlds.
Individual investors need
to hold “real” preferreds for a minimum of 61 days in order for the
dividend to be “qualified” for the reduced tax rate. Individual
investors who borrow to finance the purchase of preferreds are
allowed to deduct any interest expense incurred to carry the preferreds.
Interestingly, corporations cannot
deduct interest used to carry dividend paying stocks similar to the
prohibition on investor’s ability to deduct interest incurred to carry
tax-free muni bonds. The leveraged purchase of a high quality preferred
stock paying a tax-favored stream of income financed by deductible
interest expense could offer an attractive after-tax return to individual
The Dodd-Frank legislation
has effectively changed the landscape. Dodd-Frank phases out the ability
for companies to treat “trust preferreds” as good Tier 1 capital
starting in 2013. These companies must find other ways to increase their
regulatory capital base.
recently offered to exchange their “trust preferreds” for “real”
preferreds reversing the process started in 1993. The money raised from
these “real” preferreds will constitute good capital under both
Dodd-Frank and Basel III. We hope this is the first of many exchange
offers/refinancings. Ironically, the supply of preferreds might increase
just when the Bush tax cuts expire and the tax on dividends skyrockets to
43.4% from 15%.
Investors should be aware
that investments in preferred stocks entail risk. Investors should
carefully consider these risks before investing in any preferred stocks.
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