Trust-preferred securities (TruPS) are a type of hybrid security that combines the features of both debt and equity instruments. These securities are issued by banks and other financial institutions to raise capital for their operations. While they offer some attractive benefits, TruPS also come with certain risks that investors need to be aware of.
In this article, we will explore what TruPS are, how they work, the advantages and disadvantages of investing in them, as well as some factors to consider before investing in these securities.
What Are Trust-Preferred Securities?
Trust-preferred securities (TruPS) are a type of hybrid security that combine elements of both debt and equity financing. They were created under the Financial Institutions Reform Recovery Act (FIRREA) in 1989 as a way for banks to raise capital without diluting their existing shareholders’ ownership.
TruPS are issued by special purpose entities called trust companies or trusts. The trust company then uses the proceeds from selling these securities to buy subordinated debt from the issuer bank or financial institution. The subordinated debt is then used by the issuer bank as Tier 1 regulatory capital which can support its lending activities.
Unlike common stocks where dividends payments depend on profits earned by a company, TruPS pay fixed interest rate payments like bonds. However, unlike traditional bonds whose payment is guaranteed at maturity if not redeemed earlier by the issuer; TruPs have no such guarantee but typically have longer maturities ranging between 30-50 years or even perpetual life depending on the terms set forth at issuance.
How Do Trust-Preferred Securities Work?
To issue TruPS an issuing bank creates a special-purpose vehicle known as a Real Estate Mortgage Investment Conduit (REMIC). A REMIC is designed specifically for holding mortgage-backed securities which represents pools of residential mortgages or commercial real estate loans originated by various lenders across different geographic locations around US housing markets.
The REMIC then issues TruPS which are sold to investors in the capital markets. The proceeds from selling these securities are used to buy subordinated debt instruments from the issuing bank. The bank, in turn, uses this new Tier 1 regulatory capital and deposits it into its operations account.
The interest paid on TruPS qualifies as a tax-deductible expense for the issuer bank and is treated as dividends for tax purposes by investors who hold them through taxable accounts. However, if held through tax-deferred retirement accounts, such payments will be subject to ordinary income taxes upon withdrawal like any other qualified distribution.
Advantages of Trust-Preferred Securities
One advantage of investing in TruPS is that they offer higher yields than traditional corporate bonds or preferred shares issued by banks. This is because they carry more risk compared to these other types of securities which typically have less credit risk involved.
Furthermore, since banks cannot deduct dividend payments on their common stock when calculating their taxable income; they often prefer financing themselves with TruPs since the interest payments made on such security offerings can be deducted under US tax law rules.
Another advantage of investing in trust-preferred securities is that they have a lower correlation with stocks and bonds. They tend to perform better during periods of market volatility due to their hybrid nature and structure.
Disadvantages of Trust-Preferred Securities
While there are several advantages associated with investing in TruPS, there are also some risks that investors should consider before buying them.
One major disadvantage of these securities is that they come with a high degree of credit risk as issuers may default on interest or principal payments if they experience financial distress. In case this happens, bondholders will lose all or part of their investment depending on how much subordinate debt was outstanding at the time of default relative to total assets available for creditor claims against an insolvent issuer entity (bankruptcy).
Another key drawback associated with investing in TruPS is that they have a complex structure that can be difficult to understand for some investors. This makes it harder for them to assess the risks and rewards of investing in these securities compared to traditional bonds or preferred shares.
Lastly, due to their long-term nature, TruPs may not be suitable for investors with shorter investment horizons or those looking for liquidity as they cannot easily be sold on the secondary market without significant price discounts.
Factors to Consider Before Investing in Trust-Preferred Securities
Before investing in trust-preferred securities, there are several factors that an investor should consider:
1. Credit risk: As mentioned earlier, TruPS carry higher credit risk than traditional bonds or preferred shares issued by banks. Investors should carefully evaluate the creditworthiness of the issuer before making any investment decisions.
2. Complexity: Due to their hybrid nature and complex structure, investors should make sure they fully understand how these securities work before buying them.
3. Liquidity: Since TruPs are not actively traded on secondary markets like stocks and bonds, investors need to consider whether they will need access to their money quickly if required.
4. Yield: While high yields can be attractive, investors should also ensure that they are being adequately compensated for taking on higher risks associated with investing in TruPS.
Conclusion
Trust-preferred securities (TruPS) offer a unique opportunity for income-seeking investors who want exposure to both debt and equity markets through one hybrid security instrument. However, this type of security comes with its own set of risks that require careful evaluation before making any investment decisions.
Investors must carefully evaluate all factors including complexity, liquidity concerns as well as yield potential versus credit risk involved when considering adding these instruments into their portfolios alongside other fixed-income investments like corporate bonds or preferred stock options offered by banks issuing such non-common equity capital raising tools under regulatory guidelines set forth by US financial regulators under Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.