What it means
The structure has three steps. A company creates a trust, the trust sells preferred securities to investors, and it uses the proceeds to buy subordinated debt from the parent.
The parent's interest payments flow through the trust to the investors as regular distributions. Because the parent's payments are legally interest on debt, the parent can usually deduct them for tax, which preferred dividends do not normally allow.
At the same time, regulators once treated the securities as capital for banks, because the parent could defer payments for up to five years without defaulting. That combination made them a cheap way to raise money.
For investors, the attraction was a higher yield than ordinary bonds. The risks are that payments can be deferred, the securities rank below ordinary debt if the issuer fails, and prices can fall sharply if the issuer's credit worsens.
They typically have long maturities, often 30 years, and an option for the issuer to repay early. After the 2008 crisis, reforms in the Dodd-Frank Act phased these securities out of the highest tier of regulatory capital for larger banks, and issuance by those banks dropped sharply.
Some smaller banks were allowed to keep existing ones, and the structure still exists in other forms. Finance teams reading a balance sheet should check how these are classified.
They may appear as debt, as minority interest or as a separate category, and the treatment can differ between regulators, tax authorities and accounting standards. Analysts therefore look through the label to the terms.
The key questions are how long payments can be deferred, whether missed payments build up, and where the security ranks if the issuer fails.
In practice
Real-world examples.
Example
A regional bank holding company issued trust preferred securities to boost its capital before the financial crisis. It counted them toward regulatory capital and paid quarterly distributions to investors.
Example
A retired investor buys a trust preferred security paying 7.5% from an insurance company. She understands that the payments can be deferred for up to five years, and that the security ranks below the insurer's ordinary bonds. She limits the holding to 5% of her portfolio for that reason.
Example
A bank's credit analyst compares two funding choices, trust preferred and ordinary senior debt. The senior debt costs 1.5 percentage points less, but the trust preferred security counted as capital and allowed the bank to lend more. The analyst concluded that the extra lending capacity was worth more than the higher cost.
Formula
Calculation
After-tax cost = Coupon rate x (1 - Tax rate)
A bank holding company issues $100,000,000 of trust preferred securities with a 7% coupon. The yearly distribution is 100,000,000 x 0.07 = $7,000,000, which is tax-deductible as interest.
At a tax rate of 25%, the tax saving is 7,000,000 x 0.25 = $1,750,000, so the after-tax cost is 7,000,000 - 1,750,000 = $5,250,000, or 5.25% of the amount raised. Ordinary preferred shares at the same 7% would cost the full $7,000,000 because the dividends are paid from after-tax profit. The tax saving of $1,750,000 a year is the main reason the structure was popular.Case study
Seen in the real world.
Highland Savings Group is an illustrative, fictional bank holding company with $4,000,000,000 of assets. It issued $60,000,000 of trust preferred securities at 8% to strengthen its capital ratio.
When loan losses grew, the board deferred the distributions of $4,800,000 a year to preserve cash. Investors protested, and the securities lost 40% of their market value. The missed payments were cumulative, which meant they still had to be paid later, and the company could not pay dividends on its own shares during the deferral.
The illustrative lesson is that the hybrid features carry real risk. Highland resumed payments after returning to profit, but its treasurer later wrote a policy requiring a clear explanation of deferral risk for any hybrid investment the company bought.
Watch out
Common mistakes.
- Treating a trust preferred security as ordinary preferred stock, when the payments are interest on debt for tax purposes.
- Assuming payments can never be skipped, when issuers can usually defer them for a set period.
- Thinking they still count fully as top-tier capital for large banks, when later reforms restricted this.
Questions
People also ask.
Why did banks issue trust preferred securities?
They gave tax-deductible funding that regulators once counted as capital, so they were cheaper than raising new shares.
What is the main risk for investors?
Payments can be deferred and the securities rank below senior debt, so they can lose value quickly if the issuer weakens.
Are they still issued?
Large banks largely stopped after the reforms, though similar hybrid structures remain in use by other types of issuers, and older securities still trade in the market.
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