New Law Creates Opportunity For Capital Gain Income On Your Preferred Stocks

With the run-up in preferred stock market prices that we have seen over the last couple of years, many preferred stock investors are wondering if they are better off selling and pocketing their unrealized capital gains or continuing to hold and collect more dividend income.

I’ll explain and walk you through an example in a moment, but if you own Big Bank-issued trust preferred stocks (TRUPS) here’s the magic number: any shares where your brokerage account is showing a current capital gain of more than $4.50 per share deserve special consideration.

Section 171 of the Wall Street Reform Act, signed into law in late-July, created the largest single opportunity for preferred stock investors in history (read the details here). Because of the new law, effective January 1, 2013 Big Banks (assets greater than $15 billion) will no longer be able to count their TRUPS toward their reserves (“Tier 1 Capital”) and will therefore almost certainly redeem (“call”) them and replace them with new traditional preferred stock issues (which will still be allowed to be counted).

So these preferred stocks have about nine quarters left before they start falling under the provisions of the new law. Big Bank-issued TRUPS pay about $0.50 per share in dividends every quarter. That means that any Big Bank-issued TRUPS that you happen to own that are redeemable (i.e. have a call date) prior to January 1, 2013 have about $4.50 in dividend payout left in the event they are redeemed by the issuing bank (which the new law makes very likely).

If you currently have an unrealized capital gain on a Big Bank-issued TRUPS staring back at you from your brokerage statement that is more than $4.50 per share, you are very likely to be money ahead by selling such shares now since the remaining dividend payout, in the event of a call, is less than your current, unrealized capital gain that you can collect right now by selling.

While a $4.50 per share capital gain sounds like a lot (and, historically, it is), such unrealized gains are very common at the moment because of the rock-bottom preferred stock prices that we saw during the Global Credit Crisis. If you purchased any Big Bank-issued trust preferred stocks during the crisis, it would not be unusual for your shares to be showing a current unrealized capital gain of more than $4.50 per share. Many such TRUPS that were purchased during the crisis for less than $20 per share are now selling for well above $25, meaning that the capital gain you would realize by selling now is greater than the remaining dividend payout (in the event of a call when the new law kicks in).

Example

To protect the value of subscriptions to the CDx3 Notification Service (my preferred stock email alert and research newsletter service), I will use a real example here but substitute “PFD-A” for its real trading symbol.

Say you purchased PFD-A (a Big Bank-issued trust preferred stock) during the crisis for $20 per share. PFD-A has a coupon rate of 8.0%, has a call date of August 2012 and is selling today for about $26. So you would pocket a $6 per share capital gain if you were to sell your shares of PFD-A today.

With a coupon rate of 8%, a share of PFD-A generates $0.50 per quarter in dividend income for you. That means that if you hang onto your shares of PFD-A it will take twelve more quarters (three years) for you to make the same $6 that you can make today in one shot by selling and pocketing the $6 capital gain.

To many investors, having the $6 now rather than waiting three more years for the same money starts to make a certain amount of sense.

But here’s where the new law makes this even more interesting. PFD-A is a Big Bank-issued TRUPS and therefore comes under the provisions of section 171 of the new Wall Street Reform Act. Since PFD-A has a call date in August 2012, it will almost certainly be called by the issuing Big Bank between that date and January 1, 2013.

That’s nine quarters from now, which means that you are only likely to see $4.50 in remaining dividend payout ($0.50 per quarter times nine remaining quarters), short of the $6 that you need to break even.

Whether or not to sell your Big Bank-issued TRUPS is a decision that only you can make in light of your personal financial goals, resources and risk tolerance. But if you are considering selling and are not sure which issues might be good candidates, the just-signed Wall Street Reform Act has identified a good place to start looking - Big Bank-issued TRUPS that show a current, unrealized capital gain of at least $4.50 per share in your brokerage account.

Already a subscriber to the CDx3 Notification Service? See the CDx3 Discussion Group on the subscriber's website for the trading symbol of the preferred stock example described above.

Many Happy Returns.