Preferred Stock Strategist
February Update
The following is a summary of a UBS full-length report on this topic.
Prices mostly unchanged:
Prices in our preferred coverage universe were largely unchanged last month, as a tightening in overall credit spreads helped to offset rising yields and increased supply.
* Catalyst for change:
Moody’s altered its rules for gauging equity credit for perpetual preferreds in 2005, and recently extended the guidelines to include trust preferred securities (TPS). Moody’s is now offering additional equity credit for TPS with super-long dated maturities, equity replacement language, and mandatory income suspension triggers.
* Enhanced Trust Preferred Securities:
Enhanced Capital Advantaged Preferred Securities (ECAPS) were the first TPS that allowed for the tax deductibility of interest payments, while also achieving more equity credit from Moody's. We expect these types of securities, of both $1,000 and $25 par types, to be a viable refinancing option for the $60 billion of existing TPS becoming callable in the next two years.
* Tax-advantaged update:
Any changes to the reduced tax rates that individuals pay on qualified dividends is likely to have a limited impact on DRD-eligible preferreds, which retain the tax-advantaged status for corporate accounts. Foreign preferreds, on the other hand, are more acutely sensitive to changes in individual tax rates on dividend income.
This report has been prepared by UBS Financial Services Inc. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
Prices in our preferred coverage universe were largely unchanged last month, as a tightening in overall credit spreads helped to offset rising yields and increased supply. This month, we maintain our modest underweight allocation in the preferred market. Prospects for expected credit deterioration, heavy net issuance, and a flat yield curve will likely pressure performance even as the interest rate outlook is more benign.
Moody’s altered its rules for gauging equity credit for preferreds in 2005, which proved to be a catalyst for change in the preferred market. In particular, Moody’s raised the equity credit for perpetual preferreds and those with super-long maturities that also provide triggers for suspending income distributions. Moreover, Moody’s recently extended their guidelines to include trust preferred securities (TPS). Moody’s similarly is now offering additional equity credit for TPS with super-long dated maturities, equity replacement language, and mandatory triggers that, if breached, would suspend income distributions.
The first new trust structure that came to market was issued for Lehman Brothers called Enhanced Capital Advantaged Preferred Securities, or ECAPS. This structure allowed for the tax deductibility of interest payments, while also achieving more equity credit than traditional TPS. The ECAPS were issued with a 60-year maturity, twice as long as a typical trust security, and mandatory suspension of income distributions.
The benefits associated with enhanced trust preferred securities coupled with the amount of existing issues that become callable this year will likely result in several billion dollars of new issuance, in our view. While it remains to be seen whether the bulk of the issuance will occur in $25 or $1,000 par values, the market has recently shown signs of expected increased supply. The recent out performance in the dividends-received deduction (DRD) segment of the market may be signaling a shift away from tax advantaged issues and towards trust preferreds.
Within the tax-advantaged segment, preferreds eligible for the corporate dividends-received deduction (DRD) have outperformed perpetual foreign preferreds. The potential for a reduced supply of DRD paper, coupled with uncertainty surrounding the extensions of the 15% dividend tax rates for individuals, has contributed to this repricing, in our view. Any changes to the reduced tax rates that individuals pay on qualified dividends are likely to have a limited impact on DRD-eligible preferreds. Foreign preferreds, on the other hand, are more acutely sensitive to changes in individual tax rates on dividend income. Should the 15% tax rate sunset without extension, foreign issues would be expected to underperform DRD-eligible preferreds. Conversely, should the favorable tax rates be extended until 2010 or made permanent, foreign issues would stand to outperform DRD issues, in our view.
|
