For a Limited Time Only—No, Really
What would eventually come to be called preferred securities have been around since at least the early 1800s. Known then as preference shares, they were issued to help finance capital-intensive projects such as railways and other infrastructure. Investors wanted a preferential structure that assured they were compensated before any payments were made to common stock holders.
Back in 2010, a dramatic shift (which we refer to as the “Technical Trifecta”) began to affect this highly specialized market, with the impacts taking hold in 2013:
- Changes to rating agency (such as Moody’s) ratings of hybrid preferred securities.
- Basel-3 will gradually phase out hybrid preferred securities from Tier 1 capital over the next 10 years.
- The Dodd-Frank Act requires the phasing-out of trust preferred securities from the Tier 1 capital treatment beginning in 2013.
This timeline outlines how these regulatory changes could play out.
Historically, banks issued TRUPS primarily because these securities count toward a key measure of a bank’s reserves (Tier 1 capital). However, with the phase-out of the favorable Tier 1 or rating agency capital treatment illustrated above, these securities will likely be seen as very expensive borrowing and be called over the next few years. They’ll need to be replaced by common equity or the other preferred securities that meet regulators’ new standards, leading many to believe the market could double in size.
With the changing regulatory environment, shortened call cycle, new complexities getting added to an already-nuanced asset class, and need for ongoing bank credit analysis, professional management can help to navigate the opportunities available.
Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Risks associated with preferred securities differ from risks inherent with other investments. In particular, in the event of bankruptcy, a company’s preferred securities are senior to common stock but subordinated to all other types of corporate debt.
Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc.