Should the fixed-income investor take a closer look at the new preferred stock issues, rated AA-, from Bank of America?
These new stock issues may seem complicated, and indeed they are. But it could be interesting. Certainly, don't let phrases like "non-cumulative perpetual" and "non-cumulative perpetual convertible" keep you away from these preferred stocks.
With the likelihood of more Fed rate cuts to come, U.S. dollar fixed-income investors can, at least for the rest of this year and probably beyond, wave goodbye to 5 percent yields on savings accounts and certificates of deposit (CDs).
Yields on money-market funds are also sliding and are already down to 4.14 percent from 4.35 percent before the recent 75 basis point Fed rate cut. They were expected to drop to the 3.5 percent zone in February and even further on the most recent, 50 basis point Fed cut.
For instance, Bank of America paid 3.11 percent on a 5-year CD on Jan. 28.
It's understandable that fixed-income investors are looking for valuable alternatives that offer decent yields. This could take investors to where many haven't ever gone before, including into "preferred stocks."
Unlike other U.S. financial institutions, Bank of America Corporation (BAC) is raising $12.9 billion in capital in its home U.S. market for its two new preferred stock issues.
One is perpetual preferred stock, series K issued by BAC that offers a fixed coupon of 8 percent through January 2018, when the rate will convert to a floating rate based on LIBOR + 3.63 percent.
These securities are priced at $1,000 each, representing 1/25th interest in a share of (8 percent) fixed-to-floating after 2018 (3 month LIBOR + 3.63 percent) "non-cumulative perpetual preferred stock, series K".
You can find the prospectus online. Do review the "risk factors" carefully.
The other is perpetual preferred stock, series L issued by BAC that will convert into common stock.
The shares, $0.01 par value, with a liquidation preference of $1,000 per share (the "preferred stock") bear a coupon of 7.25 percent and are convertible into 20 shares of Bank of America Corporation common stock at the holder's option, representing a $50 conversion price per common share, which is approximately a 25 percent premium over BAC's common stock price on Jan. 23, 2008, the pricing date for the offering.
Bank of America has the option to require conversion of Series L preferred after Jan. 30, 2013 at the prevailing conversion rate, if the price of the company's common stock exceeds 130 percent of the then-applicable conversion price for 20 trading days during any period of 30 consecutive trading days.
Again, see the prospectus, including the risk factors.
Proceeds of these securities – and this is important – qualify for Tier 1 capital at the corporate level under regulatory guidelines and bring the Bank of America's pro forma Tier 1 capital ratio back toward its target of 8.0 percent.
You might think Bank of America Corporation is making this enticing offer so that investors will plug leaks in the bank's balance sheet. That's right, but only in part.
Only in part because, by using these specific capital raising vehicles, Bank of America – as Morgan Stanley and Citigroup and others before it have done – will be allowed by the federal tax authorities to book the interest payments and dividends they make to investors as tax-deductible interest on debt.
These banks are taking advantage of a controversial 2003 Internal Revenue Service ruling that blessed the tax benefits of such deals. Yes, Bank of America makes you an interesting proposal while the Fed and the SEC consider the capital that was raised as Tier 1 capital, and the IRS accepts the dividend payments as tax-deductible.
The bond-ratings agencies also view the new financing as equity. Critics say that those payments aren't tax-deductible interest on debt but more like a "fixed" dividend, which normally wouldn't be tax deductible. In the end, it seems to be a good deal for the investors and the bank, but not for the IRS.
It's also noteworthy to remember that preferred dividend income for corporations are exempt from taxes up to 80 percent. The IRS calls it a "dividend received" deduction. Unfortunately, individuals are not eligible for this tax alleviation. But should not prevent individuals from owning preferred stocks.
Banc of America Securities is the sole manager for the offering of Series L convertible preferred stock. Banc of America Securities also serves as sole lead manager for the offering of the Series K preferred stock, with Morgan Stanley, UBS Securities, Loop Capital Markets, and The Williams Capital Group serving as co-managers.
In my personal opinion, these preferred stocks are defendable as AA- rated U.S. dollar fixed-income alternatives.
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