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Banks Find New Way to Squeeze Investors: Street Whispers

NEW YORK ( TheStreet) -- Fixed-income investors are in the midst of a harsh transition as banks redeem their trust preferred shares.

In June the Federal Reserve proposed enhanced capital requirements for large banks that exclude most trust preferred shares from regulatory Tier 1 capital. Since this is considered a "capital treatment event," banks can redeem their trust preferred shares, even before the call date, often at face value, despite any premium the market previously placed on trust preferred shares paying high dividends.

Investors who "went in" over the past several years -- while possibly paying premiums for trust preferred shares on top of any commissions paid to their brokers -- are not only facing possible capital losses, they face a huge headache in trying to replace as much of their lost income as possible, without greatly increasing their risk.

Investors who traditionally relied on municipal or corporate bonds for income, have faced a difficult choice for nearly two decades as yields have declined, either to accept ever-shrinking yields or broaden their horizons.

Under the Federal Reserve's proposed new capital rules, banks will be able to have noncumulative perpetual preferred stock making up between 1% and 1.5% of their Tier 1 risk-based capital ratios.

So we're in the midst of a wave of trust preferred redemptions, with some banks and financial services companies also issuing new preferred shares with lower coupons, that are noncumulative, meaning that dividends can be suspended without missed dividends in arrears being paid.

Banks are benefiting greatly from this transition by lowering their interest expenses.
  • JPMorgan Chase (JPM - Get Report) on July 12 redeemed $9 billion in trust preferred shares, including nearly $4.2 billion with coupons higher than 6.5%. All the shares were redeemed for face value.
  • Bank of America (BAC - Get Report) on July 25 redeemed $3.9 billion in trust preferred shares, all of which had coupons of 6.00% or higher, with $2.3 billion paying over 7.50%. The company paid premium redemption prices for $1.8 billion of the redeemed trust preferreds. When Bank of America announced its second-quarter results on July 18, the company said that the retirement of trust preferred securities and debt, combined with "additional liability management actions announced for the third quarter of 2012, are expected to benefit quarterly net interest income by approximately $300 million, of which $60 million was recognized in the second quarter of 2012."
  • Many regional banks are also following the trend, as the regulators have given them no choice, including BB&T (BBT) of Winston-Salem, N.C., which in July redeemed $3.1 billion in trust preferreds at face value, of which $350 million paid a fixed rate of 8.10%, while $575 million paid a fixed rate of 9.60%.

Speaking about the current wave of trust preferred redemptions, one veteran Wall Street bond portfolio manager says "people are definitely upset and perplexed, but one way [quality-seeking] investors can try to make up for this, is to buy these new perpetual preferreds, all of which are noncumulative."

The portfolio manager adds that "high-yield spreads are pretty wide, given the relatively good news out there, corporate-wise, at least."

So where do investors go from here? There are many directions to turn, and investors had better bone-up on the various risks and rewards. Here are a few examples, none of which are recommendations. You should sit down with your broker and discuss your new income-generating investments at great length, to fully understand all the risks.
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