Although investors usually consider common stock and bond debt when they investigate investing in a company, many corporations choose alternative means to raise capital. Preferred stock and trust-preferred securities – which are sometimes known as trust-preferred stock – are additional options for financing a publicly traded company. Wise investors should understand the mechanics of each type of investment, and how it may impact a company’s bottom line or common-stock obligations, before considering purchasing either preferred stock or trust-preferred securities.
Preferred stock is equity in a company that holds a higher claim on earnings than common stock, and holders of preferred stock receive dividends before the company divides earnings among common stockholders for dividends. Unlike common stock, which awards variable dividends depending upon a company’s performance, preferred stockholders receive the same dividend each reporting period in a manner similar to bondholders. Unlike bond debt, which is reported as debt on a company’s balance sheets, preferred stock is treated as equity.
Although similar to preferred stock, a trust-preferred security indirectly leverages funding through a third party, using an instrument known as a special-purpose vehicle. In most cases, a bank or insurance company creates a special-purpose vehicle, which owns a portion of the company. This trust is then sold to investors indirectly, and the third party issues investors dividends loosely based upon the performance of the original company. The special-purpose vehicle performs largely as if it were a bond, paying coupon interest and maturing at a later date, usually 30 years, at which time an investor receives the security’s face value. Although trust-referred securities aren’t bonds, the IRS taxes them as if they were bond debt, making payments tax-deductible. Trust-preferred securities appear on a company’s balance sheet as equity, not debt.
For most investors, short-term returns don’t vary much between preferred stock or trust-preferred securities. For example, two banks post profits of $100,000 and each determines it will share earnings with investors. The first, which issued 1,000 shares of preferred stock with a quarterly dividend of $10 each, provides $10,000 to preferred shareholders. It splits the remaining amount, $90,000, among common stockholders. The second company, which owes payments on $10,000 to a special-purpose vehicle to pay for its trust-preferred security, provides the same payment to the security holders, then divides remaining earnings among common stockholders.
Choosing Preferred Stock or Trus Preferred Securities
Many companies choose to raise capital through trust-preferred securities rather than traditional equity through trusts that facilitate the security. Because payments on trust-preferred securities are deductible, many companies choose that option rather than issuing preferred stock. Because securities eventually mature, however, a bank must eventually raise the capital to buy back the securities when they reach maturity, a factor with which those that issue preferred stock don’t need to contend.