Trust-preferred security

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Trust-preferred securities are hybrid investments that act like both debt and equity. A company creates a trust, lends money to the trust, and the trust then issues preferred stock to investors. The issuer is usually a bank holding company.

Key features: these securities are long-term (often 30 years or more), can be redeemed early by the issuer, and pay fixed or variable interest. They mature at face value, and in many cases the issuer can defer interest for up to five years.

Why they matter: they can offer tax and regulatory advantages. Interest on the debt is deductible, while the dividends on the preferred stock come from after-tax income. For bank holding companies, these securities can count as capital (equity) for regulatory purposes if they meet certain conditions, helping with capital requirements. This can allow up to about a quarter of a bank’s core capital to come from these instruments.

How they’re set up: the issuing company forms a trust (often a Delaware or Connecticut trust) that owns the company’s common stock. The trust issues the preferred stock to investors, and the company issues junior subordinated debt to the trust. If the issuer is a bank holding company, it usually guarantees the interest and maturity payments on the trust’s preferred stock.

Why banks use them: for favorable tax, accounting, and regulatory capital treatment. However, they are costly. Investors demand high interest because these securities are subordinated and can be redeemed early or deferred, plus underwriting and legal fees are high. They have been linked to some bank failures in the past.

Regulation: the Dodd-Frank Act moved to exclude trust-preferred securities from regulatory capital for bank holding companies, with exceptions for very small banks and small holding companies meeting specific criteria (such as assets below certain thresholds).

Bottom line: trust-preferred securities offered capital benefits to banks, but new rules have narrowed that advantage. Other companies may use simpler forms of subordinated debt instead.