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Published: March 14, 2009
Value-seeking income investors need look no further than the
ailing banking sector to find some hidden gems. The U.S.
government has lent and guaranteed literally trillions of
dollars to financial institutions to keep them from going
bankrupt. Treasury's plans to buy toxic bank assets and absorb
up to $200 billion in losses of mortgage lenders Fannie Mae
(NYSE: FNM) and Freddie Mac (NYSE: FRE) are the latest moves to
shore up the balance sheets of the country's major lenders so
they will start lending again.
Among some 120 beaten down firms that the government has so far
"invested" in, five in particular have become virtual wards of
state. Mortgage giants Fannie Mae and Freddie Mac, American
Insurance Group (NYSE: AIG), Bank of America (NYSE: BAC), and
Citigroup (NYSE: C) -- these companies are too big to fail.
The government is doing whatever it can to keep these firms from
the fate of Lehman Brothers, whose bankruptcy last September
helped trigger the current downturn in financial markets around
the world. As Treasury Secretary Timothy Geithner said at his
confirmation hearing, Lehman's failure "didn't cause this
financial crisis, but it absolutely made things worse."
But government money comes with strings attached. Over-extended
mortgage giants Fannie and Freddie were effectively nationalized
last September, when the government put them into
conservatorship and agreed to inject $100 billion in each
company as needed. September also saw the government assuming an
80% stake in failed insurance giant American International
Group, in return for an $85 billion capital injection. The U.S.
government is now also the biggest shareholder in Bank of
America, owning a 6% interest, and in Citigroup with a 7.8%
interest.
So how can income investors capitalize on the de facto
nationalization of these financial institutions?
Partner with the U.S. Government
As Bill Gross, founder of the largest bond fund in the U.S.,
advised in his recent Investment Outlook, "Shake hands
with the government." Government backing should virtually
guarantee that these firms will not fail -- but buyer beware.
Some of the payouts are more secure than others.
What about their common shares? They have rallied recently in
response to Obama's latest efforts, but their share prices are
still dirt cheap and they sport enticing double and triple-digit
dividend yields. Remember, though, these companies have been
forced to slash payments because they can't afford to pay them.
Not only that, the common share dividends also face pressure
from the U.S. government, which wants to prevent shareholders
from benefiting at taxpayers' expense. As a condition of their
second round of government support, for example, both Bank of
America and Citigroup must limit quarterly dividends to no more
than a penny a share for the next three years. Payouts can't be
raised without government approval.
Focus on Debt not Equity
So it's not the equity but rather the debt of these
government-supported lenders that may offer income investors
relatively secure income stream. Unlike dividends, which are
discretionary, debt is a legal obligation. A company is required
to pay off its debt, unless it becomes insolvent or bankrupt.
Admittedly, these companies are facing a lot of headwinds, which
could threaten their ability to pay off their debt obligations.
But the government has shown that it will not let these
institutions fail. While these lenders may be forced to cut
their equity dividends, the government appears likely to provide
support for interest and principal payments on their debt.
One way for income investors to take a stake in these firms is
through their preferred shares -- but you need to tread
carefully. The dividends of a certain class of preferred stock
issued by these companies are questionable.
When Fannie Mae and Freddie Mac were placed into conservatorship
last September, the U.S. Treasury suspended indefinitely not
only all their common share dividends but all their preferred
stock dividends as well. This move doesn't bode well for a
certain category of preferred stock known as "traditional"
preferred stock that may be offered by other government-rescued
lenders.
Fannie and Freddie's traditional preferred stock is more like
equity -- its dividend payments, which qualify for the reduced
dividend tax rate, rank before common share dividends but after
any debt obligations.
A Buffet of High-Yield Debt Securities
In contrast, so-called trust preferred stock counts as junior
subordinated debt and the distributions are taxed as ordinary
income just like any bond. As debt, trust preferred stock
provides a greater degree of security than common or traditional
preferred shares.
Citigroup offers a full slate of these securities which trade on
the New York Stock Exchange under the tickers C-PE, C-PF, C-PG,
C-PO, C-PQ, C-PR, C-PS, C-PU, C-PV, C-PW, and C-PZ. Moody's and
Fitch recently lowered the credit rating on these issues to
"BB," but Standard & Poor's has thus far maintained their
investment grade rating of "A3."
AIG and Bank of America also offer some exchange-traded bonds
which as subordinated debt, are somewhat more secure than the
junior subordinated debt of Citigroup's trust preferred stock.
These investment-grade bonds are now trading at almost
ridiculous double-digit yields. For risk-averse investors,
the senior debt bond issues of all these firms provide secure
income and a relatively steady price.
Finally, Fannie and Freddie's so-called "agency debt" isn't just
investment grade. It's the highest "AAA"-rated debt, just below
U.S. Treasuries and above "AAA" corporate debt. These
government-sponsored mortgage issuers have had the implicit
backing of the U.S. government but now that support is far more
explicit. You can buy individual bonds and mortgage securities
issued by mortgage lenders Fannie and Freddie, but funds give
you a diverse portfolio with different maturities and yields.
Good Investing!
--Carla Pasternak
Editor
High-Yield Investing
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