What are Trust Unit Preferred Shares (TruPS)?

Trust preferred shares (TruPS) are preferred shares typically issued by banks. And although they're called 'preferred shares,' there is a big difference between trust preferred stock and traditional preferred stock (issued by companies).

Traditional preferred shares, issued by companies, are an equity investment in that company. They are normally perpetual -- that is, they have no maturity date. If the company were to liquidate, equity preferred owners have a prior claim on the assets before common shareowners, but after all debt holders. Except for those issued by real estate investment trusts, dividends generally qualify for the lower dividend tax rate.

In contrast, trust preferreds are debt, not equity. As such, they provide greater safety than traditional preferred stock. They generally can be called after five years and interest payments are typically taxed at your marginal income tax rate.

How Do Trust Unit Preferred Shares (TruPS) Work?

It's important not to confuse the roles of trusts and banks. When you buy trust preferreds from a bank, you own shares in the trust, not the bank. That's because unlike equity preferred stock, TruPS aren't issued directly by the company. Instead, the company sets up a new company or off-balance sheet trust.

Also, when trusts issue new shares, the money it raises goes to the trust, not the bank. However, these trusts usually turn around and loan the proceeds from the offering to the underlying bank.

Any company can utilize TruPS, but banks tend to use issue them most for their tax and accounting advantages. They are taxed like debt obligations but can be classified as equity in a company's balance sheet. Additionally, they have a very long life term of usually 30 years and can be redeemed early by the issuer.

To illustrate, suppose ABC Bank sets up an off-balance sheet trust, called XYZ Trust. In an effort to raise money, XYZ Trust issues 100,000 new shares for $50 each. Investors purchase the TruPS, giving $5 million to XYZ Trust. The investors that purchased the TruPS now own shares in XYZ Trust. Later, XYZ Trust loans the $5 million to ABC Bank.

Why Do Trust Unit Preferred Shares (TruPS) Matter?

The July 2010 Financial Reform Act (Restoring American Financial Stability Act) has had a significant impact on TruPS which may influence the investing strategies of income investors.

The Collins amendment changes the way banks can count Tier 1 capital -- a gauge of the cash reserves banks can use to sustain losses if their borrowers don't repay loans. Before the legislation, trust preferreds had counted toward fulfilling a bank's Tier 1 capital ratio. The final legislation gives all banks with assets of $15 billion or more five years to exclude TruPS from their Tier 1 capital ratios.

In a nutshell, the amendment means banks which issued TruPS may seek to redeem them over the next three to five years.

This change has made TruPS an interesting option for income investors. When the TruPS were originally issued, they were given higher coupon rates normally allocated to instruments with long-term maturities of between 30 and 50 years.

Now with the possibility of retrieval within five years, these TruPS offer a far higher yield than originally intended by the issuing bank.