Bank Capital Notes Draw New Attention from Investors

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NEW YORK -- Bank capital notes, a hybrid security banks began selling late last year to raise money, deserve a second look, some investors say.

The notes, which share traits of stock and bonds, were an instant hit with investors when banks started selling them in November.

Lately, though, they've slumped along with banks' conventional bonds on concern that rising interest rates will erode bank profits. Some investors say now is the time to buy the notes, which yield more than banks' regular debt and stand to become rare once Congress passes a proposal to eliminate tax benefits for companies selling them. The prospects for the banking business also remain bright as banks diversify their operations, cut costs and combine with strong partners to meet competition. "If you like bank credits, you have to like capital notes," said Mark Pittman, who helps manage $4.5 billion of bonds at the Marshall Funds in Milwaukee. "It's a great story. Supply is limited." The rush to sell bank capital notes, also called trust preferred securities, began when the Federal Reserve decided in October that banks could count them as core Tier I capital, a bank's cushion against loan losses. Since then, banks sold $25 billion of them, according to Eric Grubelich, analyst at Keefe, Bruyette & Woods, Inc. Banks like them because they offer tax treatment of bonds and capital treatment of stocks. As with debt, banks can deduct dividend payments from taxes. Like preferred stock, they don't add to a company's debt-load and dividend payments can be halted for up to five years. Though the notes had a stunning debut, they declined recently and their yields rose relative to government debt. The gap in yield between bank capital notes and Treasury securities widened about 10 basis points since the Fed raised rates in late March. Banks are more sensitive to the threat of higher interest rates because their funding costs rise, narrowing profit margins on lending fees. Chase Manhattan sold $600 million of capital notes on Nov. 25 at a yield of 7.67 percent, or 120 basis points more than comparable Treasury securities. The spread narrowed by 25 basis points to 95 basis points in February. It has since reversed, widening to 112 basis points. Congress is expected to act on a proposal by the Clinton administration to eliminate these and other hybrids as a way to raise revenue to offset tax cuts. Existing notes, which would be protected from changes in the tax treatment, or "grandfathered," would become rare. While the proposal is tied up in congressional budget hearings, banks, taking advantage of the delay, are selling more. …


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