An Investor's Guide to Preferred Securities

september 2013

An Investor’s Guide to Preferred Securities

SUMMARY Table of Contents

Preferred securities combine features of both fixed income 2 What Are Preferred Securities? and equity investments and are commonly referred to as hybrids. 2 traditional Preferred Stock They may appeal to suitable individual investors because they 3 trust and Enhanced Trust Preferred have historically offered relatively attractive yields and low Securities investment minimums (par values). 4 Additional Preferred Structures

Preferreds generally fit into three categories: 4 Overview of Investment Features

• Senior notes — Also known as “baby bonds,” these debt securities are senior, unsecured 6 Understanding Preferred Securities’ obligations of the issuer and pay regular interest income. Senior notes rank equally in a Credit Ratings corporation’s capital structure with traditional, $1,000 par senior unsecured bonds. 6 Investment Considerations • Trust preferred, enhanced trust preferred and junior subordinated debt securities — These subordinate debt instruments have fixed, long-term maturities (30 years, 60 years or per- 7 taxation of Preferred Securities petual) and pay monthly, quarterly or semiannual interest that can be deferred. Most of 7 preferred Securities at these preferreds, however, require that missed payments accumulate and be paid before Morgan Stanley any dividends are distributed to equity shareholders. • Perpetual preferred stock — This is traditional preferred stock that represents a nonvoting equity position in a corporation. Issued in perpetuity, traditional preferreds pay quarterly dividends that may be deferred without any obligation that the issuer make up missed payments (noncumulative). Real estate investment trust (REIT) preferreds, a subset of this category, is an exception because their dividends are cumulative.

This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. This is not a research report and was not prepared by the research departments of Morgan Stanley & Co. LLC or Morgan Stanley Smith Barney LLC. It was prepared by Morgan Stanley Wealth Management sales, trading or other non- research personnel. Past performance is not necessarily a guide to future performance. Please see additional important information and qualifications at the end of this material. An Investor’s Guide to Preferred Securities

What Are Preferred Securities? Traditional Preferred Stock DRD Eligible Preferred Stock Preferred securities are financial Traditional preferred stock (sometimes Dividend Received Deduction (DRD) instruments that possess both equity called perpetual “preferred” stock) preferreds make up the largest portion of and fixed income characteristics, represents a nonvoting equity position the traditional US preferred stock mar- so they are commonly referred to as in the issuing company and has no set ket. These securities are typically non- hybrid securities. The term preferred maturity date. Dividends are generally cumulative and generally pay quarterly refers to the securities’ senior posi- paid quarterly, are usually a fixed per- dividends that are tax-advantaged for tion to common equity in the cor- centage of the face value (par) — or are corporations. Internal Revenue Service porate capital structure. Preferred set at a percentage spread to a bench- rules allow corporate income taxpay- owners have a priority claim over mark rate — and may be deferred with- ing US companies to exclude 70% of common shareholders, but not bond- out any obligation that the issuer make the dividend income they receive from holders, with respect to dividends / up missed payments (noncumulative). their taxable income. In addition, these interest and any distribution result- Traditional preferred stock falls securities pay qualified dividend income ing from liquidation. into three main categories: (QDI), which is a favorable tax treatment There are many types of preferreds • Dividends received deduction (DRD) on dividend income for individuals. (See and it is important that investors eligible preferred securities page 7 for a discussion on QDI.) DRD eli- understand the various levels of • Real estate investment trust (REIT) gible preferred stock is generally subject subordination and where each ranks preferred securities to US tax withholding for nonresident in the capital structure. • Non-US preferred securities alien (NRA) clients.

Sale, Liquidation Proceeds or Revenue From Operations Available for Distribution Capital Seniority Preferred Seniority

1st From available assets after secured debts administrative and legal expenses are paid in full. Prioritygeneral of Payment unsecured Table

2nd From available assets after secured senior unsecured debt is paid. senior notes / baby bonds From available assets after secured subordinated debt and senior unsecured debts are paid.

3rd junior subordinated From assets remaining after secured enhanced trust debt debt, senior unsecured and subordinated debt have been paid in full. preferreds trust preferreds 4th From assets remaining after payment preferred stock / preferred stock of all debts and liabilities including govt. tarp costs of distribution and liquidation. preferred stock last From assets remaining after payment common stock of all debts and liabilities including costs of distribution and liquidation, after preferred stock.

This material is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. This material was not prepared by the research departments of Morgan Stanley & Co. LLC or Morgan Stanley Smith Barney LLC. Please refer to important information and qualifications at the end of this material.

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REIT Preferreds A real estate investment trust (REIT) is a trust or corporation that owns and manages income producing real estate. By law, REITs must distribute at least 90% of their net income to common shareholders in the form of dividends. Generally, REIT preferred stock is senior to common equity, is perpetual enhanced trust preferreds proved to as well as cumulative and is generally be a favorable alternative to tradi- ineligible for QDI tax treatment. Divi- tional preferred stock and common dends are generally subject to US tax equity. (See “Why Companies Issue withholding for NRA clients. Preferreds,” page 4.) These exchange-listed preferreds The enhanced preferred structure rank equally with other unsecured Non-US Preferreds was introduced in 2005, and these and unsubordinated debt of the issuer Issued by foreign companies that raise securities share many of the same and generally receive credit ratings capital in the United States, the major- characteristics as trust preferreds. equivalent to the senior long-term debt ity of non-US preferreds are traded on Generally, enhanced trust preferred rating of the issuer. US exchanges and are issued in $25 securities have longer stated maturity denominations.1 Non-US preferreds dates and interest deferral periods Junior Subordinated Debt are generally identical in structure to than trust preferreds, and they also These long-term, callable debt US-based, DRD eligible preferred stock pay cumulative interest payments. securities are senior to common and and are not subject to foreign currency Both are generally not subject to US traditional perpetual preferred stock exchange risk because their securities tax withholding for NRA clients. and typically pay a fixed or fixed-to- are denominated in dollars. They may floating rate of interest, which can be also qualify for QDI. (See page 7 for a Senior Notes deferred but is cumulative (between discussion on QDI.) Non-US preferred Senior notes, often referred to as 5 and 10 years). Junior subordinated stock is generally not subject to US tax baby bonds, are $25 par debt instru- debt securities are not QDI-eligible withholding for NRA clients. ments that pay regular interest in- because their payments are considered Traditional preferred stock may come, usually monthly or quarterly. interest instead of dividends. not be suitable for investors who are registered as US nonresident aliens, due to their tax withholding treatment Creating a Trust Preferred by the IRS. Morgan Stanley does not provide tax advice. You should consult your tax advisor prior to making any tax related investment decisions. Trust issues Investor Preferreds to purchases Parent Trust and Enhanced Trust investors. Lends Preferreds sets up Trust. Preferred Securities proceeds to Parent. from the Trust. These hybrid securities combine certain features of equity securities with parent trust investor many of the characteristics of interest- paying bonds (cumulative interest payments and no voting rights). Receives interest Investor receives In 1996, the Federal Reserve deter- on loan from Parent interest income. mined that preferred securities could and passes interest be used to meet banks’ regulatory capi- to investors. tal (known as Tier 1) requirements, and between 1996 and 2010, trust and

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Additional Preferred Structures grantor trust and issuing new securi- Mandatory Convertible ties representing ownership interests Preferreds in the new vehicle. A small segment of the market, mandatory convertible preferred Overview of Investment Features securities have a stated maturity Preferred stock and trust preferred (typically three years), at which point have obvious structural differences, they automatically convert into the but they also share several common common shares of the issuer. The characteristics. amount of stock received in a mandatory convertible preferreds transaction varies Par Values because conversion is dependent on the Historically, the preferred market of- stock’s price at the time of conversion. fered $25 minimum denominations As a result, the investor is exposed to (par value), making them an accessible the risk of falling stock prices. choice for many individual investors. The expansion of the market led to Third-Party Preferreds the introduction of different par val- Third-party preferreds are repack- ues, and investors now have a choice aged securities offered in $25 par of securities with face amounts of $25, amounts. Broker-dealer or invest- $50, $100 and $1,000. ment banks create them by depositing traditional or trust / enhanced trust Income preferreds, junior subordinated or Traditional and trust / enhanced trust, senior debt of a selected issuer in a preferred, junior subordinated debt and

ments and satisfy rating agency In the aftermath of the 2008 credit criteria. Issuing traditional financial crisis, Congress included preferreds can provide an attractive the Collins Amendment in the source of equity capital that is 2010 Dodd-Frank Wall Street nondilutive to common sharehold- Reform and Consumer Protection Why Companies ers, generally less costly than Act, which phases out trust and Issue Preferreds common stock and, in the case of enhanced trust preferreds as In a textbook capital structure, trust preferreds, allows interest Tier 1 capital. companies raise funds by borrow- payments to be deducted for As a result, US banks redeemed ing (issuing bonds) or by selling corporate tax purposes. $43.2 billion of trust preferreds ownership interests, via a common Since the late 1990s, banks have in 2012 and issued new, noncumu- stock offering. In reality, a corpora- been one of the largest issuers lative perpetual preferred stock, tion’s optimal capital structure — of preferreds. Regulators require which qualifies as Tier 1 capital. one that allows it to raise capital lenders to have adequate capital Trust and Enhanced Trust at the lowest possible cost — will to support their activities. As trust Preferred securities generally likely include different varieties preferred securities generally have provisions where the is- of equity, debt and preferreds. qualified as a form of regulatory suer can call the issue prior to the Companies issue preferred capital (Tier 1), and were typically stated call date provided a capital securities to fund their business, less expensive to issue than equity, treatment, tax or regulatory event diversify their capital sources, meet banks used them to help meet their occurs, and if regulatory approval regulatory capital ratio require- capital obligations. is received.

4 Morgan Stanley | 2013 An Investor’s Guide to Preferred Securities

$25 par senior notes can be structured as either fixed-to-float or variable-rate securities. Preferred stock typically distributes quarterly dividend income, while trust / enhanced trust, junior subordinated and senior notes typically pay quarterly interest income. You should be aware that to defer income payments on preferred dividend income and interest income securities without forcing a default. receive different tax treatment from The deferral can be for a maximum the Internal Revenue Service (IRS). period of time or indefinite, depending Preferred stock dividends are taxed as on the structure of the particular QDI, while trust / enhanced preferred, security. Details about payment junior subordinated and senior note deferral can be found in the individual interest income is taxed as ordinary security’s offering documents. income. (See “Taxation of Preferred Deferred payment can be cumula- Securities” on page 7 for a discussion tive (missed payments accumulate and on the tax treatment of preferreds.) are payable later) or noncumulative Morgan Stanley does not provide tax (missed payments do not accumulate). advice. You should consult your tax If interest payments are cumulative, advisor prior to making any tax-related the company typically must meet the investment decisions. entire outstanding obligation before You should be aware that deferred making dividend payments to holders interest payments will be treated as Payment Deferral Option of securities that are lower in the capi- income for tax purposes (phantom Preferred securities are generally tal structure. In most cases, a dividend income), and preferred holders will issued with an interest or dividend stopper prevents the issuer from pay- be liable for income tax, even though payment deferment feature. In ing dividends to common shareholders the cash payments won’t be received certain cases the issuer can choose while the deferral is in place. until the end of the deferral period. (See page 7 for a more complete explanation of phantom income.)

Deferment Options Market Access Once issued, the majority of $25 par securities trade on the New York Stock deferment phantom type time framE tax payment Exchange (NYSE), although some may trade in the over-the-counter (OTC) Traditional Defer No Phantom Tax Noncumulative market. Although publicly traded, Preferred Stock Perpetually liquidity (the ease of converting an asset to cash) is not guaranteed and Trust Defer for Phantom Tax Cumulative preferreds’ market value may fluctu- Preferred 5 Years ate. If you sell prior to maturity, the price you receive may be more or less Enhanced Defer for Phantom Tax Cumulative Trust Preferred 10 Years than the original cost or par value, depending on market conditions.

Morgan Stanley | 2013 5 An Investor’s Guide to Preferred Securities

Understanding Preferred conservative to moderate investors. Call Risk Securities’ Credit Ratings Securities rated below investment The majority of preferred securi- Credit ratings are one measure of grade are recommended for aggres- ties are callable, allowing the issuer an issuer’s ability to make timely sive investors only. to redeem them prior to maturity. payments of interest and princi- If the security is called, the inves- pal. Depending on their credit rat- Investment Considerations tor bears the risk of reinvesting the ings, preferred securities are either Credit Risk proceeds at a potentially lower rate investment grade or below invest- The possibility that the issuer might of return. To compensate investors ment grade. To be above investment be unable to pay interest and / or for this potential early redemption, grade, a security must be rated at least principal on a timely basis is known callable preferred securities typi- Baa3 / BBB− / BBB, respectively, by as credit risk. Widely recognized cally offer the following: higher yields Moody’s, Standard & Poor’s and / or rating agencies, such as Moody’s, than their noncallable counterparts; Fitch Ratings, the three major ratings Standard & Poor’s and Fitch Ratings a call protection period (usually five agencies. Investment grade securi- evaluate quantitative and qualitative years from issuance) during which ties generally have the least prob- factors to come up with a credit rating, time the issuer cannot redeem the ability of default. As such, they are which is a measure of an issuer’s securities; and, in certain cases, a call generally considered suitable for most creditworthiness. premium, which pays the holder of a called security a price greater than their par value. Credit Ratings Trust and enhanced trust preferred fitch securities generally have call provi- rating Moody’s s&p ratings sions allowing the issuer to redeem them prior to their stated call date, Best Aaa AAA AAA provided a capital treatment, tax or Quality regulatory event occurs, and if regulatory approval is received. Aa1, AA +, High Aa2, A, A Quality Interest Rate and duration Risk Aa3 A − Investment The possibility that the market value Grade of securities might rise or fall due to Upper A1, A +, Medium A2, A, A changes in prevailing interest rates is Grade A3 A − known as interest rate risk. Generally, all fixed income securities are suscep- Baa1, BBB +, tible to fluctuations in interest rates; all Medium Grade Baa2, BBB, BBB else being equal, if interest rates rise, Baa3 BBB preferred prices will generally fall, and vice versa. Duration measures a Ba1, B1 AA +, Speculative BB, bond’s price sensitivity to changes in Ba2, B2 A, Grade B interest rates. The longer the bond’s Ba3, B3 A − duration, the more sensitive its market Below value is to changes in interest rates. Caa1, CCC +, CCC − CCC, Investment Highly Your Financial Advisor can provide Grade Speculative Caa2, CCC, CC CC, you with the duration risk of your fixed Grade Caa3, Ca C D income investments.

Default C D D

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Secondary Market Risk Most preferreds are listed on securities exchanges, which may provide a degree of liquidity. However, there is no guarantee that an active or liquid secondary market will exist for any individual issue. If a security is sold in the secondary market prior to maturity (or call date), the price received may be more or less than the face value or the original purchase price, depending on market conditions at the time of the sale. Prices can be volatile during periods of market turbulence, and some preferred issues will be more liquid than others.

Taxation of Preferred Securities By comparison, trust preferred Qualified Dividend Income (QDI) securities are ineligible for QDI Dividend income on some perpetual treatment because they pay interest preferred stock will be eligible for income instead of dividends. The preferential tax treatment. The tax interest received will be taxed as rate on these dividends, known as ordinary income (federal, state and qualifying dividend income or QDI, local taxes) if the securities are securities, including a selection of is at the more favorable 20% tax rate held in a regular brokerage account. current offerings, and will assist you (plus an additional 3.8% Medicare Given their tax status, trust and in structuring a portfolio that is best surcharge) for investors in the enhanced trust preferreds may be suited to your own investment goals 39.6% tax bracket and 15% (plus an an appropriate choice for qualified and risk tolerance. additional 3.8% Medicare surcharge retirement accounts, including for certain income limits) for those individual retirement accounts (IRAs) Learn More About Preferreds in all other classifications. and 401(k) plans. Preferred stocks’ position in a com- In order to be eligible for the Trust and enhanced trust preferred pany’s capital structures places preferential tax treatment, the investors will be liable for income them in a lower priority of payment qualifying preferred securities must tax on phantom income, which are than bonds but in a senior position be held by an investor for more than interest payments that have been to stocks. As such, their dividend 90 days during the 181-day period, deferred but are treated as income payments are generally higher than beginning 90 days before the ex- for tax purposes. the interest income from invest- dividend date. ment grade bonds. Preferreds also Some preferreds issued by foreign Preferred Securities usually pay higher dividends than companies may also qualify for at Morgan Stanley common stocks because investors the reduced QDI tax rate, if one As a Morgan Stanley client, you have won’t have the opportunity to partici- of these requirements is met: the the opportunity to participate in the pate in the company’s growth. Your foreign company is incorporated in a new issue preferred market2 with one Morgan Stanley Financial Advisor can jurisdiction that has a comprehensive of Wall Street’s leading underwrit- work with you to assess your income income tax treaty with the United ers.3 Your Morgan Stanley Financial and growth needs and help you iden- States, or the preferred stock trades Advisor can provide you with ad- tify appropriate opportunities in the on a US exchange. ditional information on preferred preferred securities market.

Morgan Stanley | 2013 7 1 Investing in foreign and emerging markets entails greater risks than those receive compensation based upon various factors, including quality and normally associated with domestic markets, such as political, currency, accuracy of their work, firm revenues (including trading and capital mar- economic and market risks. International investing should comprise only a kets revenues), client feedback and competitive factors. Morgan Stanley limited portion of a balanced portfolio. Wealth Management is involved in many businesses that may relate to 2 New-issue offerings of preferred securities are offered by prospectus, which companies, securities or instruments mentioned in this material. 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