Fixed Income Strategy

Patrick McCluskey, Senior Fixed Income Strategist Fixed Income Strategy May 23, 2016 A Guide to Investing in Community Bank Preferred Stock What is Preferred Stock? Preferred stock is a perpetual fixed-income security with attributes of equity and debt, ranking junior to all other forms of debt and ranking senior only to common stock. The par price of preferred stock depends on the intended market for the particular issuance. Preferred stock is issued at $25 par for retail investors and $1,000 par for institutional investors. The $25 par value and exchange listing (typically NYSE, NYSE MKT LLC, or NASDAQ) provide greater liquidity in smaller sizes for the retail investor. The security can be issued at a fixed for life coupon, a floating rate coupon, or a coupon that is fixed for a set time period (5 or 10 years) and then, if not called, floats at a spread over LIBOR (London Interbank Offered Rate). Dividends can be cumulative or non-cumulative and can be deferred indefinitely. Companies issue preferred stock in order to receive regulatory capital treatment, strengthen their balance sheets (rating agency benefit), and improve their debt-to-equity ratio (rating agency benefit). Typically issued by banks, insurance companies, utilities, and Real Estate Investment Trusts (REITs), these securities are recorded as equity on the issuer s balance sheet, although investors typically view preferred stock as a form of debt. Even though preferred stock is recorded as equity on an issuer s balance sheet, the issuance of preferred stock does not dilute the ownership interest of the common shareholders. Defining Community Banks As the name implies, community banks primarily focus on traditional banking services, such as accepting deposits and originating loans to consumers and businesses in their local communities. Community banks tend to be relationship lenders, characterized by local ownership, local control and local decision making. The branch locations and operations of community banks are generally located in one or a limited number of states. Nevertheless, collectively, community banks serve an important role in the national economy as they are an important source of loans to small businesses. Investment and Insurance Products: NOT FDIC Insured NO Bank Guarantee MAY Lose Value Page 1 of 6

recognized definition. Although this definition includes banks under $1 billion in assets, banks between $1 billion and $10 billion are incentivized to issue preferred stock in order to meet minimum regulatory capital ratios under the new regulatory capital framework. Why do Community Banks Issue Preferred Stock? The definition of community banks has evolved over time. For example, a community bank was once defined almost exclusively by its size. Historically, a community bank was defined as a bank with $1 billion or less in total assets. However, this definition has become dated and does not account for growth. In the Federal Deposit Insurance Corporation s ( FDIC ) December 2012 Community Banking Study, the FDIC expanded the definition to capture banks that maintained the core functions of community banks but had crossed the $1 billion asset threshold provided the bank meets certain qualifying metrics. Among other things, the bank would have to achieve certain ratios, such as a ratio of loans-to-deposits greater than 33%, a ratio of core deposits-to-assets of 50% or greater, and have fewer than 75 offices with no single office having deposits in excess of $5 billion in size. By comparison, the Federal Reserve currently defines a community bank as a bank with less than $10 billion in total assets. For reporting purposes, U.S. bank regulators have separated the banks by asset size, which defines their reporting requirements. Banks above $1 billion in assets are subject to a new regulatory capital framework called Basel III, which was implemented in the U.S. on January 1, 2015. Banks subject to this new regulatory capital framework are encouraged to issue regulatory capital, including preferred stock, in order to meet minimum regulatory capital ratios. Banks above $10 billion in total assets are subject to additional regulatory requirements, such as the requirement to conduct annual company-run stress tests that are submitted to the Federal Reserve. For the purposes of this guide, we classify any bank with total assets of $10 billion and under to be a community bank, which is the most recently Banks above $1 billion in total assets are subject to regulatory capital requirements under the U.S. Basel III Regulatory Framework. As part of these requirements, the banks are required to hold minimum levels of loss-absorbing capital, or regulatory capital, on their balance sheet, expressed as regulatory ratios (calculated over onbalance sheet assets as well as off-balance sheet assets that are risk-weighted based on the type of exposure). The issuance of non-cumulative perpetual preferred stock increases the amount of the loss absorbing capital on the bank s balance sheet, thereby increasing certain regulatory ratios. If a bank were to fall below minimum regulatory ratios, the bank would be subject to restrictions on capital distributions (including payment of dividends on preferred stock) or, in extreme cases, the possibility that regulators would deem the bank to be insolvent and placed into a bankruptcy process. The U.S. bank regulatory framework does not require preferred stock to have a particular par amount, coupon structure, or presence of a call feature, but does require dividends to be noncumulative and the instrument to be perpetual in order for the preferred stock to qualify as regulatory capital. Preferred stock is often called hybrid capital because the issuer has the ability to suspend dividends, if necessary, during times of stress. For example a bank may choose to suspend dividends if net income for the past year is not sufficient to cover both dividends and a rate of earning retention that is consistent with the company s capital needs, asset quality and overall financial condition. The table on the next page outlines the new riskbased regulatory capital requirements to be required of U.S. banks pursuant to U.S. banking regulations, which follow the guidelines established by the Basel Committee on Banking Supervision (known as Basel III). Page 2 of 6

New Risk-Based Regulatory Capital Ratio Minimums* Basel III Minimum Capital Conservation Buffer (effective Jan 1, 2019) Total Minimum Ratios* Common Equity Tier 1 4.5% 2.5% 7.0% Tier 1 Capital 6.0% 2.5% 8.5% Total Capital 8.0% 2.5% 10.5% Tier 1 Leverage Ratio** 4.0% * The Basel III minimum risk-based capital requirements for the eight U.S. banks designated as Global Systemically Important Banks ( G-SIBs ) can be 1.0-5.5 percentage points higher in each of the three risk-based categories (Common Equity Tier 1, Tier 1 Capital, and Total Capital); as of 1Q 2016, the additional minimum riskbased capital requirements for U.S. G-SIBs range from 1.0-3.5 percentage points. The additional risk-based capital requirement for a U.S. G-SIB is determined on a bank-by-bank basis. As of 1Q 2016, the eight U.S. G-SIBS include: JPMorgan Chase & Co., Bank of America Corp., Wells Fargo & Co., Citigroup, Inc., Goldman Sachs Group, Morgan Stanley, Bank of New York Mellon Corp., and State Street Corp. ** Tier 1 Leverage Ratio is calculated as Tier 1 Capital divided by average consolidated on-balance sheet assets. In addition to the minimum Tier 1 Leverage ratio requirement, Advanced Approaches banking organizations (banks with greater than $250 billion in total assets and/or greater than $10 billion in on-balance sheet foreign exposures) are required to maintain a minimum Supplementary Leverage Ratio of 3.0% which includes both on- and offbalance sheet exposures. U.S. G-SIBs are required to maintain a minimum Supplementary Leverage Ratio of 5.0%. Source: Federal Reserve Final U.S. Basel III Capital rules. Preferred Stock Ratings Bank preferred stock is not required to have a rating at the time of issuance or anytime thereafter, but most banks have their preferred stock securities rated by one or more of the Nationally Recognized Statistical Rating Organizations, a credit rating agency that issues credit ratings that the U.S. Securities and Exchange Commission permits companies to use. Issuers may choose to have their preferred stock rated in order to increase transparency with investors, increase credibility, and provide standardized comparability between the issuer s preferred stock and the preferred stock issued by other entities. In assigning a rating on a bank, rating agencies typically analyze the risk profile, liquidity position, capitalization, and financial performance of banks, among other factors. Rating agencies further take into account subordination of the instrument and deferral risk in assigning the rating on bank preferred stock. Preferred Stock Investment Risks Preferred stock securities have certain risks in common with other fixed-income securities. These risks affect the market price of the securities, which in turn affects their yield. In general, investors demand higher yields to compensate for higher risks. Interest-rate or market risk There is no guarantee as to the market prices of preferred stock securities; therefore investors may suffer a loss. As with bonds, the prices of preferred stock securities will move inversely with interest rates. When rates rise, prices fall; when rates fall, prices rise. Credit risk Credit risk is the risk that an issuer will be unable to meet its obligations to investors because of financial difficulty within the company. Credit ratings by independent rating agencies help investors judge the credit risk. Issuers with lower credit ratings will tend to pay higher coupon rates to compensate investors for the additional credit risk. Any change in an issuer s credit rating or in the marketplace s perception of an issuer s business outlook can have a profound impact on the value of any outstanding securities. Default risk Defaults occur when a company fails to pay an interest or principal payment to a debt holder as scheduled and as specified in the legal agreements, i.e., the indenture. Factors such as business cycle volatility, excessive leverage or threats of competitive takeovers may lead to default. Page 3 of 6

In a corporate bankruptcy or dissolution, an investor may lose some or all of their investment. Preferred stock securities investors would be paid only after all payments are made to senior debt holders. Although secured bondholders and holders of senior debt issues may receive some distribution of corporate assets, it is rarely enough to make whole the total investment. Companies in default tend to trade at very low prices, if they trade at all, and liquidity may be nonexistent. Deferral risk The issuer of a preferred stock security can typically defer payment of distributions in case of financial difficulties. Bank regulators can also force banks to defer payment of distributions. A bank that falls below a minimum regulatory ratio may be unable to make payment of distributions. The company can defer income distributions only if the parent company stops all other stock dividend payments or any payments to securities junior to the preferred stock ( Dividend Stopper ). If the preferred stock is cumulative, then all suspended dividend payments must be paid in full before distributions can be made to common shareholders. If the preferred stock is non-cumulative, the issuing entity is not required to pay any suspended dividend payments to the holders of the preferred stock, and may resume distributions to common shareholders when the issuing entity resumes payment on the preferred stock. Call or reinvestment risk Many preferred stock securities are issued with call features that allow the issuer to redeem or call the security at a stated date before maturity, so investors should not rely on distributions through their maturity dates. Downward trends in interest rates make the issuer more likely to use the call feature (so as to issue new securities at lower interest rates). When this happens, investors may have to reinvest their principal at lower interest rates reducing their income stream. Alternatively, however, the current low interest rate environment coupled with the fact that perpetual noncumulative preferred stock counts as Tier 1 Capital for bank regulatory purposes means that the risk of early redemption is greatly reduced. Event risk encompasses a variety of pitfalls that can affect a company s ability to repay its debt obligations on time. These include poor management, changes in management, failure to anticipate shifts in the company s markets, rising costs of raw materials, regulations and new competition. Community Bank Sector Risks Risks that are specific to the community banking sector can be additive to the general risks above that apply to preferred stock securities, including: Geographic concentration risk The branch locations and operations of many community banks are generally concentrated in one or a limited number of states, counties or cities. As a result, the financial performance and stability of community banks can be adversely affected by an economic downturn in their concentrated area(s) of operations. Product concentration risk Community banks may concentrate their lending activities in a limited number of exposures or products, such as residential or commercial real estate. The lack of diversification in the loan portfolio of a bank can exacerbate credit losses during an economic downturn. In addition, lack of demand for a specific product or other industry dynamics can have an adverse effect on banks that are highly concentrated in one or a limited number of loan products. Revenue stability risk Compared to larger banks, community banks maintain a greater reliance on the interest income they earn on loans. Community banks can be limited in the amount of services they offer, which negatively impact their ability to generate non-interest income. The ability to generate stable non-interest income to supplement interest income can help to offset the adverse impacts of a challenging interest rate environment or other dynamics that may reduce the interest income banks earn on loans and investments. Despite community banks stronger asset quality and capitalization levels compared to larger banks, the revenue pressures particular to community banks have generally resulted in lower returns. Efficiency risk An efficiency gap exists between community banks and larger banks, as community banks must spread their noninterest expenses (for example, the cost of buildings, employees, and marketing) across a smaller asset base. This has the Page 4 of 6

ability to put community banks at a disadvantage versus banks with larger asset bases. General Tax Treatment Distributions from bank preferred stock are typically taxed at a reduced rate for most investors. Individual investors receive qualified dividend income (QDI) which is currently taxed at a maximum rate of 20% for individuals in the 39.6% tax bracket and 15% for individuals in the 25-35% tax brackets. Under the dividend receives deduction allowance, only 30% of distributions made from preferred stock and paid to C-Corporations are currently taxed at the company s ordinary income tax rate. Capital gains and losses If a preferred security is sold before the security is redeemed by the issuer, the investor may realize a capital gain or loss. Although a gain or loss on the sale of a security is generally considered to be capital, special rules apply to shares of securities purchased at market discount. In such a case, a portion of any gain up to the amount of accrued market discount is taxed as ordinary income, unless the seller has elected to include accrued market discount in income on a current basis. Wells Fargo Advisors is not a legal or tax advisor. Please consult with your tax advisor before engaging in any transaction that may have tax consequences. Investor Characteristics Suitability Purchasers of preferred stock securities are generally income investors seeking to earn a stated interest rate. These securities also may appeal to institutional investors such as money managers and corporations. Further, you should not purchase preferred stock securities unless you are able to understand and bear the associated market and yield risks. Preferred stock securities investors should have the financial status, knowledge and experience in financial and business matters to evaluate the merits and risks in light of their particular circumstances. Costs of Investing in Preferred Stock Securities Preferred stock securities are generally sold on an exchange or bought and sold between dealers and investors much like other fixed-income instruments. Dealers trade the securities at a net cost, which includes their own spread, or profit, on the transaction. Upon purchase and sale of a preferred stock security, you will generally incur a commission or markup in processing the transaction. Preferred stock securities purchased during the Initial Public Offering (IPO) period have an underwriting fee built into the purchase price. A portion of this underwriting fee (paid by the issuer) is paid to your Financial Advisor for these transactions. How are Your Financial Advisor and Wells Fargo Advisors Compensated on Preferred Stock Securities? For helping you invest in the most appropriate preferred stock securities, Wells Fargo Advisors and your Financial Advisor are compensated in ways that vary depending on the selected security. If the purchase is made during the IPO period, a Financial Advisor may be paid a sales concession. This sales concession is built into the share price and is passed by the issuer along to the Financial Advisor. Your Financial Advisor will receive compensation in the form of a commission or markup from most transactions made in the secondary market. For most purchases, this compensation is based on the dollar amount purchased or sold in the preferred stock security transaction. In certain fee-based accounts, a Financial Advisor s compensation may be based on a percentage of assets in the account rather than on the commission, as mentioned above. The compensation formula that determines the amount of payment to your Financial Advisor is generally the same for all preferred stock securities. Page 5 of 6

In addition to receiving compensation, your Financial Advisor may receive internal credits in the syndicate allocation process for sales in preferred stock securities and other products. For securities their clients have indicated an interest in purchasing, Financial Advisors may receive allocations of new equity syndicate deals based on the number of internal credits accumulated. For example, a Financial Advisor accumulating a large number of internal credits may receive a greater allocation of a new equity syndicate issue than a Financial Advisor with fewer credits. Wells Fargo Securities, LLC may receive compensation for making a market or keeping an inventory on select offerings. Wells Fargo Securities may have an investment banking relationship with preferred stock issuers. Disclosures of any such conflicts are noted on research reports. Within the division that operates in Wells Fargo financial centers and some Wells Fargo stores, a Licensed Banker may refer you to a Financial Advisor, as they generally work as a team. In this case, the Licensed Banker will be compensated through a referral arrangement with the Financial Advisor. Talk with Your Financial Advisor Preferred stock securities can be a valuable addition to your fixed-income portfolio when suitable. Your Financial Advisor can help you determine whether these securities fit your investment objectives and risk tolerance and which types may best suit your investment needs. For more information on hybrid securities and your portfolio, consult your Financial Advisor today. Additional information available upon request. Past performance is not a guide to future performance. The material contained herein has been prepared from sources and data we believe to be reliable but we make no guarantee as to its accuracy or completeness. This material is published solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or investment product. Opinions and estimates are as of a certain date and subject to change without notice. Wells Fargo Advisors is registered with the U.S. Securities Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Securities is the trade name for the capital markets and investment banking services of Wells Fargo & Company and its subsidiaries, including Wells Fargo Securities, LLC, member NYSE, FINRA and SIPC and Wells Fargo Bank, National Association. Wells Fargo Bank, N.A. is a banking affiliate of Wells Fargo & Company. Wells Fargo Advisors is the trade name used by two separate registered broker-dealers: Wells Fargo Advisors, LLC, and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliates of Wells Fargo & Company. 2016 Wells Fargo Advisors, LLC. All rights reserved. CAR 0516-04380 Page 6 of 6