How to Play the Banks After Stress Tests

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Investors should then determine the class of preferred shares that will be exchanged first—usually by finding the largest issue with the highest dividend rate. In Bank of America's case, that's an issue known as Bank of America Series E. This security has a floating rate that can't go lower than 4% and currently trades at around 40¢ on the dollar. If Bank of America does decide to convert this issue, it could make the offer at nearly twice that, Jacoby says. The risk is that Bank of America won't convert the shares, leaving investors with a security they may not want long term. This is not an investment for the faint of heart.

Other managers see opportunities in hybrids—supersubordinated debt that gets treated as equity on a bank's books. Hybrids begin by paying a fixed rate before converting to a floating one. For example, a PNC hybrid maturing in 2049 pays a fixed rate of 12%. In 2012, it will convert to a floating rate 8.61 percentage points above the London Interbank Offered Rate, a benchmark rate used on corporate loans.

For hybrids, buy strong banks

But here's the catch: At the time of the conversion, banks have the right to buy these bonds back from investors at face value. That's a good thing. Since the floating rates are higher than a bank could get in the market now (and one assumes they will still be higher when the bonds convert) the banks will most likely choose to buy them back, says John Boland, a principal at Maple Capital Management. The upshot is that investors receive a high yield for three to four years and should then get their principal back to invest someplace else.

Yet much could go wrong. For starters, the bank could decide not to call the bonds, leaving investors holding a fixed-income product that doesn't mature until sometime in the 2040s. They're also near the bottom of the capital structure, only a step above common and preferred stock. For that reason, Edward Maran, a portfolio manager at the Thornburg Value Fund (TVAFX), recommends sticking with such stronger banks as JPMorgan Chase (JPM), Goldman Sachs, and US Bancorp (USB).

Or investors can just keep it simple. If they truly believe in the future of the U.S. financial industry, they can wait for a pullback in share prices and then buy a financial mutual fund or an exchange traded fund such as the Financial Select Sector SPDR (XLF), diversifying the holdings. Just because the stress test is finished doesn't mean the industry's troubles are over.

"There's still some baggage [in the industry]," says Kevin Mahn, Chief Investment Officer at Hennion & Walsh Asset Management. "It's very difficult to know which [bank] will suffer the most difficulty the next time around."

Levisohn is a staff editor at BusinessWeek covering finance and personal finance.

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