Value-seeking income investors need look no further than the ailing banking sector to find some hidden gems. The U.S. government has lent and guaranteed literally trillions of dollars to financial institutions to keep them from going bankrupt. Treasury’s plans to buy toxic bank assets and absorb up to $200 billion in losses of mortgage lenders Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) are the latest moves to shore up the balance sheets of the country’s major lenders so they will start lending again.

Among some 120 beaten down firms that the government has so far “invested” in, five in particular have become virtual wards of state. Mortgage giants Fannie Mae and Freddie Mac, American Insurance Group (NYSE: AIG), Bank of America (NYSE: BAC), and Citigroup (NYSE: C) — these companies are too big to fail.

The government is doing whatever it can to keep these firms from the fate of Lehman Brothers, whose bankruptcy last September helped trigger the current downturn in financial markets around the world. As Treasury Secretary Timothy Geithner said at his confirmation hearing, Lehman’s failure “didn’t cause this financial crisis, but it absolutely made things worse.”

But government money comes with strings attached. Over-extended mortgage giants Fannie and Freddie were effectively nationalized last September, when the government put them into conservatorship and agreed to inject $100 billion in each company as needed. September also saw the government assuming an 80% stake in failed insurance giant American International Group, in return for an $85 billion capital injection. The U.S. government is now also the biggest shareholder in Bank of America, owning a 6% interest, and in Citigroup with a 7.8% interest.

So how can income investors capitalize on the de facto nationalization of these financial institutions?

Partner with the U.S. Government
As Bill Gross, founder of the largest bond fund in the U.S., advised in his recent Investment Outlook, “Shake hands with the government.” Government backing should virtually guarantee that these firms will not fail — but buyer beware. Some of the payouts are more secure than others.

What about their common shares? They have rallied recently in response to Obama’s latest efforts, but their share prices are still dirt cheap and they sport enticing double and triple-digit dividend yields. Remember, though, these companies have been forced to slash payments because they can’t afford to pay them.

Not only that, the common share dividends also face pressure from the U.S. government, which wants to prevent shareholders from benefiting at taxpayers’ expense. As a condition of their second round of government support, for example, both Bank of America and Citigroup must limit quarterly dividends to no more than a penny a share for the next three years. Payouts can’t be raised without government approval.

Focus on Debt not Equity
So it’s not the equity but rather the debt of these government-supported lenders that may offer income investors relatively secure income stream. Unlike dividends, which are discretionary, debt is a legal obligation. A company is required to pay off its debt, unless it becomes insolvent or bankrupt.

Admittedly, these companies are facing a lot of headwinds, which could threaten their ability to pay off their debt obligations. But the government has shown that it will not let these institutions fail. While these lenders may be forced to cut their equity dividends, the government appears likely to provide support for interest and principal payments on their debt.

One way for income investors to take a stake in these firms is through their preferred shares — but you need to tread carefully. The dividends of a certain class of preferred stock issued by these companies are questionable.

When Fannie Mae and Freddie Mac were placed into conservatorship last September, the U.S. Treasury suspended indefinitely not only all their common share dividends but all their preferred stock dividends as well. This move doesn’t bode well for a certain category of preferred stock known as “traditional” preferred stock that may be offered by other government-rescued lenders.

Fannie and Freddie’s traditional preferred stock is more like equity — its dividend payments, which qualify for the reduced dividend tax rate, rank before common share dividends but after any debt obligations.

A Buffet of High-Yield Debt Securities
In contrast, so-called trust preferred stock counts as junior subordinated debt and the distributions are taxed as ordinary income just like any bond. As debt, trust preferred stock provides a greater degree of security than common or traditional preferred shares.

Citigroup offers a full slate of these securities which trade on the New York Stock Exchange under the tickers C-PE, C-PF, C-PG, C-PO, C-PQ, C-PR, C-PS, C-PU, C-PV, C-PW, and C-PZ. Moody’s and Fitch recently lowered the credit rating on these issues to “BB,” but Standard & Poor’s has thus far maintained their investment grade rating of “A3.”

AIG and Bank of America also offer some exchange-traded bonds which as subordinated debt, are somewhat more secure than the junior subordinated debt of Citigroup’s trust preferred stock. These investment-grade bonds are now trading at almost ridiculous double-digit yields.  For risk-averse investors, the senior debt bond issues of all these firms provide secure income and a relatively steady price.

Finally, Fannie and Freddie’s so-called “agency debt” isn’t just investment grade. It’s the highest “AAA”-rated debt, just below U.S. Treasuries and above “AAA” corporate debt. These government-sponsored mortgage issuers have had the implicit backing of the U.S. government but now that support is far more explicit. You can buy individual bonds and mortgage securities issued by mortgage lenders Fannie and Freddie, but funds give you a diverse portfolio with different maturities and yields.