In the early 1990s, a product called fixed-rate capital securities was introduced to meet the needs of income-oriented investors and provide a cost efficient source of capital for issuers.
These securities combine the features of corporate debt securities and preferred stock: generous yields compared with other investment vehicles, regular income disbursement, predictable investment time frames, liquidity and investment grade quality (in almost every case).
Fixed-rate capital securities (aka hybrids) are like preferred stock, but with a few peculiarities. There is no DRD tax advantage; thus, they pay a higher yield than preferred stocks or bonds from the same issuer. The have a lien status that is higher than preferreds but below creditors, and they carry the credit rating of the issuer. They are traded in the OTC market and most are also listed on the NYSE and AMEX stock exchanges. Most are priced at $25 per share, they have a stated maturity, and are callable after 5 to 10 years. Most issuers are utilities, industrial companies, and financial institutions.
FRCS are also classified based on how they are issued:
1.Junior subordinated debentures are issued directly by the parent company.
2.Trust preferred FRCS are issued by a trust.
3.Partnership preferred FRCS are issued by a partnership.
Specific FRCS are known by acronyms and names which describe the frequency of the payments, or how they are issued, such as:
•MIDS – Monthly Income Debt Securities
•QUICS – Quarterly Income Capital Securities
•QUIDS – Quarterly Income Debt Securities
•QUIPS – Quarterly Income Preferred Securities
•SKIS – Subordinated Capital Income Securities
•TOPrS – Trust Originated Preferred Securities
•TruPS – Capital Trust Pass-through Securities
The main difference between preferreds and FRCS is that FRCS pay interest—not dividends—monthly, quarterly, or semi-annually, but can be deferred if the company is in financial trouble. However, payments can be deferred only if no dividends are being paid for the issuer’s common or preferred stock, and if the interest payments are deferred, then interest continues to accumulate until it is paid. Sometimes FRCS are issued as zero coupon bonds, which are original issue discount (OID) instruments.
However, these securities can have tax complications, either because of interest payment deferral or because they are OIDs. In these cases, interest accrues, and if it is not paid in the year earned, then the investor in these securities must pay taxes on the accrued interest, which is calculated according to complex laws and formulas.
Besides the deferral risk mentioned above, there is also a special event risk, which allows the issuer to redeem the FRCS, at any time, for face value, if the tax law changes that disallows the tax deduction for the interest payments for the issuer’s parent company.
Features and Benefits
Priority of Claims
• FRCS typically offer a higher security claim than preferred and common stock, but rank junior and are subordinate in right of payment to all senior debt of the issuer.
Potential for Attractive Yields
• FRCS typically provide yield advantages relative to preferred stock and corporate bonds of the same issuer, partly to compensate investors for claims with a lower priority in addition to payment deferral risk.
• Certain FRCS trade on the OTC and listed markets, and generally have easily attainable quotes. Many FRCS are also listed on the NYSE®.
• FRCS may be rated by investment rating agencies such as Moody’s® and Standard & Poor’s® to assist investors in their evaluations of the securities.
Low Investment Minimum
• Many FRCS are issued at $25 a share (although some are issued with a $1000 par value). This feature enables investors to buy and sell in smaller increments. The actual price paid by the investor may be more or less than $25, particularly when the security is purchased in the secondary market.
While it may seem appealing to look at securities that offer higher yields, investors should consider those higher yields to be a sign of potentially greater risk.
• FRCS are subject to price fluctuation due to material events affecting the issuer or the market. Additionally, FRCS prices typically decline on ex-dividend days (the dates that buyers of FRCS are not entitled to receive the dividend).
Interest Rate Risk
• FRCS tend to rise in value when interest rates fall, and decline in value when interest rates rise.
Credit and Default Risk
• Investors should consider the possibility of risk that a corporation might default on its payments of interest or principal. Purchasing top–rated securities from companies with a stable or good credit history may help reduce credit risk.
• FRCS generally have a call provision which entitles the issuer to redeem the shares prior to maturity. Typically an issuing corporation will call its securities when interest rates fall, leaving the investor with potentially less favorable reinvestment possibilities. When evaluating FRCS, an investor should know whether call options exist and when these options may be exercised by the issuer.
Special Event Risk
• Many FRCS include a “special event” redemption option, allowing the issuer to redeem the securities at the liquidation value if a tax law change disallows the deductibility of payments by the issuer’s parent company, or subjects the issue to taxation separate from the parent company.
• FRCS permit the deferral of payments without declaring default, if the issuer experiences financial difficulties. Payments may be deferred or suspended for some stipulated period. If the issuer defers payments on a cumulative FRCS issue, the deferred income typically continues to accrue for tax purposes, even though the investor does not receive cash payments. Investors should consult with a tax professional regarding the tax treatment of investment income.
• FRCS are subject to the risk that the rate of the yield to call or maturity of the investment may not provide a positive return over the rate of inflation for the period of the investment.
Posted in Business in Switzerland