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    Offbeat Offerings: Fixed-Rate Capital Securities

    by Cara Scatizzi

    Offbeat Offerings: Fixed Rate Capital Securities Splash image

    Fixed-rate capital securities are debt/equity hybrid investments, first developed in the early 1990s, that attempt to combine certain advantageous features of equity and debt securities to both issuers seeking to raise capital and income-oriented investors.

    Preferred partnership securities, trust preferred securities, capital securities, MIPS, MIDS and QUIPS are just a few examples of the various forms of fixed-rate capital securities.

    For investors, fixed-rate capital securities marry certain features of preferred stock and bonds, offering: attractive yields, a fixed and regular income payment, a stated maturity date, liquidity, a higher claim on assets than common or preferred shares, and, in most cases, investment-grade credit quality. In addition, retail-targeted offerings trade on a major securities exchange.

    For issuers, fixed-rate capital securities offer several advantages over other methods of raising capital: Distributions made on fixed-rate capital securities are fully tax-deductible to the issuer, just like interest payments on traditional debt issues; but unlike debt issues, a fixed-rate capital offering is treated as a non-debt liability—thus, the offering adds no debt to the balance sheet.

    Typical issuers include electric and gas utilities, industrial companies, telephone companies, insurance companies, and banks and other financial institutions. Examples of issuers in the past include: Cadbury, Ford Motor Co., Wells Fargo, and Conseco.

    The actual issuer may be the parent company itself (in the case of junior subordinated debentures), or a conduit financing vehicle organized by the parent company (in the case of preferred partnership securities, trust preferred securities and capital securities).

    How They Work

    Fixed-rate capital securities are issued by a corporation, either directly or through a conduit financing vehicle, in order to raise long-term capital. After issue, retail-targeted fixed-rate capital securities trade on the major exchanges including the New York Stock Exchange, the American Stock Exchange and NASDAQ.

    The term “fixed-rate” refers to the coupon payment, or the regular payment (usually monthly, quarterly or semi-annually) made to holders of the security. Distributions are fully taxable to the investor.

    On the secondary markets, they tend to trade similarly to traditional bonds, selling at premiums and discounts to par based on the security’s stated coupon rate relative to prevailing interest rates, as well as the market’s perceptions concerning the credit quality of the issuer.

    Typically, retail-targeted securities (not aimed at institutional buyers) have a $25 par value (the value of the security if held until maturity). However, they are priced at a rate that includes any accrued income payments since the last payment date, in addition to any premium or discount from maturity value.

    Maturities typically range from 20 to 49 years, but some are perpetual. Most, however, have call provisions entitling the issuer to redeem shares prior to maturity. Callable securities typically would be redeemed prior to maturity during periods of falling interest rates, which means these investors would be forced to reinvest their returned principal at the lower prevailing rates.

    Fixed-rate capital securities are rated for credit quality by the various rating agencies (including Standard & Poor’s and Moody’s). Most carry investment-grade ratings. Typically lower-credit-quality issues pay higher coupon payments to compensate for the extra risk, while the higher-quality issues pay relatively low coupon payments.

    Fixed-rate capital securities generally offer a higher yield than a corporate bond from the same company. This is because the company has the option to defer payments on the capital securities for up to five years under certain conditions, making an uninterrupted stream of income payments from these securities less certain compared to traditional bonds.

    They also typically carry higher yields than preferred stock from the same company because the payments are fully taxable to all investors, including corporate investors (typically, preferred stock dividends are not taxable to corporate investors).

    Fixed-rate capital securities rank senior to common and preferred shares in the issuer’s capital structure, which means holders of these securities are paid interest before dividends are distributed to common and preferred stock shareholders, and if bankruptcy occurs, holders of fixed-rate capital securities will be paid before any common or preferred shareholders receive their slice of the payouts.

    Types and Identifying Acronyms

    There are various types of fixed-rate capital securities based on the structure of the issue. Currently there are three basic structures:

    • Preferred Partnership: The issuer is a limited partnership or limited liability company that is organized by the parent company, with proceeds used to buy junior subordinated debentures from the company;
    • Trust Preferred: The issuer is a grantor trust established by the parent, with proceeds used to buy junior subordinated debt; and
    • Junior Subordinated Issues: These are issued directly by the company.

    The securities often are identified by acronyms that are service-marked or trademarked by the investment banker serving as the issuer’s underwriter.

    The most common include:

    • MIDS (Monthly Income Debt Securities);
    • MIPS (Monthly Income Preferred Shares);
    • 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); and
    • TruPS (Capital Trust Pass-Through Securities).

    How to Trade

    Most fixed-rate capital structures are sold on various exchanges and the OTC market, and can be traded through a brokerage firm.

    You can buy these securities at origination or in the open market from other investors who wish to sell their securities before maturity.

    Investors have two options for liquidating the securities. One is to hold the security until it reaches maturity (or until it is called), meaning you get the par value of the offering (or the call redemption value) in addition to any interest that was paid throughout the holding period.

    Another option is to sell the security on the open market. Depending on current interest rates, credit quality of the issue, fixed payment (or coupon) rate, and time to maturity, the amount other investors are willing to pay will vary.

    Investor Suitability

    Fixed-rate capital securities may be suitable for investors who want the safety of regular, fixed-income payments but prefer a higher yield than a government bond or a similar corporate bond and are willing to accept the extra risks (relative to traditional bonds) involved with fixed-rate capital securities.

    Tax Consequences

    Fixed-rate capital securities pay regular interest which, like a typical interest-paying bond, is taxable. However, if the issuer defers interest, the holder will still have a tax liability during the deferral period on the deferred income. The income continues to accrue, typically at a compounded rate, even though it is not actually paid. To avoid these tax obligations, investors can hold the securities in a tax-deferred retirement account.

    Also, if the security is sold prior to maturity, any capital gains or losses are appropriately taxed or refunded, just like bonds and preferred stock. To be aware of all the tax liabilities you may incur while holding these securities, a tax specialist should be consulted before purchase.

    The Pros

    Higher Yields Than Traditional Bonds or Preferred Stock

    Typically investors will receive higher yields compared to the bonds or preferreds of the same corporation, due to the less certain nature of an uninterrupted stream of payments. Investors will be guaranteed the stated coupon payment for the fixed-rate capital security until maturity, or until the security is called. Also, if prevailing market interest rates fall, the value of the security in the secondary market is likely to rise, giving investors the potential to sell it for a premium.

    Investment-Grade Credit Ratings

    Many fixed-rate capital securities are issued by large, well-known corporations, and most carry investment-grade ratings from two or more rating agencies. Typically the higher the credit rating, the lower the yield.

    Liquidity

    Because these securities are traded on major exchanges, they can be bought and sold relatively quickly and easily—although you may suffer losses due to adverse market conditions.

    Fixed-Rate Payments

    Barring financial difficulties, a company is obligated to make regular interest payments to holders of the fixed-rate credit securities. If the company puts a hold on the payments, they can usually only do so for five years, then they are required to pay accrued interest and continue with future regular interest payments.

    Higher Claim Than Common

    Fixed-rate capital securities rate higher than preferred and common stock when it comes to payments and in terms of bankruptcy.

    Guaranteed Principal

    If a fixed-rate capital security is held to maturity, investors are guaranteed the par value of the security.

    The Cons

    Interest Rate Risk

    Fixed-rate capital securities’ prices are inversely related to prevailing interest rate movements; if interest rates rise, the price of an existing security will fall and an investor will have to accept a lower price in the secondary market if he wishes to sell before maturity.

    Reinvestment Rate Risk

    If interest rates fall, existing security holders must reinvest interest payments and any principal payments at the lower prevailing interest rates, which could result in a lower total return than expected.

    Credit Risk

    The value of existing fixed-rate capital securities can change if the issuer’s credit rating falls or the market perceives that the issuer’s prospects will adversely affect the payments of the outstanding securities.

    Liquidity Risk

    Although the securities are liquid to the extent that there is a market for them on the exchanges, the current market value of the securities will change with current interest rates, and an investor who needs to sell may be forced to sell at a price that results in a loss of principal value.

    Possible Deferral of Payments

    A company usually has the right to defer interest payments for up to five years if it is under financial distress. Investors will be paid the accrued interest, but cannot always rely on an uninterrupted stream of payments.

    Call Risk

    For securities with a call or “Special Event” clause, the issuer may redeem the security early, usually at an inopportune time for the investor when interest rates have fallen and principal must be reinvested at lower rates.

    Additional Information

    InvestinginBonds.com

    www.investinginbonds.com
    The InvestinginBonds Web site offers a look at various types of bond investments for investors of all experience levels. It was created by The Securities Industry and Financial Markets Association (SIFMA) to foster knowledge of the fixed-income markets.

    InvestinginBonds.com offers current market data including bond prices, news and financial data as well as glossaries, FAQs and detailed descriptions of numerous bond types, including fixed-rate capital securities. Go to “Learn More” at the upper right side of the home page, select Types of Bonds, and then click on Fixed-Rate Capital Securities in the left-hand column.



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