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Domestic financial engineering Part 1:
Add safe income plays to your portfolio!
As rates fall, expand your fixed income universe
by Charles R. Wolpoff
Every time the Fed decides to cut interest rates, you end up with good news and bad news. The stock market normally likes it when rates go down. And a decline in rates makes the potential for high capital appreciation from stocks more attractive than the declining yields offered by bonds. Plus, lower interest rates mean lower mortgages for homeowners, lower car payments, and easier availability of business loans.
The bad news is that you need income to balance your portfolio in rough markets. Now you’ll have to look harder to find high yields while avoiding high risk.
It doesn’t make things easier that the supply of U.S. Treasuries is being depleted. Due to the expected huge budget surpluses, the government just announced that it will no longer offer a 52-week bill, and it may well get rid of its 30-year bond. The lower supply of Treasuries will help keep a lid on Treasury yields.
Of course, Treasuries are free from state income tax and worth a place in your portfolio. But to beat inflation with the fixed income side of your portfolio, you need more.
MIPS and QUIPS
Scientists keep discovering new particles in our universe, giving them crazy sounding names like "quarks." Well, imaginative brokerage firms keep inventing income-type securities, with a mixture of equity and income qualities, and giving them weird-sounding acronyms like MIPS, QUIPS, and TOPrS. As a group, these instruments are sometimes referred to as fixed-rate capital securities.
Preferred stock is a hybrid between common stock and debt. While you have no voting rights, you get a steady stream of dividend income. And preferred stock dividends must be paid before dividends to common stock holders.
Companies issue preferred stock when they do not want to dilute their equity shares, need more capital, but don’t want to damage their financial statements with too much debt.
Generally, preferred stock gives the investor a high yield and predictable cash flow.
But issuing companies have a tax problem with preferred stocks, namely, the dividends cannot be deducted for tax purposes by the issuing company. That reduces the amount of the dividend they can issue.
The hybrids generally offer higher yields than preferred stocks since, unlike preferred stocks, they are not eligible for the 70% intercorporate dividend tax deduction (because these quirky inventions are treated by the tax gods more like debt than equity). To compensate corporations for the absence of the special tax treatment, issuers offer a higher yield. Since individuals wouldn’t be eligible for the 70% deduction anyway, they get higher yield with no extra downside.
One such hybrid is called MIPS, or "Monthly Income Preferred Securities." MIPS work as follows. The company creates a subsidiary to issue preferred stock. Then the subsidiary loans the proceeds to the parent.
The parent gets to take the interest deduction. But its overall debt-equity ration isn’t hurt.
For you, MIPS offer a higher yield than you can get with money markets. You get monthly payments. And you can buy them for less than you generally pay for corporate debt instruments.
Usually, they’re initially offered at US$25 a share.
They are subordinated to debt. So there’s a little more default risk compared to bonds, but less than with common stock. And the issuer sometimes has the right to defer dividend payments, although the income is allocated. Prices can go down, just like bonds. And the issuer can redeem the stock, which places a ceiling on how high the price can go.
Uncle Sam wants his cut
You have to report dividends because they are considered payments from a partnership for tax purposes. But there are many variations on this theme created to avoid these and other problems.
Brokerage firms have invented a slew of similar investments—such as QUIPS ("Quarterly Income Preferred Securities"), QUIDS ("Quarterly Income Debt Securities"), and TOPrS ("Trust Originated Preferred Securities").
These investments are generally sold on stock market exchanges like the New York Stock Exchange.
Like bonds, these fixed-rate capital securities usually mature by a certain time, often 20 years or longer.
Most of these securities are issued with a US$25 par value. This makes it much easier to buy these investments than your typical bond.
And like bonds, they are often rated for credit risk. For example, the highest credit rating issued by Moody’s is "Aaa."
Dividend payments can be deferred if the issuer faces financial difficulties. Bu the investor will still incur a tax obligation. Also, the issuer can call the investment before the maturity date.
You may want to familiarize yourself with these arcane inventions by first investing in a mutual fund that specializes in these things. For example, the no-load Fidelity Convertible Securities Fund (800-544-6666), which returned 7.21% in 2000 and has shown an annualized return of 18.65% over the past ten years, invests in convertible securities, preferred stocks, and other income securities.
Check out the 247taxes Bureau of 247profits today for more income investing, tax, and privacy strateiges from Charlie Wolpoff.
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