High Yields, Low Cost, Funny Names

One of RJR Nabisco's favorite new offerings is TOPrS. But don't think snack food. Think trust originated preferred securities, one of a class of high-yielding hybrid securities combining features of preferred stock and corporate bonds.

Cooked up by Wall Street over the past three years, the hybrids hold great appeal to retirees and other investors looking for steady income. Unlike corporate bonds that are sold in $5,000 lots, these securities are more accessible to the average investor--just $25 a share. Although there is usually no minimum purchase, most are sold in round lots of 100 shares. They offer fixed monthly or quarterly dividends and yields of about 7.5% to 10%, while investment-grade corporate bonds are averaging 7.2%, slightly more than 30-year Treasuries. But hybrids also have longer maturities--typically 30 to 49 years. That makes them riskier, because it can be a long wait before you are able to recover your principal. Yet they are liquid: You can sell them on the open market. Most issues currently trade between $23 and $28.

Hybrids are rapidly replacing traditional preferred stock. Last year, companies issued $7.4 billion worth of hybrid securities, representing 65% of the total preferred stock issued, according to Merrill Lynch. What makes them so attractive to companies is that they generate a sizable corporate tax break, because dividends are paid with pretax dollars. That's why hybrids can pay a higher return than preferred stock.

Trying to get a handle on this booming breed of securities is akin to learning a new language. Hybrids are sold under a variety of catchy acronyms, depending on the underwriter and the security's structure. Monthly income preferred securities (MIPS), created three years ago by Goldman Sachs, were the first. Here's how they work: The parent company sets up a limited liability company (LLC), which issues MIPS. The LLC lends the proceeds to the parent company in the form of a long-term subordinated bond. The parent company then makes tax-deductible interest payments on this loan timed to the dividends on MIPS. Because the LLC is a partnership, MIPS investors must report all income on the more onerous K-1 tax form instead of a 1099.

VARIATIONS. To get around the K-1 issue, Merrill Lynch countered with TOPrS, which substitute a trust for the partnership but pay dividends quarterly. Goldman's version of TOPrS is called quarterly income preferred securities (QUIPS). Other brokerages have their own variations. Most are traded on the New York Stock Exchange, so they are easy to monitor.

One concern is that the Internal Revenue Service might eliminate the hybrids' increasingly popular corporate tax break, says John Crain, an accounting professor at Southeastern Louisiana University in Hammond, La. If that happens, the company can redeem your hybrid shares at par for cash or exchange them for a comparable bond.

Just like any fixed income investment, hybrids are sensitive to interest-rate fluctuations and credit changes. Although hybrids can be called, you'll receive a fixed dividend for five years--as long as the company is solvent--no matter which direction interest rates head. Then if rates decline dramatically, those with higher dividends would be more likely to be called, just as with a regular preferred stock or a bond, and redeemed by the company at par, says Carlos Andres, a junior analyst at Merrill Lynch in New York.

While interest-rate moves are inevitable and unpredictable, you can protect yourself against credit risk. Stick to issues rated BBB and above by Standard & Poor's; anything below that is speculative. Then check the rating agencies to ensure that the issuer's credit outlook is stable to positive.

Hybrids may suspend dividends temporarily if the company faces financial trouble, although that hasn't happened with any issues yet. Unlike traditional preferreds that can stop payment indefinitely, hybrids may defer dividends no longer than five years. But the risk is mitigated because the company first would have to cease dividends on its common and preferred stock. Also, suspending payment would make it more difficult for the company to raise capital at a later time. If the company defers, the hybrid's owner must still pay tax on the accrued but unrealized interest.

Hybrids were designed largely to benefit issuers. But for individuals, they are an alternative to corporate bonds and traditional preferred stock. Once you understand their basic ingredients, they may satisfy your hunger for income.

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