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Income Investing Risks (Interest Rates, Bankruptcy, Calls, Tax Events)

by Art LaPella, a QOL Supporter

A QuantumOnline Note: Art LaPella is a long time user and supporter of QuantumOnline (QOL). Art made the mistake of suggesting that QuantumOnline should do a writeup on income investing risks. Turning the tables, we suggested that instead he should do the writeup as a long time and knowledgeable income investor. The results of his writeup are provided below.

If you have any comments on Art's discussion, you can email them to us and we will forward them to Art. We can't promise he will answer but he might. We are also willing to consider publishing similar thoughtful and useful contributions on investment risks or any other subject that might be of interest to QuantumOnline users. Email us to discuss any proposed contribution you might have in mind before spending a lot of time on it.

Below is Art's contribution on income investment risks.

Here are some things that can go wrong when buying exchange-traded fixed income investments. I'll start out with the most obvious risks. So you might want to skip down to the end, where I discuss little-known loopholes buried deep in the prospectus (contract). The most obvious risk is:

BANKRUPTCY - If the issuing company goes bankrupt, then you will normally lose your investment. Other creditors and maybe bond holders usually get whatever's left. In an unusual case like Pacific Gas and Electric, there was enough to pay off the bond holders, and after that there was still enough for preferred stockholders. But usually you're lucky to get a fraction of a cent on the dollar. Note that bonds get paid before preferred stock, so bonds are a little safer, but not much.

How do you avoid a security that's headed for bankruptcy? You can never be completely safe, but some securities are safer than others. QuantumOnline's Income Tables (see the Income Tables menu at the top of any page) show how each security is rated by Moody's and S&P. The lower the rating, the more likely a bankruptcy. For more information see QuantumOnline's Credit Ratings page. Another way to guess a security's safety, is by its yield. A risky security will have a high yield. If it didn't have a high yield, few people would buy a risky security, and the price would drop until it did have a high yield. That doesn't mean you should only buy the highest rated securities. Generally, you get what you pay for. You'll get a better return by choosing lower rated securities, but only if your luck holds out. How much risk you should accept depends on your personal situation, as well as the odds of bankruptcy.

Another way to avoid a security headed for bankruptcy, is to study the company's financial reports. I'll briefly describe what people look at, but you'll need to know a lot more before you can successfully second-guess ratings and yields. I've never tried it myself. A corporation is required to publish balance sheets and income statements. You'll find them by clicking QuantumOnline's information page for the corporation, where you'll find a link to the corporation's website. If the financial statements say the company is losing money, then it's more likely to go bankrupt. If it makes lots of money in good years but not in bad years, then it's more likely to go bankrupt than a company with steady earnings. A big, old company is safer than a small, new company. High-tech companies are more likely to go bankrupt. They're also more likely to hit the jackpot, but the jackpot will go to the common stockholders, not us - although you'll get a diluted share if your securities are convertible (see QuantumOnline's "Income Investments" page). The safest fixed-income investments are usually in highly regulated businesses like utilities, banks, insurance, and stock brokers. But even then, you have to worry about politicians and the public deciding that your company's money is a free lunch, as in the California power outage or mandated insurance coverage.

A risk related to bankruptcy, is that dividends can be suspended. This normally happens only to companies near bankruptcy. So this risk can be minimized in the same way - by buying high rated securities. Why doesn't a healthy company suspend dividends? It isn't allowed to pay common stock dividends unless the preferred dividends are paid. If the common stock dividends aren't paid, then the stockholders could theoretically revolt, support a proxy fight and fire the management - although that seldom happens in practice. A money-losing company will stop paying dividends and the stockholders go along, because you can't squeeze blood out of a turnip. I said preferred stock, but bonds and securities based on bonds are similar - if bond interest isn't paid, the bond holders' trustee can force the company into bankruptcy, so once again, only a company near bankruptcy will suspend payments. Sometimes bankruptcy follows the suspension, and sometimes the company recovers years later and makes money again. If it recovers, there will be a big balloon payment covering all the preferred stock dividends that were missed. If the prospectus (see QuantumOnline's glossary) requires such payments, then the security is "cumulative". Nearly all non-foreign preferred stocks are cumulative.

If the company is near bankruptcy and you sell the security, it will cost you even if the dividends haven't been suspended and bankruptcy hasn't been declared. Nobody wants to buy a security near bankruptcy unless it's dirt cheap. So the price you get will depend on how safe the security is. How safe it is at the moment, not how safe everyone thought it was when you bought the security. So don't count on selling if things start going bad, unless you realize that the price you get will be reduced accordingly.

INTEREST RATES - If the interest rates of other securities rise, then the market price of your security will fall. You might not care, because you will keep getting the same percent dividends that you expected to get. But if you want to sell your security, nobody will pay you the same amount you invested, because they can get higher interest from other investments. So the price of your security will drop, until the price drop makes the yield match the yield of other securities. I don't mean to say that all securities have the same yield. I explained above that risky securities yield more than safe securities. But if interest rates rise, then safe securities will yield more than safe securities used to yield, and risky securities will yield more than equally risky securities used to yield. Wait a minute, didn't I just say the market price was falling? What's this about rising? One of the most confusing things about fixed-income investments is that when yields go up then prices go down, and when yields go down then prices go up. That's because when you aren't expecting a call or a maturity any time soon, yield is somewhere near dividends divided by price. And dividing by a bigger number makes the answer smaller. And dividing by a smaller number makes the answer bigger. Got it?

So you might think that the trick is to buy fixed-income securities when interest rates are going down, and sell when they are going up. Yeah right, Nostradamus! Rates going down can go back up, and vice versa, and predictions aren't for amateurs. Interest rates change all day like stocks. Here is a five year graph of the 10 year bonds from Yahoo Finance. I have no idea where interest rates are going. But you say, I saw this guy on TV and he had the Answer! Wait a minute. If we could really predict interest rates by watching TV, then billionaires would pay people to watch TV, get the prediction, and buy up interest rate futures until rates have dropped by the predicted amount. By the time you got around to buying something, it would be too late to make any money on the predicted interest rate move. But that isn't what really happens. Interest rates jump after economic reports and anything Ben Bernanke does or says, not after TV opinions. So why do people go on TV making predictions on interest rates, or on stocks for that matter? Mainly because it gets better Nielsen ratings than the honest answer: I Don't Know. Full service stock brokers are no better at predicting rates - billionaires can easily find out what they think too, if they cared. Don't even think about outguessing the market on interest rates, unless you are a committed Fed watcher who reads everything Ben Bernanke says.

Interest rates are as likely to go up as to go down. You might think you don't care, because that means your security is as likely to go down as up. But actually, securities don't go up as far as they go down, because of the next risk:

CALLS - A call means that the company chooses to give you your initial investment back, usually $25 per share. Then they don't have to pay you dividends or interest any more. The prospectus says the company doesn't have to call. So you expect a call when it's profitable for the company. When is it profitable? If interest rates are down, then the company can issue new securities at a lower rate, and use the money they get to call the old securities at a higher rate (rate here means interest/dividend rates, not safety ratings). The company pockets the difference between the rates. This doesn't work when rates are up, because the company won't be able to issue securities at a lower rate at a time when investors can get a higher rate elsewhere. OK, it's imaginable that the company could get a lower rate because its bankruptcy risk is down, and it's imaginable that it would call just because it doesn't have a better use for some cash it earned. But normally you expect calls because everybody's rates are down. Your first reaction could be that's OK, I got my money back, and the dividends were nice while they lasted. But if you take your money and buy another fixed-income security, you won't get as much yield because rates are down. That still might seem OK, until you remember that isn't the deal you get when interest rates are rising. If interest rates rise, you keep the old security paying the old rate, and if you sell the value is down. But if interest rates drop, then there will probably be a call. You don't keep the old security, you can't keep collecting the old rate, and the value didn't go up. If you reinvest the money, then the rate will be less. The way interest rates affect fixed-income securities can be summarized as heads I win, tails you lose. It is a delicate question whether investors would buy callable securities so eagerly, if they really understood this Catch-22. Well, now you've been warned.

Issuing companies get investors to play this game by postponing their right to call until any time after the first five years. It reminds me of credit cards sucking you in by giving you a teaser rate for six months. The details depend on the prospectus, but most exchange traded fixed-income securities are uncallable for the first five years. During those first five years, it is possible for the price of the security to go above the $25 you paid for it. If interest rates fall, then the value of dividends up to the five-year mark will rise, so the stock will rise. But if interest rates rise the stock can drop a lot more. That's because you no longer expect the stock to be called at five years. So it's today's value of dividends forevermore that is dropping, not just today's value of dividends for five years. That's why the securities don't rise as far as they can drop. If you buy such a stock for $26, for example, then you can expect to lose a buck when the stock is called for $25. If the callable date is four years away, then you will lose about 4% over 4 years, or 1% per year. So the yield is about 1% less than dividends divided by price. It might be a good deal anyway. It would be safer in case of rising interest rates, because it won't drop as far as a security under $25 would drop. Also, since you expect a call in four years, you should compare the yield to short-term interest rates, not long-term. And short-term interest rates are usually lower.

If you buy a stock after the callable date, then it is already callable. You might pay over $25 if people don't expect a call right away. Or you might pay over $25 even if people do expect a call, just because nobody happens to be selling today. There is a major risk, especially if you're a trader and not an investor, that you could pay $26 today and be called at $25 tomorrow, losing a quick buck per share. You need to keep track of callable dates. They're listed on QuantumOnline's tables (see the Income Tables menu at the top of any page).

A maturity date is like a callable date, except that the company doesn't have to call on or after the callable date. It calls if it wants to. But on the maturity date, the company has to give the initial $25 back, no matter what interest rates are doing. If it doesn't pay up, it can be forced into bankruptcy. So you can expect them to pay unless they're really short of cash. The maturity date isn't a risk factor because including a maturity makes a security worth more, not less. You don't have to think about what the world will be like in 2100, to value a security that matures in 2040.

CALL DATE LOOPHOLES - The commitment not to call a stock for five years has a list of loopholes.

TAX EVENTS - Many securities are designed so that the real company issues a bond or other security. That security is sold to a trust - a legal abstraction with some of the same rights as real people. The trust takes the interest from the bond, and pays dividends to us little guys. I'm not sure of the point of this elaborate game, but it looks like they're telling one branch of the government that they're paying interest, and another branch that they're really paying dividends, to get some tax or regulatory advantage. If the IRS or other regulator ever blows the whistle on this game, the prospectus says the company - the real company that is, not the trust - can call the securities before the call date. So your $26 security could suddenly be worth $25 - although some prospectuses provide for a premium to be paid. No security has actually been called because of a tax or regulatory ruling. But if there ever were such a ruling, there would be a dramatic effect throughout fixed-income markets. Zillions of dollars worth would be called all at once, with some values jumping and other values falling off a cliff. An "Investment Company Event" is another regulatory change that would allow mass premature calls.

MERGERS - When one company swallows another or merges, fixed-income stocks may be called early. The prospectuses may say that the company can call before the call date in case of a merger. Once again, you lose if the stock was worth more than $25.

TENDER OFFERS - A tender offer is an offer to buy securities - not just a few thousand at a time at the stock exchange, but all (or a major fraction) of that security that anyone owns. To sell to a tender offer is called tendering. Some prospectuses say a stock can be called if there is a tender offer for the "underlying securities" - that is, the bonds sold to the trust, not the "certificates" you really get. I'm unaware of that ever happening, but it sounds like you could lose big if the stock was worth over $25.

REPORTS MIGHT NOT BE FILED - Some prospectuses say that the security can be liquidated if reports aren't filed. I never took that danger too seriously until some Verizon securities were liquidated for that reason. Not called at $25, liquidated for less. In the Verizon cases, securities issued just months before at $25 were liquidated for a lot less, because the market price had dropped.

REIT STATUS - Every once in a while, a preferred stock issued by a REIT is called because the REIT goes private. The prospectus will say the preferred can be called for any reason that makes the REIT lose its REIT status: going private, or having too much ownership concentrated in too few owners.

EXCHANGE DELISTING - If a preferred is delisted from its exchange and you wanted to sell, it would be hard to find a buyer without trading in an exchange. This might happen after a takeover or merger. It also happens when the parent company is at or near bankruptcy. Delisting can theoretically happen if the company uses its right to dissolve the trust and give us the underlying bonds instead, but I don't know of any delistings for that reason.

DEFERRED DISTRIBUTIONS - Deferred distributions is legalese for getting stiffed. Many prospectuses say that the company can put off payments to you for a certain number of years or dividend periods. I don't know of any company that has quoted this clause when the payments stop. Payments stop when a company is running out of money no matter what the prospectus says, not because they defer distributions and count missed dividend periods. However, if a profitable company ever decided it didn't want to make any payments any sooner than it had to, I don't know what would keep them from routinely stalling a couple years.

MAKE-WHOLE PAYMENTS - Whenever a prospectus says that a security is callable at any time instead of five years, you will find later on that the early call requires a make-whole payment - unless there is a tax event or other regulatory event. A make-whole payment is what the security would be worth if it paid a little more than Treasury yields to maturity. If they tried to issue securities at an even lower rate to raise money for a make-whole payment call, then nobody would buy the lower rate securities because they wouldn't be as safe as Treasury bonds. So no make-whole payment has ever happened to my knowledge, and therefore there have been no early calls for this reason. But it might happen if it were the only way for the issuing company to wiggle out of some inconvenient commitment in a prospectus. And if it did, you wouldn't get the make-whole bonanza. That would be collected by whoever the company sold the call rights to. The prospectus calls that organization names like "swap counterparty" or "call warrant holders". You would get $25 plus some much smaller premium, and you hope you don't lose on the deal. Also, when a prospectus describes a call premium, I'm often left wondering if we really get the premium, or does it go to the swap counterparty.

This description does not necessarily apply to convertible securities. In at least one case (SGP-B, as it became MRK-B), the prospectus doesn't specify anything like a swap counterparty, and shareholders actually received a make-whole payment.

ORIGINAL ISSUE DISCOUNT (OID) - OID may horribly complicate your income tax return. Furthermore I can't tell you how, because there are consequences for providing tax advice. I presume this because when you read tax advice, it's accompanied by the obvious lie that the tax advice mustn't be construed as tax advice. Naw, let's just leave it alone.

ECONOMIC COLLAPSE OR CHANGE - Economic collapse or change in the distant future could make everything in a prospectus irrelevant. Will people still use dollars, hyper inflated dollars, reorganized dollars, or some computerized, global or interplanetary currency? Will they even have private accounts to which the dollars can be transferred? Who really knows what will happen on a maturity date 100 years away? Contracts from last century have generally been honored in our time, but railroad bonds payable in gold were nullified in 1933 - you had to take dollars worth a lot less. Second and Third World investors were treated worse, and some countries were destroyed by war. For the next century, substitute terrorists and weapons of mass destruction. How will the obligation to pay be transferred to whatever kind of organizations will exist in 100 years? Will people (if any) still care what it said on an early 21st century piece of paper, or will our future resemble some poor, corrupt Third World country?

PROSPECTUSES - The final authority on risks and other terms of a fixed-income contract, is the prospectus, not me. The prospectus includes a lot of details I skipped over, and what the prospectus says is what goes. But prospectuses are a lot longer than what you just read, and a lot harder to read. In a more perfect world, any contract over 5 pages wouldn't be enforceable against anybody who can't afford lawyers - unless you get a 2-page summary that covers the biggest surprises. For now, you have this.

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