Tuesday, February 10, 2009


Income Investors Should Be Familiar With These, Which Are Similar to Both Canadian Income or Royalty Trusts, and Master Limited Partnerships


Here we are again. Stocks plummeting, investors bolt to investment-grade bonds for safety and income, but the stampede to quality bonds bids up their price and drives down their yields. Thus we face an unpleasant choice: risk further loss of principle in stocks or high yield/risk bonds, or accept quality bond yields too low to match taxes and inflation.

One rational approach is to deploy investing capital (as opposed to cash needed for near term expenses) into stocks of strong companies with high dividends. You earn substantial income, and when the market recovers, equally substantial appreciation.

Like any successful business, Wall Street gives us what we want, so no surprise that various advisories are recommending a relatively new kind of security to meet the demand for solid but high dividend stocks. Its comprised of both a share of common stock and a subordinated bond wrapped together, which purportedly a seemingly ideal combination of income, safety, and potential for appreciation.

There are three variations of these stock/bond hybrids.

· There are the AMEX-listed Income Deposit Securities (IDSs) and Enhanced Income Securities (EISs), which are for initial public stock offerings (IPOs) over $200 million

· Toronto Exchange (TSX)-listed Income Participation Securities (IPSs) for smaller IPOs of U.S. companies

Below we look at their history, structure, and risk factors. There is also a recommendation, Atlantic Power Corp (OTC: ATPWF, TSX: ATP.UF).


All of these are attempt to duplicate the benefits and features of Canadian income trusts (CIT for short), adapted to U.S. conditions. What’s a CIT?

· The short answer: it’s a kind of legal structure designed to allow businesses that produce lots of cash to generate unusually high income for investors. When done right, they provide junk bond-like returns with greater safety and appreciation.

· The longer answer: It’s is a publicly traded trust that sells shares or units and invests the funds received in a company that operates assets that are supposed to generate stable cash flow. In return, the trust gets a portion of the cash generated in the form of royalties, dividends and/or interest payments that pass directly through to unit holders without tax at the trust level. These payments are tax deductible to the operating company, i.e. come out of pre-tax income, so there is more cash available to distribute and less overall tax.

The Canadian income trust (also known as Canadian royalty trust) was itself just a variation on the Canadian energy trusts, which had been around since the mid-1980s. The goal was to encourage energy development by allowing the capital intensive energy companies to sell off some of their cash flow from established oil and gas fields to these trusts, and thus have more funds to invest in new projects. The low tax on the trusts allowed them to sell shares or units by offering yields high enough to justify the perceived risks that the projected income stream, and unit price, could be unstable because these rise and fall with the often volatile price of oil and gas.

Yield-hungry Canadian investors bought enthusiastically, and a new kind of investment was born. By around 2000, this structure was being used to attract higher valuations and investment to almost any kind of business that could presented as a reliable cash cow.

For those who follow this blog, you’ll recognize that the CITs have a lot in common with another favorite investment vehicle of mine, Master Limited Partnerships (MLPs). Both sell units and invest the funds in capital intensive industries with good cash flows, and receive a share of that cash, which passes straight through to the unit shareholders without tax at the partnership level. Thus the MLPs too can justify higher valuations and investment by offering unusually high distributions. Strict US laws limit the use of MLPs to firms with the most stable cash flows, like oil and gas pipeline and storage firms.

In the wake of the “tech wreck” and market collapse in the U.S during 2000-2, American initial public offerings (IPOs) in 2002 were at a low. Canadian IPOs, however, were around an all time high, with about 90% of that activity in offering shares (called trust units) by income trusts. Then too, investors sought shelter in securities offering high yields that justified their risks. The opportunity was noted on both sides of the border.

In 2002, Canadian investment banks, already experienced in income trust IPOs, sought to promote these to US firms seeking capital. First, however, they and their US counterparts had to adapt the CIT to US conditions. The result was the IDS, EIS, and IPS.


The main problems with applying the CIT structure to US firms were:

• Setup was complex

• Canadian capital markets were too small for IPOs of larger American firms

• Trusts were usually not as tax efficient in the US as in Canada

Thus the investment banks duplicated the benefits of the Canadian income trusts by creating the publicly traded IES/IDS/IPS in place of the trust structure. Aside from the minor differences noted above, these are all essentially the same kind of security: a publicly traded share of common stock and a subordinated bond packaged together.


In theory, the direct transfer of pretax income to unit holders, and the relatively more predictable cash flows from the bond component, should make the cash distributions of the IES/IDS/IPS higher and more stable than normal stock dividends.

But are they as safe as CDs? Hardly.

A. The Risks

Here’s a summary of the main risks to consider.

1. Unlike CDs, there is no FDIC insurance. The level of risk to both principle and income stream is tied to the fortunes of the business. These are not for cash you can’t afford to lose.

2. The common stock portion of the overall dividend: Part of the total dividend is from common stock, and performs accordingly. Even though the company may be bound to distribute a fixed percentage of available cash after ongoing expenses, that cash flow can decline along with the fortunes of the company. That means a reduced dividend, and almost certainly reduced share price, even as the bond portion of the dividend holds steady.

3. The bond portion of the dividend is a subordinated bond: Be well aware that its holders get paid only after the more senior bonds and other debt. So it’s critical to understand how much senior long term and monthly debt liabilities exist compared to current cash levels and cash needed for the distributions. This portion is certainly safer than the common stock dividend. How much safer depends completely on the soundness of the company and its cash position.

4. Overall market risk: As with any listed stock, these hybrids tend to decline with the overall stock market. They may decline more or less, depending on how the market views the company. But even well regarded firms can be irrationally oversold in times of great fear.

5. Liquidity: These are usually thinly traded, usually well under 100,000 shares a day. This makes for added volatility, since just one big seller can pressure the price. Lack of share volume also makes for wide bid/ask spreads, which may mean you’re forced to accept dramatically lower price in case you need to sell out quickly in times of sudden need or fear.

6. Currency risk: Some of the companies offering these hybrid securities are Canadian and their dividends are fixed in Canadian dollars, so changes in exchange rates between US and Canadian dollars can affect your returns for good or bad.

In sum, these stock/bond fusions do not have the virtually guaranteed principal and interest of CDs. Theoretically; they aren’t even as safe as the bonds of the same company. That’s because for bond holders, the business only needs to survive with enough cash flow to pay the bond dividends and principle when the bonds mature. With the hybrids, there must be enough cash to maintain payments to the more senior bonds, the subordinated bonds, and also common stock dividend.

If the company is succeeding, then there’s enough for all and this difference remains purely theoretical and thus irrelevant. As hybrid securities, they present hybrid risk and reward.

So, those are the risks.

B. The Reward

This part is simple. When carefully chosen, you get rewards well out of proportion to the risks. With stocks beaten down, there are junk bond-like yields well over 10%, backed by prospering businesses that have simply been indiscriminately sold with the rest of the market.

To give you some perspective, around a year ago Ecuadorian bonds paid around 11%. Ecuador was a poor country likely to elect Rafael Correa, a left wing politico who openly threatened defaulting on the bonds (and recently did so) and whose role model was Venezuela’s Hugo Chavez. The below recommended IPS, Atlantic Power Corporation (OTC: ATPWF, TSX, ATP.UF) has a very reliable income stream, is profitable, shareholder-friendly, and currently pays over 12%.

C. The Conclusion: These Hybrids Offer Opportunities to the Selective

Like any investment, it all gets down to the business behind it. Each hybrid presents a different risk/reward combination. Whether that combination is appealing depends both on one’s own tastes and on the company. With the market beaten down, there are many solid businesses with high dividends made higher still by the depressed stock prices.


I like the risk/reward offered by Atlantic Power Corp.’s [OTC: ATPWF, TSX ATP.UF] IPSs up to about USD 8. I’ll go into full detail in my next blog, but here’s the short version:

A. Why Atlantic Power Corp?

· They have very stable revenues

· These revenues appear sufficient to cover both their substantial existing debt (not uncommon in the power industry) and their over 12%IPS distribution, as evidenced by their actually raising the distributions 8% in late November, while at the same time completing acquisition of another power plant.

· They don’t appear to have problems accessing finance – a primary concern for a power company under current conditions.

In sum, Atlantic Power Corp. is showing signs of prospering even in this difficult environment, and appear to be a great income play for those seeking high dividend stocks paying outsized yields compared to the risks.

B. Disclosure

Cliff has a position in ATPWF

C. Want More?

For more on these, see my next blog, coming soon at: http://highdividendstocksguide.blogspot.com, http://incomestocksguide.com

D. Interested in Earning Online?

Check out my blog http://introtoebusinessguide.blogspot.com

Best Wishes,

Cliff Wachtel

Your Highdividendstocksguide Blogger

No comments:

Post a Comment