Saturday, March 28, 2009

Volume 3, Issue #23

Also in Today's Issue...

There are only eight of these securities in the world. They carry an astronomical average dividend yield of 17.2%. They have been a bulwark of stability amid the market turmoil of the last few months. As a group, they have delivered impressive total returns (including dividends) of +9% so far this year, well ahead of the broader market average of -12%, as measured by the S&P 500 index.

Double-digit yields and dividend safety often make an uneasy pairing in today's markets, but these securities are a rare exception. Part bond, part stock -- these hybrid securities offer the security of a bond's fixed income and the growth potential of a stock.

Each security clips together one common share and a bond issued by the company. The lion's share of the distribution is fixed interest income from a corporate bond issued by the company. The rest comes from the stock dividend powered by the company's cash flow.

For example, rural telecom operator Otelco (Nasdaq: OTT) pays a quarterly distribution of $0.42 per security. Each security is comprised of one common share and a note issued by the company paying a fixed rate of 13%. The total distribution reflects a cash dividend $0.17625 per share and an interest payment of $0.24375 per note. The distributions together with share price gains have contributed to the company's +27% returns so far this year.

The stock dividend portion may go up or down -- two companies raised their dividends this year, one slightly reduced it, and the rest kept them stable. In any case, whatever happens to the dividend portion, the bond payment remains fixed, giving you that extra degree of security in volatile markets. All but two of them pay their distributions with monthly frequency, which provides another layer of payment protection.

In addition, these companies throw off steady cash flow from stable, recession-proof businesses. One is the fifth largest funeral home operator in North America, another is one of the top 40 local phone operators in the U.S., yet another distributes some of the best known brands of packaged foods in the country. They also count among them the fifth largest provider of school bus transportation services in the U.S., and the nation's leading manufacturer of heavy-duty transit buses.

The companies are industry leaders, but their publicly traded securities lie under the radar of most Wall Street analysts. That's partly because there are so few of them, but also because they originally were designed by Canadian investment bankers for U.S. companies seeking to tap the Canadian capital markets. 

Back in the early 2000's, these companies were looking for an investment vehicle that would provide a tax-efficient way to distribute their cash flow to shareholders, something like the Canadian income trust but better suited to American tax laws.

The result: a hybrid security that goes by many different names. We call them income deposit security (IDS), but they are also called enhanced income security (EIS) or income participating security (IPS). Whatever name you use, they are essentially the same security.

Like Canadian income trusts, they pass along to shareholders almost all their cash flow. Fortunately, however, these securities don't share the same fate of Canada's royalty trusts, which are doomed to disappear in 21 months. As the legislation passed by Canada's federal government now stands, companies that issued these securities are corporations not trusts. As such, they shouldn't need to convert to ordinary tax-paying corporations by January 1, 2011 like Canadian royalty trusts.

As you see in the list below, two of the securities trade on major U.S. exchanges -- B&G Foods (BGF) and Otelco (OTT). The rest are listed on Canada's benchmark Toronto Stock Exchange (TSX) but also trade over-the-counter in the U.S. As a U.S. investor, you can trade Canadian-listed stocks with either the Canadian ticker (like ATP.UN for Atlantic Power) or U.S. ticker (ATPWF).

The shares are more actively traded on the Canadian exchange, but you can trade online more easily with the U.S. ticker and save the cost of calling your broker. Canadian tickers will give you the most recent price in Canadian dollars, while the U.S. ticker gives you the last U.S. trade in U.S. dollars.

We should note that the six Canadian-listed securities pay distributions in Canadian dollars. For example, funeral home owner Keystone North America (KNA.UN/KNAJF) pays a monthly distribution of $0.38 per security in Canadian dollars. That translates to about $0.31 in U.S. dollars at the current exchange rate. If the Canadian dollar continues moving higher as the U.S. dollar weakens, the value of the distribution for U.S. investors will increase.

As for taxes, generally the stock dividend portion qualifies for the reduced 15% tax rate or it may be treated as non-taxable return of capital. The bond portion is taxable as interest income at your marginal income tax rate. Canadian-listed securities are subject to a 15% foreign withholding tax, but you can claim a tax credit on this amount if you hold the position outside a tax-deferred IRA type of account. The credit is more difficult to claim within a tax-deferred account.

Income deposit securities are a timely investment idea in today's turbulent markets. They provide steady income with extraordinary yields and are holding their value remarkably well so far in 2009.

Good Investing!

--Carla Pasternak
Editor
High-Yield Investing

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