10 features of income securities

So you're looking at picking up a few income securities but can't tell the difference between the unfranked cumulative converting non-redeemable note and the participating preference share with a fixed resettable payment.

The jargon attached to income securities has become a bit of a joke and has led to investment bankers coming up with such forgettable acronyms as Amcor PACRS (as in packaging company) and Westpac FIRsTS (Australia's first bank). Apart from keeping bankers in a job, some of these characteristics can be very important. So let's examine them.

1. Franking

Whether a security is franked or unfranked is an extremely important issue. Investors should be aware of the benefits of franking and how to calculate this value. Basically, a 7% fully-franked yield is the equivalent to a 10% unfranked yield.

2. Converting/Convertible

The above terms relate to whether the income security may convert to another form of stock, usually an ordinary share. The timing of the conversion is likely to be set at fixed points in time, five years after the instrument is first issued, for example.

The term convertible refers to the fact that either the company issuing the security or the investor has the right to decide on whether to convert it into another form of share. On the other hand, converting means that the security will convert into another form of share at a fixed point in time.

3. Participating

This is a feature that is very rarely seen in income securities these days. It means that even after receiving dividends from a preference share, the security also participates in profits left over for ordinary shareholders.

4. Fixed/Floating

Fixed or floating refers to the interest rate applying to the payments you receive on your investment, similar to your home loan or bank deposits.

5. Resettable

Do you have a home loan with an interest rate fixed for five years and reviewed at the end of this period? That's what a reset feature on an income security is.

If the interest you are receiving is fixed there is the possibility that at some point in time the rate will be reset. This is to take into account any movements in interest rates since the security was first issued.

Reset dates are normally about five years apart, in order to ensure that the security does not become an outright punt on interest rates, which is what would occur if the interest rate was fixed indefinitely.

6. Cumulative

Cumulative refers to what occurs to any payments that are missed due to any financial distress of the issuing company.

If the security is cumulative, any missed payments will have to be paid before ordinary shareholders get a cut. If non-cumulative, any missed payments are gone forever.

From an investor's point of view, cumulative would seem preferable, although you pay for what you get. The distinction between cumulative and non-cumulative is also very important in another way. It is a key issue in determining whether the tax office considers the security to be debt (fixed interest) or equity (shares).

If the security is debt, the issuing company can claim a tax deduction for any payments made.

But if the security is regarded as equity, the payments won't be tax deductible and the issuing company must also ensure that any distributions are fully-franked.

Generally, if the payment is cumulative, the tax office is inclined to regard the security as debt. After all, if you missed a mortgage repayment to your bank, you can rest assured that it will still require the money at some point in time.

However, if the payment is non-cumulative, then the tax office is more likely to view the instrument as equity and therefore not allow the payments as a tax deduction to the company.

7. Redeemable

Redeemable refers to whether the issuer has a right to buyback or redeem the instrument at a future point in time at a set price.

Again, this is a very important point as often the price that the instrument can be redeemed at is less than what the current price is.

A good example of this is the Crown Ltd bonds. While the interest on the bonds might look attractive right now, investors will be facing a $7.30 capital loss (at time of writing) in two years when the bonds are redeemed.

8. Secured

Some income securities are secured over specific assets, or sometimes the entire company. As with any secured loan, the investor is likely to receive a lower payment as a trade-off for the additional security.

9. Discount on Conversion

Some income securities convert to ordinary shares or can be redeemed, usually about five years from issue date. When this occurs, the investment may provide for a discount on conversion, usually about 2.5% to 5%.

This can work as an additional small bonus for investors. For example, consider an income security with a face value of $100 and a 2.5% discount on conversion. When the discount is grossed up, this effectively provides the investor with a redemption value of $102.56 ($100/(1-0.025)).

10. Subordination

Subordination refers to where in the queue an income security holder will be if the issuing company is wound up.

Most income securities will rank behind a company's trade creditors and bank debt but ahead of ordinary shares. Income securities such as bonds will generally rank ahead of preference shares.