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I read your article about the Corts Trust for J.C. Penney Debentures (KTP) - Get Report. Has J.C. Penney's rating been changed since then, and did that affect the price? The yield looks terrific, and I am considering buying. Some of the other trusts also look awfully good for fixed-income investments. What are the risk factors here?
--Tom Aufenthie


You've got at least three kinds of risks with the J.C. Penney Corts and similar instruments -- credit risk, liquidity risk and call risk. But you're right that the yields look pretty yummy.

First, let's review what these securities are. They are effectively bonds that have been re-denominated to give them a face value of $25, and listed on the

New York Stock Exchange


They came into being last year, when

Salomon Smith Barney



took a $100 million block of J.C. Penney bonds, put them in a trust, and had the trust issue 4 million shares of stock. Each share of stock entitles the holder to a portion of the cash flow from the bonds. The bonds have a 7.625% coupon, so they pay $76.25 a year in interest on each $1000 of face value. Accordingly, a share of stock representing $25 of face value earns $1.91 a year.

Corts is a Salomon Smith Barney acronym for corporate-backed trust securities.

There are three very similar issues in existence. One of them is practically identical.

Cabco Trust for J.C. Penney Debentures

(PFH) - Get Report

differs from the J.C. Penney Corts in size alone -- its trust holds a $50 million block of the same bonds. Cabco is a PaineWebber acronym for corporate asset-backed corporation.

Corts Trust for BellSouth Debentures

(KTB) - Get Report

holds $50 million of bonds issued by

BellSouth Telecommunications

, the primary operating subsidiary of





Cabco Trust for Florida Power & Light


holds $25 million of bonds issued by

Florida Power & Light

(FPL) - Get Report


The key details on each deal are contained in this table:

As $25-par-value, exchange-listed instruments with fixed dividends, these four issues are comparable in many respects to preferred stock. But they are superior to preferred stock in that they represent interest in a bond. In most cases, corporations retain the right to defer dividend payments to preferred stockholders. They retain no such right where bonds are concerned, and these securities channel the payments on the bonds directly to the trust stockholders.

As you can see from the table, at prices substantially below their $25 offering price, all four issues offer generous yields. But why are they so cheap?

In part, they're cheap for the same reason other kinds of exchange-listed fixed-income vehicles -- including preferred shares and bond closed-end funds -- are also depressed: The bond market got whacked last year, making these vehicles ideal candidates for tax-loss selling to offset massive gains on the equity side of investor portfolios.

Before you pounce on them, let's consider those risk factors.

With all of the issues, but with the J.C. Penney issues in particular, you've got credit-quality risk. The J.C. Penney bonds have indeed been downgraded -- once by

Moody's Investors Service

, twice by

Standard & Poor's

-- since the stock was first offered last spring. Their current ratings are just two notches above junk. J.C. Penney may never default on the bonds, but additional downgrades probably would further depress the price of the trust stocks.

By contrast, Florida Power & Light has a solid credit rating, and BellSouth's is top-notch.

Then, there's liquidity risk -- the risk that you won't be able to unload shares at a price close to the current market price. All the issues have some liquidity risk because their floats are relatively small. (Float size is why the J.C. Penney Corts trade a higher price than the J.C. Penney Cabcos.) And all the issues have very distant final maturity dates -- 2026 for the Florida Power & Light issue, 2095 (yes, 2095) for the BellSouth issue, and 2097 for the J.C. Penney issues, so it's very likely you will want to sell them before they mature.

But liquidity risk is also closely related to credit risk -- the more credit risk is associated with an issue, the more difficult the issue will be to unload at a price close to the current market price. Accordingly, the bid-offer spreads have been significantly wider on the J.C. Penney issues lately than on high-quality preferreds, the head of preferreds for a major firm tells me -- about 3/8 for the J.C. Penney issues vs. about 1/8 for high-grade issues.

Finally, there's call risk. I leave this for last because, with all these shares underwater, call risk doesn't come into play. Call risk is the risk that interest rates will fall below where they were when the bonds were issued. In that case, the price of the bonds (and, presumably, of the trust shares) would return to near face value. Then, if the bonds are callable, the issuer may call them, returning investors' money ahead of schedule in order to issue new bonds at lower interest rates.

The BellSouth bonds are noncallable, so this doesn't apply to them.

The Florida Power & Light bonds become callable in 2003 at a price of 102.73, or 25.68 per trust share. The call price gradually declines to par by 2013.

The J.C. Penney bonds have a more complicated call structure. They are callable at any time, at the higher of two prices: par, or the price that makes their yield equal to the yield of a Treasury security plus 20 basis points.

Which Treasury security? My earlier article specified the 30-year bond, and at the time, that was the only Treasury security that would have made sense. Its yield was highest, which would make the call price lowest, compared to the call price dictated by a lower-yielding, shorter-maturity Treasury.

Now however, the 30-year Treasury yield is lower than shorter-maturity yields. This would make it more expensive for the issuer to call the bonds using the 30-year yield as a benchmark than a shorter-term security. Fortunately for the issuer (an unfortunately for investors), its bond indenture is flexible, instructing it to use as its benchmark a Treasury security selected by an independent investment banker in accordance with certain guidelines.

Having said all that, if all you want is a long-term fixed-interest payment, these issues give you one at a substantial discount. The BellSouth issue comes with the least amount of risk. That, of course, is why its yield is lowest.

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