My 87-year-old father-in-law told me about a new investment his PaineWebber broker talked him into buying: Corts Trust for J.C. Penney Debentures (KTP). What is it? Is this the type of investment an 87-year-old man of limited means should be buying?

-- Dale Simmons

Dale,

Your father-in-law is one of the first owners of a new type of security, created this year, that represents the latest mutation in the world of exchange-listed fixed-income securities. You've probably heard of preferred shares. These are similar, but different.

Not to worry. The security your dad-in-law owns is essentially a J.C. Penney ( JCP) bond. It's not a particularly high-quality bond, but credit analysts think default is unlikely. The main risks are the same ones an actual J.C. Penney bond would carry: interest-rate risk and possibly some liquidity risk.

First, let's get a grip on exactly what we're dealing with here.

In the beginning, there was preferred stock, a stock-bond hybrid. Most preferreds are issued by financial institutions and utilities.

Like a bond, a preferred share has a face value and pays interest on it at a fixed rate. While bonds have a face value of some multiple of $1,000, preferreds' face value is $25. (Obviously, you can build a diversified portfolio of preferreds much more cheaply.)

That fixed dividend makes a preferred share much less volatile than a common share. A preferred share won't go down in price as much as a common share when a company is in trouble, but it won't rise as much when the business is booming. It's rare for an investment-grade preferred share with a $25 face value to trade below 22 or above 26 1/2.

Preferreds are less secure than bonds for two reasons. Companies have to pay their bondholders before they pay their preferred shareholders, so in the event of default you'd rather be a bondholder. Also, many companies reserve the right to defer dividend payments on preferred shares for up to five years in times of stress. (They have to pay preferred dividends before they pay common dividends, however.) Bonds don't have that feature. As a result, a company's preferred shares typically carry lower ratings than their bonds.

In addition, most preferred shares become callable by the company five years after their issue date, meaning that if interest rates fall, the company may buy the shares back from you at face value, leaving you to reinvest your money when rates are low. Of course, the same may be true of a bond.

Trust Preferred Securities

Strictly defined, preferred stock is no longer very common. It has been largely replaced by trust preferred securities. But both types are casually referred to as preferreds.

So what's the difference? Very little to the investor (apart from the fact that trust preferred shareholders get paid before standard preferred shareholders), but a great deal to the issuer.

Basically, issuers (alright, their bankers) figured out that by creating a trust to issue preferred shares rather than issuing them directly, they could save a bundle on taxes. Interest payments on debt are tax-deductible for the issuer, while dividend payments on stock are not. But it's better to issue shares than to add debt to the balance sheet. Trust preferreds give the issuer the best of both worlds. They issue subordinated debt to the trust and deduct the interest payments on it, while at the same time improving their balance sheet by issuing shares, explains Stephen Carter, senior analyst at MCM CorporateWatch.

As a result of this invention of the early '90s, most preferred issuance is now of the trust variety rather than the standard variety. This year, about $13 billion of trust preferreds have been issued, compared with about $5 billion of standard preferreds, according to Salomon Smith Barney.

Trust preferreds go by a variety of names, depending on the underwriter. Some pay quarterly income, like standard preferreds; others pay monthly. You've probably heard some of these acronyms: Mids (monthly income debt securities), Mips (monthly income preferred shares), Quids (quarterly income debt securities), Quics (quarterly income capital securities), Quips (quarterly income preferred shares), Skis (subordinated capital income securities), Toprs (trust originated preferred shares) and Trups (trust preferred stock).

Now There Are Corts

So, what does any of this have to do with your father-in-law's Corts? They are not, after all, preferred stock or trust preferred securities, but they are comparable. They are $25 face value, exchange-listed instruments that pay interest at a fixed rate.

Here's how they are different: The Corts (a Salomon Smith Barney acronym for corporate-backed trust securities) are issued by a trust containing J.C. Penney bonds. The trust was created not by J.C. Penney, but by underwriters, in this case Salomon Smith Barney, with PaineWebber ( PWJ) as co-manager. The underwriters bought a $100,000,000 block of J.C. Penney bonds with a 7 5/8% coupon maturing in 2097 in the secondary market (the bonds were issued in 1997) and put them in a trust. Then the trust issued 4,000,000 shares at $25 apiece.

It's essentially a re-denomination of the bonds to give them a face value of $25 instead of $1,000. This type of security is sometimes called a pass-through. The payments on the bonds pass directly through the trust to the investor. Each shareholder collects his or her portion of the income payments on the bonds semiannually. The Corts carry the same credit rating as the underlying bond, and if the bond's rating changes, so will the trust's, explains Terry McCarthy, a structured finance analyst at Standard & Poor's.

The J.C. Penney Corts also have a different kind of call option, PaineWebber's director of taxable fixed-income, Tom Naratil, explained. They are callable at any time at a price that would make the yield equal to the 30-year Treasury bond's plus 20 basis points, but under no circumstances less than par. Saturday, for example, with the 30-year Treasury yielding around 6%, the Corts are callable at 30 12/16, the price that makes their yield equal to 6.20%.

Solly and PaineWebber have done five of these deals, all this year, using bonds from issuers whose names are familiar to retail investors, Naratil said. The others are Cabco Trust for J.C. Penney Debentures ( PFH), Corts Trust for BellSouth Debentures ( KTB), Cabco Trust for BellSouth Debentures ( BFH) and Cabco Trust for Florida Power & Light. (I imagine ownership of these securities is pretty common in Boca Raton.) Cabco is a PaineWebber acronym for corporate asset-backed corporation.

The J.C. Penney Corts would seem to be fine for your father-in-law so long as he is comfortable with owning a corporate rather than a government obligation, and so long as he doesn't mind the very long maturity, which gives the securities a relatively high degree of interest-rate sensitivity (though by a quirk of bond math, not much more than a 30-year issue would have). Plus, there may not be great liquidity in the shares: If he has a particularly large block, he may not like the price he can get for it.


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TSC Fixed-Income Forum aims to provide general bond information. Under no circumstances does the information in this column represent a recommendation to buy or sell bonds, funds or other securities.

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