The World According To Arps

The new adjustable-rate and auction-rate preferred mutual funds may be oddities, but companies looking for cash repositories will find their aftertax yields attractive.

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Putting aside a little something for a rainy day is wise counsel for the fiscal as well as the home front. But where to keep the little something to have it come out a bigger something is the cash-rich business's enigma, especially now that the yields of conventional conveyances are scraping 10-year lows. Thanks to the inventive folks who have been coining such creatures as zeros, strips, swaps, and floaters as if there were no tomorrow (which some observers of the economic scene believe there won't be), the challenge is more interesting now than it was 10 years back. And to make the choices simpler for chief financial officers shopping for shortish-term cash parking places, as soon as a monetary mutant is introduced, mutual-fund firms have been quick to start up new pools to invest in it.

Two of the newest corporate funds were devised to enable businesses to take advantage of a specific tax provision. Congress has maintained that double taxation from business to business is unpatriotic -- a view that held through the revised tax code as well. Thanks to that belief, when one domestic corporation invests in the stock of another, a substantial amount of the dividend income is deductible. For corporate investors, this dividend-received deduction (DRD) can dramatically enhance aftertax yields of equities over such debt instruments as prevail in the money market.

Mutual funds for individual investors that take partial advantage of qualified-dividend tax treatment have existed for years, dealing in volatile equities at some risk to shareholders. Although it's more likely that the net asset value will remain stable in the new versions designed specifically for corporations, there's no guarantee that it will, markets being what they are. On the other hand, there are ample opportunities for CFOs with cash to burn to end up in far worse shape. Rolling over dividends via commonstock portfolios is apt to be an unrewarding venture in the late stages of a bull market; so is buying a public corporation's own stock. Even more dangerous are covered-option programs. And those cash managers who bet that interest rates had hit bottom a few months ago and loaded up on long-term Treasuries with the expectation that the bonds would appreciate are probably now looking for jobs outside finance.

As a means of raising capital from conservative investors while still shielding them from adverse interest-rate fluctuations, a novel kind of preferred stock with dividends that go up and down according to prevailing bond yields was created recently. The two approaches to the instruments are called adjustable-rate preferreds (ARPs) and auction-rate preferreds (no acronym yet, since ARP is taken). New mutual funds invest in a number of these instruments, spreading the risk and passing the tax advantage on to corporate investors. Corporations are allowed to benefit from the daily dividend dispersion as if they owned the stocks outright. And the funds are so accessible that even a small business can consider investing in them for a month or two.

The net asset value of the handful of mutual funds that deal in adjustable-rate preferred stocks already exceeds $4 billion. But despite the Street's apparent welcome, notes Peter M. Dodge, manager of 1985's best ARP performer, W. P. Carey's Corporate Preferred Fund, "The typical small-business man still tends to work within certificates of deposits, commercial paper, and repos, and worries about 0.05%: can he get 6.23% or 6.28%? He's not trained to look at aftertax returns." Indeed, cash flow from ARP funds -- which have most of the familiar characteristics of money-market funds, including check-writing privileges -- has been double that of three-month Treasury bills.

Going into October, ARP funds were paying about 6.4%, while three-month T-bills were at 5.2% -- a reasonable premium, considering the full faith and credit behind the latter. But it's what happens after the government gets paid that counts. After maximum corporate taxes, the ARP-fund investment yielded 5.9%, while T-bills returned a mere 2.8%. Stated another way, the ARP investment was the pretax equivalent of a 10.9% yield, or more than twice that of T-bills.

The amount of dividend income that may be deducted, currently 85%, has been reduced only to 80% under the tax overhaul. Thus, if in 1988 the maximum corporate rate is 34%, the maximum tax rate on dividend income will drop from the current 15% of 46% (or 6.9%) to 20% of 34% (or 6.8.%). Chances are good that our learned solons, earnestly trying to balance the budget by squeezing more revenue from commerce, didn't realize that in this situation they actually lost ground. The table on the following page shows the comparative effects of the DRD on a dividend of 7%.

Despite these aftertax returns, ARPs are hardly the sort of slow-but-steady vehicles that cautious asset-management advisers have in mind for a business's treasury. Corporate cash managers need absolute liquidity and safety, says Brett Silvers, a vice-president and head of cash-management loans at The Bank of New Haven. "From the standpoint of a small business," Silvers assesses, "adjustable-rate preferreds are a risky investment. It's the same thing as investing in the stock market: you're prey to the management of the company that issues them." Silvers would prefer the bank's clients put their money into Treasury bills, repurchase agreements, bank certificates of deposit, money-market accounts, or, in case the bank itself liquidates, savings accounts secured by the government. More adventuresome, but still tolerable, is AAA-rated commercial paper -- short-term debt instruments from the finest U.S. corporations.

To be sure, the risks of investing in ARPs are real. For one thing, the secondary ARP market may be thin and unable to support a large sale. Or the issuer may go under, in which case preferred stock stands ahead only of common stock; even commercial paper, which is a legal loan obligation, would be ahead of it. But this exposure is offset by the reassurance that the market value of variable-rate securities stays relatively steady as yields change. The value of straight bonds with their fixed payouts, by contrast, is at the mercy of interest-rate trends; if yields go up, the price of bonds goes down. Furthermore, bonds, unlike preferred stock, can be called before their redemption date.

Nor are ARPs infinitely variable. There is a floor to the dividend, as well as a ceiling. A recent issue of 2 million ARP shares by Georgia Power Co., for example, which came out with an initial dividend rate of 9.3%, was bound by a minimum rate of 6.25% and a maximum of 12.75%. An ARP's dividend, usually reset quarterly, is tied to prevailing Treasury rates -- but with a twist, should long-term rates be more favorable than short-term rates. The stipulation for Georgia Power's periodic adjustment was 80 basis points (a basis point is 0.01% of yield) below the highest of three Treasuries -- the three-month T-bill, the 10-year note, or the 20-year bond. Thus, if short-term rates were to decline precipitously, as they did earlier this year, the falling yield would be cushioned by its being pegged to the higher long-term indices.

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