The World According To Arps
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.
Cash managers buying ARP shares on their own would not be able to effect the daily liquidity that a fund affords. For one thing, even if they ran their own investment programs, individuals would have to wait out the standard seven-day settlement interval before getting the proceeds from a sale. Corporate mutual funds are willing to transfer cash by wire on the day shares are redeemed, and this liquidity comes relatively cheap. ARP funds are what is known as low load: buying into the Corporate Preferred Fund, for instance, costs from 2.5% for amounts less than $100,000 to a free ride for amounts more than $4 million. There's no charge for redemption, and some funds require no minimum balance. Liquidity aside, could a small-company CFO choose to buy and sell ARPs separately and skip the fund? "Sure," responds Peter Dodge. "Buy three issues and pray that none of them has a hiccup."
ARPs do go up and down in the secondary market, however, and so does the net asset value of the fund that owns them. In periods of high volatility in the preferred markets, an ARP may require a six-month stay before yield advantages overtake the inherent volatility of the fund shares. But for even more risk-averse treasuries seeking shorter-term havens for cash, a new corporate-fund concept -- the auction-rate perferred fund -- was cleared by the Securities and Exchange Commission this summer.
Auction-rate preferred stocks also throw off dividends that qualify for a deduction from corporate income. But because the underlying preferred stock, usually from a bank, characteristically is so conservative to begin with, the yields start out low and aftertax results don't gain so dramatically over taxable alternatives. The point of auction-rate preferred funds is the utter stability they can provide to short-term (from just a few weeks up to six months) money.
As of October, auction-rate preferred funds were expected to yield some 2.6 points less than ARP funds -- about 3.8% pretax, compared to 6.4%. But in return, auction-rate preferred funds have shown no volatility -- so far, anyway. Since they have come on the market, auction-rate preferred stocks have always been resalable at par; that is, for every $100 of cost, $100 was returned when sold (plus, of course, the dividend). "The market is saying for the confidence that you're going to get in and out at par, you have to accept a much lower dividend rate," explains Donald G. Taylor, manager of Fidelity Management Research Co.'s proposed new fund, he Fidelity Corporate Trust & Auction-Preferred Portfolio. "Adjustables don't give that degree of confidence; therefore, their yields are higher."
Because the auction-rate preferred stocks are so new, free-market relationships with other vehicles that compete for short-term cash have not settled in yet, but their recent history shows an average aftertax yield advantage over one-month commercial paper of 166 basis points -- a considerable advantage. And the advantage can be even wider: in one month, the difference was more than 300 basis points. At $100,000 to $500,000 a share, the instruments tend to be too dear for the average corporate investor. But as with ARP funds, the advent of auction-rate preferred funds diversifies risk and opens the door to amounts as small as $50,000.
Dividends are reset every 49 days via a "Dutch auction." Each bidder puts in for shares at the dividend level he or she would like to see for the next 49 days. After all the bids are submitted, the "auctioneer" -- a disinterested agent -- arranges them in ascending order. Buy orders are accumulated starting with the lowest dividend bid until the available shares are committed. The dividend rate at that cutoff point establishes the rate for the next 49 days.
Anyone already holding shares in auction-rate preferreds, such as a fund manager, has three choices going into the auction: one, elect to do nothing and simply hold the issue in question for another 49 days regardless of what the new dividend rate turns out to be; two, elect to keep that position provided the dividend rate turns out to be at least a specified percent; and three, sell his position regardless of the new rate.
For any dividend payment to qualify for the tax deduction in the eyes of the Internal Revenue Service, the payee must be at some risk. Sure enough, the auction process is accommodating -- barely. Although no Dutch auction has failed to absorb a given day's offerings at par since 1984, when American Express introduced the concept, a capital loss is possible. Besides, unlike bonds, preferred stock carries no pledge on the part of the issuer to pay up by a certain date. A defaulted preferred can stay out in the secondary market forever, like the man without a country; the obligation to pay dividends is cumulative, though, and the issue cannot be retired until arrears have been cleaned up. Depending on the fund, a corporation can keep a balance as small as $10,000. As with ARPs, fund shareholders can get out whenever they want and have funds wired to their cash accounts.
Understandably, the new funds have yet to gain wide acceptance, since the workings of their portfolios are so arcane. But even financial whizzes are puzzled by the large disparity between ARP-fund and auction-rate-fund yields. Until that gap narrows, the vote is for ARPs, despite their slightly more chancy aspect. Anyway, there's no guarantee that a simple account in a major bank won't turn your hair gray, either. Ask customers of the First National Bank of Chicago, Continental Illinois, and other dubious guardians of our hard-earned cash.
Proposed DRD and 34% tax
Less 80% DRD (5.600)
Taxable amount 1.400
Less 34% tax (0.476)
Plus excluded 5.600
Aftertax yield 6.524
Current DRD and 46% tax
Less 85% DRD (5.950)
Taxable amount 1.050
Less 46% max. tax (0.483)
Plus excluded 5.950
Aftertax yield 6.517