Deceptive securities label

Scriptwriters and finance experts share a common trait: They are imaginative in the choice of titles and plots for their crafts.

Depending on the needs of their clients, investment advisers have devised financing schemes that go by such names as long-term commercial papers, collateralized debt obligation, convertible stocks and global depositary receipts.

Like commercial advertisements, these labels are aimed at attracting the attention of potential investors and, with the right pitch, encourage them to entrust their money to issuers or underwriters of securities or financial instruments.

The road shows or promotional activities undertaken to ramp up interest on these issuances are no different from those done by advertising companies when they vie for the accounts of big ticket clients.

Good features are highlighted, sometimes to the point of exaggeration. Handicaps are played down or given a spin that make them look like blessings in disguise instead.

The idea is to put their best foot forward and pray that the prospective client will buy their line.

Stiff competition in the industry has forced some investment companies to take a similar approach in the promotion of their products to the disadvantage of small (or retail) investors, or those who do not have the expertise and resources of hedge funds, pension plans and other big league investment groups.

Features

In recent years, securities described as “perpetual bonds or stocks” have been floated or offered to the public by some companies to meet their expansion requirements or to pay debts earlier incurred for corporate purposes.

For the layman, perpetual means forever or without any time limit. Not so for business people who have given it a different meaning when used to describe bonds or securities.

Perpetual bonds are fixed income instruments (or corporate debt obligations) that do not have maturity dates. They pay their holders a high fixed interest rate up to a specific date but the return of the principal is not guaranteed. It may or may not be paid back depending on the terms of the offer.

Perpetual stocks (often in the form of preferred shares) have similar features. They pay a fixed dividend rate and are non-voting, non-convertible to common stocks and non-participating, i.e., their holders have no share in the corporation’s assets in case of liquidation.

Contrary to their common sense meaning, these instruments are hardly perpetual or, at best, coterminous with the corporate life of their issuers.

They can be redeemed or bought back by their issuers, at their sole option, after, say, five years in the case of bonds and three years for stocks, from the date of their issuance.

To make the offering more attractive, the issuers promise to “step up” or increase the interest or dividend rate by a certain percentage if they are not redeemed on their indicated redemption dates.

Discretion

The holders of these bonds or stocks have absolutely no say on the productive life of the instruments they own. All the cards are stacked in favor of the issuer on when the interest or dividends shall continue to be paid or when the principal will be repaid.

In investment jargon, these securities are “callable,” or subject to termination at the discretion of their issuers.

Thus, if, for example, the issuer thinks it can secure fresh money from the market by selling new bonds at interest rates lower than those given to the bonds earlier issued, it may opt to redeem the latter ahead of its maturity period and, in the process, save on interest payments.

A similar action may be taken for perpetual shares if the company has surplus profits that allow it to buyback those shares (whose proceeds may have enabled it to rake in additional revenue) and, as a result, forgo further dividend payments.

For high-flying investment groups, the hefty interest rates that accompany perpetual bonds make good business sense. The payoff becomes higher if the principal is also repaid. And even if it is not, their profits from other investments could make up for the difference.

But not for small investors. If the bond is called and their principal returned, they have to content themselves with reinvesting their money in bonds that offer lower rates.

Dividends

In the case of perpetual shares, while the diminution of dividend payments in case the stocks are called would not adversely affect the bottom line of professional investors, the same cannot be said of small investors.

Most retail investors put their money in these stocks in the expectation that they will enjoy dividend payments from the time they fall due until the stocks remain in their hands.

The dividends are looked at as “pension funds” that can pay for or supplement the holders’ daily financial needs. If the shares are redeemed and the dividend payments cut short, finding another venue for investment that offers similar benefits would not be easy.

In the first place, there are not that many companies that offer securities to small investors that provide healthy dividend rates. And if there are, the offerings are far and in between. Such offerings are made only when the need arises or the market conditions favor taking that action.

So what’s in a name? A lot and more, especially if it is attached to something that can result in adverse financial consequences to people who can be misled by it.

Word of advice to potential investors in financial instruments: Examine carefully their terms and conditions before letting go of your money. If in doubt, consult a knowledgeable friend.

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