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I also was looking for a fixed income security with a high yield and safety with upside (hard to find!). My Paine Webber recommended GPW, a convertible preferred issue of Georgia Pacific which had been beaten down with the other paper stocks to the point where it was yielding 12% when I bought it at 30. It's now 33.
Convertibles can be good alternatives!
Bob
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You might want to take a look at Security Analysis -- the book (a Speaker's corner board here) to see a short discussion of the risk/reward situation for convertibles and preferreds.

This link will point to the general area of the discussion:

http://boards.fool.com/Messages.asp?bid=113813&mid=13067939

Note: I haven't researched the GPW preferred to assess its risks, but at the return you quote, there are likely (though not certainly) going to be some risks associated with the preferred that are likely to be greater than what one would find with investment grade bonds. It might be a good idea to assess those risks before committing the capital that could be at risk in such an investment. In an established firm like GPW the risks may not be as great as the yield suggests, but I know I'd want to check their leverage, and debt ratios and credit ratings to assure myself of just what sort of risk I was assuming.

A general discussion of the commonly found risks of preferred stocks appears in the threads that follow:

http://boards.fool.com/Message.asp?mid=13067939

The subject was Kmart, and included a consideration of their common stock, preferred (convertible) stock, and outstanding bond commitments.
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Another general problem with individuals buying preferred stocks is that they tend to price like municipal bonds on the yield curve -- so if you find a preferred stock with a high yield it is probably a VERY risky investment.

The reason for this is that dividends are 70% excluded from corporate income taxes. So to an insurance company, bank, or any other company, preferred stock, which pays dividends and not interest, is priced much like a municipal bond would be to an individual.

This doesn't mean that preferreds are neccesarily bad, but just one more cautionary item when dealing with these hybrid investments.
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I analyzed GP's financials. They are a good company with low risk. The reason the yield was so high is that the market beat down all paper stocks and their cousins, convertible preferreds. The coupon was 7.75 % as I recall when they were issued at par. These are not junk bonds.
Bob
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The reason for this is that dividends are 70% excluded from corporate income taxes. So to an insurance company, bank, or any other company, preferred stock, which pays dividends and not interest, is priced much like a municipal bond would be to an individual.

I don't understand the point you're trying to make here. To whom are dividends exluded from corporate income taxes by 70%? Are preferred dividends somehow accounted for differently than regular dividends?

Can somebody help me out here?

-Ortman
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If they are not junk bonds, then why not select the common and dispense with the upside limitations that exist with the preferred?

As a fixed income investment, assuming your allocation targets and needs at the moment demand something in the high yield, relatively higher-risk area, and assuming your analysis is correct, and I would guess there's a very good chance that it is -- considering what I've seen (rough take) looking at paper stocks, it certainly sounds like a good choice.

However, the concern does remain, longer term, that a preferred stock tends to be senior only to the common in terms of priority, should the company run into serious (fundamental) trouble, somewhere down the road.

Whether that risk is significant now or not, it remains a risk for the lifetime of the security. Which is not to pass judgement on the preferred... it remains somewhat less risky than the common, and does, in any case, offer those dividends, which may be very useful to someone who requires a steady flow of income from their capital, assuming the yield is reasonably secure.

Are there any provisions in the prospectus that allow GP to suspend the coupon payments? Any other adverse factors there that may explain the premium, aside from the whims of the market (which are quite possibly all the explanation needed)?
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I don't understand the point you're trying to make here. To whom are dividends exluded from corporate income taxes by 70%? Are preferred dividends somehow accounted for differently than regular dividends?

Can somebody help me out here?


Any C corporation excludes 70% of any dividends (common or preferred) from income taxes. This is in comparison to interest from bonds which they must pay full taxes on. The comparison looks something like this.

ABC Insurance company is looking at investing $10,000 dollars, they have a choice of investing it in the Preferred Stock of XYZ Corporation paying 10% on Par of $100 and trading at Par of $100, or in XYZ Corporations 10% Bonds trading at 100. Here is how EAT statement is affected with the two options.

Option 1 -- Preferred Stock of XYZ Corp, $100, Par Value, Trading at 100, Paying 10% on Par.

Amount purchased -- $10,000 or 100 shares
Dividends per years -- $1,000
Corporate Income Tax 35%
Taxable amount of Dividends $300
Total Tax on Dividends $105
Total Income to Shareholders 895

Option 2, $10,000 in Bonds at 10% per year trading at 100.
Amount purchased -- $10,000 or 1 bond
Interest per year -- $1,000
Corporate Income Tax 35%
Taxable amount of Interest $1000
Total Tax on Interest $350
Total Income to Shareholders 650

Although as previously mentioned in other posts, the bonds are safer than the prefered stock due to their priority on assets and requirements for payments, much straight preferred stock is issued and valued as a bond type intstrument. When this is the case, the preferrential treatment preferred stock receives becomes a major factor in its valuation because corporations often purchase it in lieu of strait debt.

Now, to complicate matters, much preferred stock is not striaght, but rather participating or convertiable. In this case it has the ability for underlying appreciation in addition to only dividend payments and return of par value. In this case it does get valued more like the underlying common stock, with a guarenteed "kicker" of a bond, but additional saftey provided by preferred stock. In this case, individual analysis of the equity must be performed.

I'm not trying to say that investing in preferred stocks are neccisarily a bad thing, just that the old maxum of "reward is directly correlated with risk" is not shelved when dealing with these hybrid securities. Additionally, because of C corporations special advantages when dealing with preferred stocks, it rarely makes sense for indivuduals to own them when valuing them on a risk/reward continum -- there are usually bonds that will provide nearly the same return characteristics, but are less risky, or stocks that have the same risk and potentially more reward.

All this being said, this assumes the existance of an efficient market, which is less likely when dealing with these hybrid and extremely unique securities. If you believe your or your broker have special knowledge about the characteristics of a stock, then by all means, take advantage of it. But remember, it must be Unique enough to overcome the built in corporate tax advantage in addition to the efficient market.

rubindj
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in addition to rubindj's excellent summary of the dividends received deduction for corporations, let me add one point.

There is a lot of case law (and IRS regs, as well) revolving around the issue of whether an instrument is "debt" or "equity". I won't go into the specifics here (Section 385 of the Code is the pertinent section, but there's a lot of subjectivity involved), but suffice to say that it is possible for a company to issue something they name "preferred stock", yet it could be treated as a debt issue and not get the preferential tax treatment accorded to "dividends".

So, don't be surprised to find little "wrinkles" in preferred stock to ensure that it gets treated as equity rather than debt.

-synchronicity
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Any C corporation excludes 70% of any dividends (common or preferred) from income taxes. This is in comparison to interest from bonds which they must pay full taxes on. The comparison looks something like this.

Thanks for the wonderful explanation. Actually, I only needed the paragraph above. I was unaware that C corps received favorable tax treatment regarding dividends.

Thanks for the reply,
-Ortman
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The reason for this is that dividends are 70% excluded from corporate income taxes. So to an insurance company, bank, or any other company, preferred stock, which pays dividends and not interest, is priced much like a municipal bond would be to an individual.

This in no way changes the point of your posts, which were excellent. But for insurance companies the exclusion is 59.5%.

I get this from Berkshire's 1999 Annual Report:

Indeed, the 70% rate applies to most corporations and also applies to Berkshire in cases where we hold stocks in non-insurance subsidiaries. However, almost all of our equity investments are owned by our insurance companies, and in that case the exclusion is 59.5%


Just FYI

Ryan

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The subject was Kmart, and included a consideration of their common stock, preferred (convertible) stock, and outstanding bond commitments.

Do you think Kmart is a good investment in light of all the troubles they have had? Will the new CEO pull them out of the ash can?
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Do you think Kmart is a good investment in light of all the troubles they have had? Will the new CEO pull them out of the ash can?

There's a good argument to be made in its favor (at least for the common). Read the thread on the "Security Analysis -- the book" board and you'll have the gist of my thinking and the pretty reasonable views of several others whose views I respect. There's something intangible that keeps me from buying them myself (and some of that may just be how overweight my portfolio is at the moment in retail issues)... but I could very well be missing a good turnaround here. I've taken at least one more store visit since that discussion, with an eye to scoping them out as an investment.

There's definite improvement in ambience, and I *might* actually shop there a bit more than I have in the past. But the taste of the past is strong, and I suspect that's an intangible that may weigh heavily on management's ability to transform the company.

All in all, my take from the discussion was that this was very likely an investment unlikely to lose significant value, if held long-term, but I can't say how strong the upside could be, and with what I see as overcapacity in retail, and Kmart in a sort of "not big enough/not small enough" bind against fresher horses I can't say there's *no* risk of further decline or even eventual insolvency. Someone else might well reach a different conclusion than I have, after looking at much the same thing. A strong showing by the new management could well turn things around for them, and at least in the physical stores I've seen, there are signs the new management is changing things for the better.

Read the discussion, it covers a lot of bases and isn't limited to my subjective opinion of the company.

A good place to start might be Woodstove's valuation notes at:

http://boards.fool.com/Message.asp?mid=13035285

That puts you more or less in the middle of the discussion, trace back a week or two from there to get the background and development of the discussion.
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