A High-Yielding Dow Component Issue With 25% Upside

Telecoms are famous for issuing large amounts of debt to finance network build outs and the like but the debt issued by many corporations is untradeable by most retail investors. However, there are some debt instruments that are exchange traded and allow investors access to debt from Dow component companies. In this piece, we'll take a look at the 2004-102 SBC Communications Floating Rate third party trust preferred (GYC) to see if it is right for your portfolio.

To begin, we'll define exactly what GYC is. GYC is a third party trust preferred security which basically means that a trust, that is administered by a third party, is set up to issue shares and then uses the proceeds from the share sales to purchase a debt security by the issuer. In this case, the debt is from SBC Communications, which of course is now part of AT&T (T). As such, GYC is now the responsibility of AT&T and by purchasing GYC you are essentially buying AT&T debt. GYC is so attractive in part because the payer is a seasoned debt issuer and has very steady cash flows from which to make payments.

In addition, GYC is a floating rate security, meaning it has no stated coupon rate like many other debt securities and third party trust preferreds. The stated interest payments on GYC are USD LIBOR plus 65 basis points so long as the range is between 3.25% and 8% per annum. With USD LIBOR hovering around only 25 basis points GYC is paying the smallest amount of interest possible at the moment. However, this is one of the attractive things about GYC; as rates rise, so too will the interest distributions on GYC, juicing returns for long term holders. This is the inverse to traditional debt securities which fall in price when rates rise; GYC should actually trade up when rates rise due to the rising payout.

So now that we know what GYC is we can take a look at the price and yield of the issue. GYC was issued in $25 increments that pay the floating interest rate in quarterly payments. At present, GYC is paying about 20.5 cents per quarter, good for only a 3.25% yield on the issue price. However, GYC has traded down to $19.56 as of this writing and as such, the current yield is 4.2%. Now, you can do much better than that yield in debt securities without really looking that hard but the current yield is not why I like GYC; the yield will go up as rates rise and the massive discount to the issue price also provides some potential capital gains.

GYC has reached its call date (back in 2009) so AT&T can call it at any time. However, with it paying only 3.25% on the issue price that is about as likely as an alien invasion at this point. But when rates begin to rise and GYC potentially pays up to 8%, AT&T may be more likely to consider redeeming GYC. Once rates rise and the interest distributions increase the price will likely trade up in sympathy and simultaneously make it more likely AT&T will redeem GYC. If AT&T does decide to redeem GYC it must do so at the full $25 issue price. This creates two very large tailwinds that could produce 28% capital gains for long term holders.

In addition, this security is set to mature on its own in 2034 regardless of whether or not AT&T decides to redeem it as the underlying bond matures. Thus, if AT&T decides to let GYC ride until maturity you've essentially got a 20 year floating rate bond you can trade in and out of like a stock or ETF.

And one final note on GYC is that its distributions are interest payments and not dividends which means they are subject to normal taxation instead of the favorable dividend rate. In a retirement account this shouldn't matter but for those holding GYC in a taxable account that could be a sizeable negative.

With GYC already paying out the minimum distribution I don't see interest rate risk as a problem as it is with most other debt issues. Its payout cannot go any lower and when rates do rise, GYC's payout will rise along with them so if anything, interest rate risk is to the upside. If you can stomach the low payout today for the chance at some huge capital gains in the future, GYC may be right for your portfolio. It isn't for everyone but the prospect of 25%+ capital gains on top of a payout that rises along with interest rates is very tempting for those investors who want exposure to debt without suffering from the inherent risk of the interest rate markets sending your securities plummeting.

Source: A High-Yielding Dow Component Issue With 25% Upside

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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