It was greeted as "an oddball security from Canada" when it debuted in December 2003. Wall Street pundit Richard Steinberg compared this new security, inspired by the Canadian income trust, to "the roach motel where you check in but you can't check out." Steinberg thought investors wouldn't be able to easily trade this new type of security since it was so different, and people at the time were still favoring growth over yield.

Fortunately, not all portfolio managers sang the same tune. Bill Shrier of CIBC World Markets, which helped launch the world's first income deposit security (IDS), predicted the yield on these securities would "beat the pants off" of just about any other investment. 

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What makes income deposit securities so unique is they comprise one share of common stock and one high-yield bond. In other words, about half of the yield comes from common share dividends that can grow with the company's cash flow. The rest comes from a high-yield bond that pays you virtually guaranteed income. Shrier and others argued that if income deposit securities offered yields of around 10%, then this would be sufficient to overcome the skepticism that typically greets a new security.

He was right. It has taken a few years, but in a market driven by fears of slowing growth and flattening interest rates, the average income deposit security has rallied to fresh 52-week highs. Although just four income deposit securities are available on the U.S. market today, they have surged an average of +26% in the past year -- more than doubling the performance of the S&P 500 over the same stretch.

But share price gains are not their only attraction. These income deposit securities also carry monster yields of up to 10%. That's DOUBLE the average 5% yield on an investment-grade bond, and it's about five times better than the 1.7% yield for the average stock in the S&P 500 Index.

Plus, all four companies are in defensive industries that should remain largely immune to an economic slowdown. After all if a recession hits, who is going to stop doing laundry, having a beer and a hot dog, or talking on the phone? These are the types of recession-resistant industries that these four IDS companies are involved in.

Taxes
The dividends paid by an income deposit security may qualify for the reduced 15% dividend tax rate, or they may be treated as return of capital, which is not taxed until you sell the security. The interest income is taxed as ordinary income, making the shares suitable for tax-advantaged accounts.

Reporting the dividends to Uncle Sam is not hard. You receive two 1099-DIV forms and simply fill out one for the interest income and the other for the dividend income.

The stock and bond are "clipped" together because they were sold as a unit, but a nifty feature of these securities is that, through your broker, you can "unclip" them, trade them separately, and re-clip them at a later date. That also means you could hold the stock in one account and the bond in another, and thereby utilize different tax advantages.

In fact, if the bonds mature or are redeemed, the IDS would automatically be separated and trade as common stock. At that time, the company may decide to extend the maturity date of the bonds or simply issue new income deposit securities with identical distributions. These would be automatically exchanged for your old securities.

Valuation
As you can see, income deposit securities don't play by the same rules as ordinary stocks, so you need to use a different set of tools to value them. Take their price-to-earnings (P/E) multiples, for instance. The average P/E for the group is an outrageous 115 times next year's earnings! Before you turn away, remember that half the security is a bond, and since bond prices have nothing to do with earnings, this ratio is always inflated.

In short, we need to keep the lofty P/Es in perspective and instead focus on the cash flow that powers these distribution machines. One relevant metric for evaluating these securities is to calculate their share price as a multiple of cash flow. On that basis, the group is attractively priced with an average cash flow multiple of around 16 -- roughly on par with the S&P 500's average multiple of 14.

As we said, only four companies have issued income deposit securities in the U.S.  These include a food and beverage firm with a 9.8% yield, and a laundry equipment company that offers a juicy 8.5% yield. Throughout the remainder of today's article, we'll bring you an in-depth look at these two firms, both of which could make excellent opportunities for income-oriented investors . . .

Important Note:  Throughout the remainder of this article, we provide a closer look at two of our favorite income deposit securities (IDS). However, in order to view the remainder of this article, you'll need to subscribe to our premium income-oriented newsletter -- High-Yield Investing. After you subscribe you'll receive immediate access to this full article, as well as our monthly High-Yield Investing newsletter and a host of additional premium content. Please visit one of the following links to continue...

Good investing!

Carla Pasternak
Editor
High-Yield Investing
http://www.StreetAuthority.com

Carla has been employed in the investment industry for more than two decades. In addition to her work as a writer for several other nationally recognized financial publishers, her previous experience includes a position as President of a well-respected investor relations firm. She has also been writing shareholder reports for public companies (annual reports, speeches, corporate profiles, slide shows, etc.) since 1980.

A highly successful investment analyst, Carla specializes in high-yield, income-paying stocks. In that pursuit, she's always mindful to select companies that not only pay rich dividends, but that also have the potential to deliver strong long-term capital gains.

On the educational front, Carla holds both MBA and Ph.D. degrees. When she's not watching the market, she's teaching business courses at the college level and managing several million dollars in portfolio assets.

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