It was greeted as "an oddball security from Canada" when it debuted in December 2003.
I'm speaking about one of the newest (and most lucrative) asset classes to hit Wall Street in recent years -- enhanced income securities (EIS). The name might not sound very glamorous, but who cares when they offer juicy yields of 11%?
The Perfect Successor to the Dying Canadian Trust
EISs are really Canadian income trusts in disguise, efficiently distributing a company's cash flow to shareholders. Canadian investment banks designed them specifically for U.S. companies seeking an income trust structure better suited to American tax laws.
As you may know, Canadian trusts have been a staple of many income investors' portfolios for years. But soon, we can kiss our favorite trusts goodbye. Thanks to the Canadian government's decision to tax them like corporations starting in 2011, their double-digit yields will become a thing of the past.
Not to worry. Enhanced income securities can pick up the slack -- they're as close to Canadian trusts as hot chocolate is to cocoa, but they likely won't face the same onerous tax penalties in the coming years.
A Peculiar Stock/Bond Hybrid
What makes these securities so unique is that they are comprised of 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.
It has taken a few years, but enhanced income securities are starting to receive some much-deserved attention from investors. And for good reason -- many pay more than DOUBLE the average yield on an "A"-rated bond, and more than four times the average yield delivered by the S&P 500 Index.
The Best of Both Worlds . . . High Yields with Low Risk
While many high-yield securities carry equally high risks, EISs are special because their rich yields are buoyed by the bond portion of the security. And for me, this is of paramount importance. After all, it's not often investors can count on enjoying high yields from investment-grade bonds while also having the upside of an equity. That's why I seek out securities like EISs that offer income investors like us the highest potential reward with relatively low risk.
In order for a firm to issue an EIS, it must generate a steady stream of regular annual cash flows. After all, income deposit securities are expected to pay both regular interest on a bond and steady dividends. As a result, those companies with unpredictable earnings and poor cash flows need not apply. Since cash flows must be stable, only steady companies in solid, predictable industries issue the securities.
These companies run the gamut from school buses and hospitals to funeral homes and recycling plants. Whatever their focus, all of them are in recession-proof businesses that throw off piles of free cash flow, even in a slowing economy. And they all pass along the lion's share of that cash flow to investors by paying abnormally high dividends.
A Closer Look at My Favorite EISs
The long-term picture for EIS's looks bright. EIS issuances have only been executed by a handful in the U.S., so this unusual asset class has been largely overlooked. But I first called attention to these high-yield gems two years ago in my premium newsletter -- High-Yield Investing.