Trigger Securities (A Warning)

This morning I learned about a new investment vehicle that seems created to take advantage of people like me from the most recent edition of Richard Young’s newsletter. Trigger Securities sometimes called High Income Trigger Securities promise a higher income stream than available with conventional bonds, certificates of deposit, money market funds, or savings accounts. However, they appear to be a better deal for the bank or investment house selling them than for the individual investor is search of income.

There doesn’t appear to be a lot of information on these products. I assume they are a pretty new idea, but this is how they work according to Ivestinganswers.com and Richard Young. An investment house issues an unsecured debt obligation connected to the price of an individual stock or to the level of a stock index such as the S&P 500. Let’s say you invest $100 in one of these things. Here is what might happen. First the broker selling the product takes about $5.00 off the top. Then, like a bond, you own a security that will pay a guaranteed coupon rate for the term of the agreement, say 5% for two years. At the end of the term you will receive some portion of your money back or shares in stock as described in the agreement.

This is where things get a little tricky. Like annuities these agreements are complex. Each individual Trigger Security will be different, but basically three things can happen. Trigger securities have two points of interest, the price of the stock or level of the index at the time the security is sold and the trigger point, generally around 75% of the initial level.

If the asset or index has stayed above the issue price since time of issue or finishes above the issue price the investor may get his money back or even a little more than his original principal (read the fine print).

If the asset or index never dropped below the trigger price during the term of the agreement or finishes above the trigger price the investor will get his money back, like a bond.

If the asset or index dropped below the trigger price during the term of the agreement the investor will get some portion of his money back or a number of shares as calculated by the terms of the contract.

So, in this example, the bank gets to use your $100 for two years without investing it in any kind of an underlying security, perhaps they will lend it to a credit card holder at 18%. The salesman gets his $5.00 up front. You get $10.00 in interest income (less taxes) paid out over two years. At the end of the two years, you may or may not share in any increase in the asset. If the value of the asset drops below the issue price or finishes below the issue price but above the trigger price you will probably get your money back, but if it drops below the trigger price, unlike a bond, you will lose some portion of your original investment. Generally this loss will equal the total loss suffered by the security or index.

There isn’t a secondary market for trigger securities. This means that unlike a share of stock, you can not sell it for an easily determinable price at any time you need the money or change your mind about the future of the company. If you buy it you are pretty much stuck with it for the term of the agreement. Also please note that unlike ownership in individual securities or index mutual funds you aren’t getting any dividends from the stock or index connected to the trigger security. As readers of the blog know, I believe dividends are where it is at. Roughly half of your increase in your stock or stock mutual fund investments will be generated by dividends. Of course, if the company issuing the trigger security goes belly up, there is no underlying asset on which you can place a claim. Good luck with the bankruptcy judge; you might get a few pennies on the dollar. Evidently, the IRS has not yet decided what to do with income generated by these things. It may be taxed as capital gains or at the higher rates for regular income.

Richard Young indicates that these products are pitched at “free dinners” for investors. I get invitations to these things all the time. A long time ago, I went to one on estate planning at the recommendation of my broker. The jumbo shrimp were particularly excellent and the drinks were free. The pitch was professional, but I didn’t buy anything. Unfortunately, many people, particularly retired folk, have not been so lucky. They learned a painful lesson, “There ain’t no such thing as a free lunch.”

Please: Let’s be careful out there!