Fixed-Rate Capital Securities

What Are Fixed-Rate Capital Securities (FRCS)?

A fixed-rate capital security (FRCS) is a security issued by a corporation that has a $25 par value (although some are issued with a $1,000 par value) and offers investors a combination of the features of corporate bonds and preferred stock. These securities provide the benefits of attractive yields:

The Basics of Fixed-Rate Capital Securities

Fixed-rate capital securities are financial hybrid instruments that can be structured either as debt or equity, depending on how it is presented in the prospectus. Rating agencies have taken a positive view of this financing tool for the issuer because it provides long-term capital and permits the deferral of interest payments to investors should the issuer experience financial difficulties.

However, as with preferred stock, such deferrals can only occur if the parent company stops all other stock dividend payments. With deferred interest securities, investors are not guaranteed income by holding FRCS, especially when the issuer is in financial distress. The interest deferral option on FRCS places the security at a higher risk than preferred stock or corporate bonds and, thus, offers a higher yield to investors.

New and secondary issues of FRCS are listed on the New York Stock Exchange (NYSE) and can also be traded over the counter (OTC). On the secondary markets, they tend to trade similarly to traditional bonds, selling at premiums and discounts to par based on the security’s stated coupon rate relative to prevailing interest rates, as well as the market’s perceptions concerning the credit quality of the issuer.

Unique Risks of FRCS

Unlike common and preferred stock dividends, the distributions made on fixed-rate capital securities are fully tax-deductible for the issuer, which is similar to how the interest payments on traditional debt instruments are treated. If a change in tax law lessens or eliminates the corporation’s tax advantage, the company could execute a "special event" redemption or extraordinary redemption option, allowing the issuer to redeem the securities at the liquidation value prior to maturity.

Fixed-rate capital securities are rated for credit quality by the various rating agencies including Standard & Poor’s and Moody’s. Issues with lower credit rating pay a higher yield to investors to compensate for the perceived risk. However, most FRCS are rated investment grade.

Nonetheless, FRCS carry a greater degree of risk, given that it ranks lower in the corporation’s capital structure than senior debt. In the event of default or liquidation, senior debtholders will be repaid first before FRCS investors get their investment back. FRCS holders do have a higher claim on the issuer’s assets than preferred and bond security holders.

Movements in the market may affect the daily trading prices of these hybrid securities. For instance, FRCS prices typically decline on ex-dividend days, which are the dates that buyers of FRCS are not entitled to receive the dividend. Even though the securities are traded in the open market, FRCS are considered fairly illiquid, especially when prevailing interest rates in the market increase.