Talking Trading: IDS

I've realized that I really haven't done any discussion of economics or finance here yet. Since one of the points of So Derivative is to be a forum for me to talk about trading, especially given that most of my friends' eyes glaze over when I start in on this topic, I suppose I should get down to business. So, I now present the first installment of Talking Trading.

So, I've come across an interesting hybrid security recently. It's called an Income Deposit Security, or IDS, although apparently there are other 3-letter acronyms for this same exact type of instrument. (One I've come across is EIS, or Enhanced Income Security.) The deal here is that an IDS is actually a packaged security - every IDS unit that a company issues is made up of one share of common stock and one bond. While they are publicly listed on an exchange, and trade together as a single unit, they are seperable into the two components under certain conditions. Further, there is (theoretically) an OTC market for the separate pieces. Naturally, this would lead to some obvious arbitrage potential, but my guess is that virtually nobody would bother to actually separate the two parts. Most likely, the units need to be separable for tax purposes, but nobody ever bothers to actually go through the process.

As far as I can tell, the IDS concept was pioneered in Canada, and really hasn't caught on very well in the US. I've only found a handful of these that trade, all on the AMEX. They don't seem to be very well publicized, as seems to be the case with most publicly traded structured products. What's intriguing to me, though, is that several of them seem to trade at a very high yield. What's more, I think there's a real opportunity for mispricing. Let's say, for example, company XYZ issues an IDS at $10 - $5 per share of common stock and $5 per bond. Further, let's assume that XYZ earned $1 per share for last year. A cursory glance at XYZ would lead one to believe that it was trading at 10x earnings - $10 per unit divided by $1 per share. But, half of that unit is a bond, which will be redeemed at a set date in the future. In reality, XYZ is trading at 5x earnings, since each share is worth only $5. If you actually went through the motions of separating out the two pieces of the unit, you could sell the bond, get your $5 back, and still have access to the same exact earnings stream. A few minutes online leafing through a prospectus, and you should have no problem figuring out what the par value of the bonds are on any IDS, thus giving you the true value of the stock portion of the unit. A few more minutes on Yahoo! finance can give you some back-of-the-envelope industry comps, which will give you a decent idea as to whether and IDS is grossly undervalued or not. Even after applying something like a 25% discount to peers due to the investing public's fear of the unknown, and I still suspect there's quite a bit of opportunity here.

I've already bought a few units in one company, and I'm planning on searching for some more. Due to the almost complete lack of publicity, they're not that easy to find. Also, many of the companies that issue structured products do so because they are on shakier ground - they need something to entice potential buyers because the common stock on it's own isn't particularly attractive. I wouldn't bet the farm on something like this, but it's probably a nice addition to the portfolio. Adding yet another wrinkle here is the fact that many of these IDSs are Canadian. On one hand, taking the Canadian units into account gives you many more choices. On the other hand, you'd be taking on currency risk as well as the ordinary risks in buying both the stock and bonds of the same company. It's in no way cost-efficient for an individual investor to hedge a small amount of currency risk, yet over an extended time-span the effect could be very significant.

Oh well, nobody said this game was easy. These IDSs could turn out to be giant flops. Then again, it wasn't that long ago that people were buying publicly traded warrants under parity, and convertible bonds could be bought for a credit. Never underestimate the stupidity of the market - the opportunities are still out there.