Path: bloom-picayune.mit.edu!snorkelwacker.mit.edu!americast.com!americast.com!americast-post Newsgroups: americast.ibd From: americast-post@AmeriCast.Com Organization: American Cybercasting Approved: americast-post@AmeriCast.com Subject: Executive Update Date: Thu, 12 Nov 92 13:00:17 EST Message-ID: <7.1992Nov12.130018@AmeriCast.com> 11/12/92 TITLE Executive Update Wising Up: Advantages Of Merrill's SMART Notes Securities Aim To Cut Financing Costs For Issuers, Risks For Investors Vineeta Anand In Washington Within months of introducing a security that lets investors bet on the market without risking losing their shirts, the financial engineers at Merrill Lynch & Co. have developed a new strain of the instrument. The latest version of the security gives inves- tors a bigger safety net and removes the tax guesswork associated with the first generation of the product. Finance With interest rates on certificates of deposit and money market accounts down to about 2%-plus and with the stock and bond mark- ets acting unpredictably, the hybrid security offers conservative investors the opportunity to earn at least 3% a year and possibly as much as 10.5%. Investors also are assured of getting all their money back in five years. The Wall Street firm, which frequently raises money for itself through new securities before pitching them to corporate clients, sold $28 million of the second genera- tion of securities at $1,000 a pop through a premiere offering in late October. The securities, dubbed SMART notes, for Stock Market Annual Reset Term, give corporate issuers fewer tax breaks and cash flow advantages than the first generation but are still more economical than convertible debt and plain vanilla bonds. SMART Notes are likely to be more popular than the first genera- tion of securities, called Market Index Target-Term Securities, or MITTS. The original securities gave individuals the opportuni- ty to earn higher returns, but they could also earn nothing at all. Steve Bodurtha, director of global equity derivatives at Merrill Lynch, says SMART notes should appeal to investors who are more interested in earning income each year than they are in long-term appreciation in stock prices. SMART notes consist of five consecutive one-year equity options on the Standard & Poor's basket of 500 stocks that are spliced on to a bond. Investors will receive $15, or 1.5%, on June 30, and the remaining interest in December. The second yearly interest payment would equal 70% of the increase in the S&P index each year, up to a maximum of 9%. At the minimum, however, investors would receive another 1.5%. Financing Costs They also will receive their initial investment back in five years when the securities mature. Merrill Lynch intends to use the proceeds of the offering for general corporate purposes, as well as to its hedge its risk in case it has to pay out investors 10.5% each year. Robert Wil- lens, senior vice president at Lehman Brothers Inc., expects Mer- rill Lynch to market its new security to corporations that are looking to cut their cost of financing below that of convertible debt, which can dilute equity. Bodurtha says there has been in- terest in the SMART Notes. "We've received some inquiries from both investors and issuers," he said. The previous-generation MITTS consist of a zero-coupon bond and a single option on the S&P index that pays no annual interest but gives investors the opportunity to earn 115% of the increase in the S&P index between July 23 and maturity in five years. Merrill Lynch raised $77.5 million for itself by issuing these securities at $10 each in July. If in five years the S&P is below its July 23 value, MITTS holders will simply get their principal back and Merrill Lynch will have had a free ride on their money. MITTS Advantage If, however, the S&P index takes off over the next five years, investors who hold MITTS could come out ahead of those who bought SMART notes. Moreover, because MITTS have a zero-coupon bond element, which doesn't pay annual interest but lets issuers take tax deductions as if they had, investors get dunned with taxes on interest they don't receive, unless they hold them in tax-exempt or tax-deferred accounts such as individual retirement accounts or Keoghs. Because of the uncertainty of how tax rules apply to a five-year option on a broad stock index, investors could end up paying taxes on paper gains in the S&P index each year. In the case of SMART notes, investors receive a clear-cut notice that they must pay taxes each year on the S&P-linked interest payments they receive each year. Merrill Lynch got around the thorny tax issues surrounding MITTS by structuring the SMART notes so that they consist of five separate annual options on the S&P. Since the year-end interest payments on the options are based on an opening value of the S&P set at the beginning of each year, Mer- rill Lynch argues that investors cannot be expected to pay taxes on undetermined gains in the successive options. Broad Marketing "From the investor's standpoint, the reduction in the uncertainty of marking to market is important," said Bodurtha. The securities are also attractive because of the annual reset feature of the S&P options. "The investor does not have to make up or retrace past years' losses from the stock market," he said. As a result of the SMART note refinements, Merrill Lynch was able to broadly market the securities to individuals and institutional investors. The murky tax aspects of MITTS made them attractive only to pension funds, other tax-exempt institutional investors and individuals with tax-deferred accounts. This article is copyright 1992 Investors Business Daily. Redis- tribution to other sites is not permitted except by arrangement with American Cybercasting Corporation. For more information, send-email to usa@AmeriCast.COM