Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

High-Income Trigger Securities (HITS)

What it is:

High-income trigger securities (HITS) are senior unsecured debt securities that pay an annual coupon rate and repay their original principal either in cash or shares, depending on the issuer's stock performance.

How it works (Example):

Let's assume Morgan Stanley issues HITS on Company XYZ that have $10 face values, pay a 10% annual coupon, and mature one year from today. Meanwhile, the HITS carry a trigger level of 75% of Company XYZ's share price at the time the HITS are issued. So if XYZ shares trade at $100 per share on the HITS' issue date, the trigger price is $75. If on the HITS' maturity date Company XYZ's stock price has stayed above the trigger price of $75 per share for the entire life of the HITS, then Morgan Stanley will repay the $10 principal in cash. But if Company XYZ stock fell below $75 per share at any time, investors receive a predetermined number of shares (say, 0.25) of Company XYZ for each HITS held, rather than a cash payment.

Note that Company XYZ is not involved in issuing HITS and has no obligations with respect to the securities. Investment banks or other financial institutions are usually the issuers, and they must file registration statements and prospectuses with the SEC when offering HITS.

There is very little secondary market for HITS, meaning that the purchasers of these securities often hold them until maturity. Therefore, investors generally cannot experience any appreciation in the value of the HITS themselves. Their returns are typically limited to the coupon paid.

Why it Matters:

Like convertible bonds, HITS share the characteristics of both stocks and bonds. With a convertible bond, however, the bondholders can participate in the company's stock price appreciation because the higher the market value of the underlying shares goes, the more the bond trades like a stock. But this upside is limited with HITS; the investor instead simply collects their interest payments and gets the privilege of potentially receiving his principal back in cash when the HITS mature.

Likewise, convertible bondholders are somewhat protected from steep stock price declines: during those times, they still receive their interest and principal payments and have priority over the company's stockholders. But HITS do not offer this principal protection. If the price of the underlying stock declines, the investor could theoretically receive a stock worth much less than the initial investment. Thus, HITS remove one of the safety nets bond issuers give to their investors -- the promise of principal repayment. These risks are primarily why HITS usually pay a higher fixed coupon than similar convertible debt and usually yield more than the stock they are linked to -- making them ideal for income investors.