Income Deposit Security (IDS)
What it is:
How it works (Example):
An IDS is a hybrid security that consists of both common stock and a bond rolled into one instrument. The IDS itself is listed on an exchange, but the underlying securities may or may not be. IDS holders generally may, after a specified period, detach the underlying shares or debt instruments and trade these components separately.
IDS holders receive periodic distributions from the issuer. A portion of each distribution represents dividends on the underlying common shares. Meanwhile, another portion represents interest on the underlying debt securities. IDS issuers are often required to adhere to strict written distribution policies, many of which require the issuer to distribute a stated percentage of its free cash flow.
It is important to note that although the issuer may have an obligation to pay out a stable percentage of its free cash flow, this free cash flow amount can vary from month to month or quarter to quarter. As a result, the dividends paid by an IDS may rise and fall depending on the company's operating performance, acquisition activity, or other factors that affect cash flow.
For tax purposes, a portion of an IDS distribution may be considered an ordinary taxable dividend, while another portion may be counted as return of capital. In general, returns of capital are taxed at the 15% capital gains rate when the owner sells his or her shares. Meanwhile, the interest portion is generally taxed as ordinary income.
Why it Matters:
For certain investors, such as long-term income investors, income deposit securities offer the best of both worlds. They provide current income, and because they are part stock, they protect against inflation by allowing the investor to participate in share price gains.