High-yield investment notes from STEN

But when a debt issuer promises to pay more than 11.5 percent at a time when the Federal Reserve is cutting interest rates, you need to consider whether you want to be on the issuing side of a subprime loan to a corporation.

Indeed, the ultrahigh interest rate makes a big case for buying renewable, unsecured subordinated notes issued by STEN, but the uncertainty of the paper makes the notes a Stupid Investment of the Week.

Stupid Investment of the Week showcases the conditions and characteristics that make a security less than ideal for the average consumer, and is written in the hope that spotlighting trouble in one case will help readers root out other dangers on their own. While obviously not a purchase recommendation, neither is the column an automatic sell signal, as unloading a problem investment sometimes makes the problems mount.

Investors in the STEN notes would have a tough time bailing out early. Premature withdrawals are allowed only on condition of death or "total permanent disability," or with approval of management and at a significant penalty. That means current investors should buckle up for a bumpy ride.

The good part of the ride is the big yield. The Minnesota-based firm first issued the notes last April, but it created a 30-day bonus period at the start of September that raised rates way beyond the norm.

Today, the three-month STEN note carries an annual yield of 11.63 percent if purchased in amounts over $5,000. If an investor is willing to lock that money in for four or five years, the yield will climb well past 14 percent, rising as the amount invested goes up.

The rates are well more than double what savers can get on a certificate of deposit for the same duration, even for dollar amounts too small to qualify for the current bonuses.

Even when compared to similar unsecured, subordinated debt issued by other companies through Sumner Harrington, the Minneapolis firm acting as agent for STEN, the company's interest rates are way above the curve, particularly for notes of the shortest duration.

Typically, a company pays above-market rates for two reasons: 1) It is desperate for the money or 2) It is using the high rates as a marketing ploy.

Ed Elverud, president of Sumner Harrington, says that STEN's rates were "not set out of desperation at all," but added that he does "wonder if they will raise more questions than money because they set the rates so much higher that people could get worried about what it means."

The worry is understandable. "Renewable unsecured subordinated notes" are personalized, small-scale junk bonds. The debt is unrated, uninsured, has no sinking fund to pay off the notes, and has no trading market. If STEN goes belly up, all leftover funds will be used to pay every other debtor before the noteholders get a penny, and the odds are there would be nothing left.

That means an investor needs to understand an issuer's business and believe in it. Under normal circumstances with corporate bonds, there's a credit rating to review, but STEN hasn't been rated by the major agencies.

STEN (ticker STEN) is a micro-cap stock — market capitalization about $7 million — that has its hands in several businesses, but which primarily involved in providing financing for credit-impaired used-car buyers.

So you're making a subprime loan — in the form of the notes — to a subprime lender.

In STEN's case — unlike subprime mortgage companies that have been in the news — the financing deals are secured by a depreciating asset, namely the car.

STEN has a system in place that dramatically limits its potential losses, effectively having a reserve fund from the dealers it works with; the dealers, in turn, put a locating device in each car, so that they can be repossessed if the buyer defaults. The company also has some manufacturing operations, has payday lending operations, and is involved in the Burger Time restaurant franchise and more.

Looking through the prospectus on the notes and the company's financials, it becomes clear that STEN's financing business is what Wall Street types like to call "a high-margin business," which means that the high payouts on the notes may not be quite so far out of line. The company uses the notes to make more financing deals, and can afford to pay the notes because those subprime lending deals generate those high margins.

The stock gets no analyst coverage. Morningstar considers it "distressed," which it defines as a "companies that are having serious operating problems." Despite that designation, the Chicago firm gives STEN a 'B' grade for financial health and a B-minus for profitability. While the stock gets a D grade for growth, there's nothing in the balance sheet that makes any sort of default on the notes look imminent.

For an investor looking at a big yield on a short-term note, having the company alive and kicking when the paper comes due is about all that matters.

But the stock's price movement is a reason for concern. STEN is off almost 30 percent this year, has seen its value more than cut in half since peaking last November, and would need a miracle to avoid having 2007 end as its third straight year of significant losses.

And while investors may be drawn to the current high rates, they shouldn't expect them to last. Many notes issuers have a temporary uptick in rates, then scale back over time, hoping that the person who jumps at the teaser rate today will roll into a lower-paying renewal down the road.

Elverud noted that the STEN notes are appropriate only for people who understand how they work, and only as a very small portion of a diversified investment portfolio.

That's solid advice, because while there's no denying that the high rates are a successful marketing ploy, it's tough to shake the feeling that an issuer would have to be desperate and on its last legs if it's paying more than 11 percent yields in the current market.

Chuck Jaffe is senior columnist for MarketWatch. He does not own or hold short positions in any securities covered by Stupid Investment of the Week. If you have a suggestion for Chuck Jaffe's Stupid Investment of the Week or a comment about this week's column, you can reach him at jaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.

2007, MarketWatch