SLM Exchange Traded Debt: Attractively Valued

Includes: SLM
by: John D. Frankola

Much has been written about attractive opportunities in the preferred shares of financial companies that have been especially hard hit in the market’s downturn. Indeed, this week’s Barron’s has an article on the subject.

While many preferred shares look interesting, one of the most attractive fixed income securities in my view is the exchange-traded debt offerings of SLM Corp. (NYSE:SLM) (Sallie Mae), which trade under the symbols OSM (11.02) and ISM (10.99). These securities functions like Treasury Inflation-Protected Securities (TIPS) and pay a yield which is adjusted monthly to equal the 12-month CPI change plus 2.00% for OSM, and plus 2.05% for ISM.

As their names imply, these securities trade on the New York Stock Exchange, which permits them to be mispriced on a regular basis. They were originally issued at $25 a share (similar to many preferreds), but unlike preferred stock, these are debt securities that will mature at some point in the not-too-distant future. OSM matures on March 15, 2017 and ISM matures on January 16, 2018. At their current prices and dividends, the yield-to-maturity for both securities is over 22%. These securities are currently rated BBB- by S&P.

Interestingly, SLM has other debt issues of roughly the same maturity which are currently trading with a yield-to-maturity slightly below 10%. Why the big price discount and yield advantage for OSM and ISM? It seems that these securities fly way under the radar. The average 90-day daily volume for OSM and ISM is 7,600 shares and 3,400 shares, respectively - not enough to get institutional notice. These securities were probably marketed to individual investors when they were issued. Many original investors have probably bailed out and taken their tax loss.

While the lack of interest seems to account for the mispricing, it also means that investors should be cautious when placing orders to buy or sell. There is often a 5% spread between the bid and ask prices – so it is best to use limit orders.

To conclude, here is a chance to buy investment grade debt with potential returns of 20% compounded for the next nine years. As debt securities, they are senior to preferred and common shares – and they have a maturity date. Considering that SLM is forecasted to earn $1.41 per share in 2009 and that 81% of their outstanding loans are guaranteed by the U.S. government, the risk/reward tradeoff looks favorable for patient long-term investors.

Disclosure: Author owns a position in ISM and OSM and manages accounts which hold both securities.