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Summary

  • ETD is debt traded on stock exchanges and is more accessible to the lay investor.
  • ETD provides higher returns than comparable treasury securities and can be used to replace the risk-free asset in a portfolio for higher returns with limited upticks in risk.
  • ETD interest payments are taxed at the ordinary income tax level.
  • An investor should watch out for the call dates on ETD issues to avoid capital losses in low interest rate environments.

Exchange Traded Debt (ETD): Properties, Returns, and Analysis

Exchange traded debt securities are unique products that allow investors to invest in the debt market via equity exchanges making them significantly more accessible to (and potentially cheaper for) the individual or lay investor. Smart investment can lead to quick lower risk returns for very little effort.

Like equity, these securities are traded on stock exchanges using tickers; however they are subordinate to debt, senior to equity, and behave like notes or bonds. They can be thought of as preferred stock that pay out consistent coupon payments.

Below is a shortened list of securities from a much larger listing that is worth our consideration:

Exchange Traded Debt Securities

Company Ticker

ETD Ticker

Security

Coupon Rate

Interest per Year

Issue/ Call Price

Call Date

Maturity Date

Moodys/ S&P

AV

AVV

Aviva plc, 8.25% Capital Securities

8.25%

$2.06

$25.00

12/1/2016

12/1/2041

A3 / BBB

AEG

AEK

AEGON N.V., 8.00% Non-Cumulative Subordinated Notes

8.00%

$2.00

$25.00

8/15/2017

2/15/2042

Baa1 / BBB

ARCC

ARY

Ares Capital Corp., 7.75% Senior Notes

7.75%

$1.94

$25.00

10/15/2015

10/15/2040

Ba1 / BBB

LYG

LYG-PA

Lloyds Banking Group plc, 7.75% PINES (Public Income Notes)

7.75%

$1.94

$25.00

7/15/2015

7/15/2050

A3 / A-

SCG

SCU

SCANA Corp., 7.70% Enhanced Junior Subordinated Notes, 2009 Series A

7.70%

$1.93

$25.00

1/30/2015

1/30/2080

Ba1 / BBB-

CTL

CTW

Qwest Corporation, 7.50% Notes

7.50%

$1.88

$25.00

9/15/2016

9/15/2051

Baa3 / BBB-

AFG

AFQ

American Financial Group, 7.00% Senior Notes

7.00%

$1.75

$25.00

9/30/2015

9/30/2050

Baa1 / BBB+

ARCC

ARN

Ares Capital Corp., 7.00% Senior Notes

7.00%

$1.75

$25.00

2/15/2015

2/15/2022

Ba1 / BBB

CTL

CTU

Qwest Corporation, 7.00% Notes

7.00%

$1.75

$25.00

7/1/2017

7/1/2052

Baa3 / BBB-

CTL

CTX

Qwest Corporation, 7.00% Notes

7.00%

$1.75

$25.00

4/1/2017

4/1/2052

Baa3 / BBB-

TDS

TDJ

Telephone and Data Systems, 7.00% Senior Notes

7.00%

$1.75

$25.00

3/15/2016

3/15/2060

Baa2 / BBB-

Table 1. Security Listing - all securities are traded on the NYSE. Note: Qwest Corporation (CTQ), is a subsidiary of CenturyLink, Inc. which is listed as the underlying company in the table for Qwest's securities.

The mentioned securities are all investment grade with coupons of 7% or higher with call dates that are at least a year away (with the exception of Scana Corp., 7.70% Enhanced Junior Subordinated Notes, 2009 Series A (SCU) and Ares Capital Corp., 7% Senior Notes (ARN)). They all have an issue/call price (a par value in bond terms) of $25 and usually make quarterly payments. The highlighted securities are the main focus of this article.

Aviva Plc, 8.25% Capital Securities (AVV), AEGON N.V., 8.00% Non-Cumulative Subordinated Notes (AEK), Ares Capital Corp., 7.75% Senior Notes, Lloyds Banking Group plc, 7.75% PINES ((LYG-PA)), and Qwest Corporation, 7.50% Notes (CTW) all have higher coupon rates, higher liquidity in the market compared to the other available issues (essential to reduce reinvestment risk and to enable quick selling if required), and hence, higher earning power. The below scenarios consider an investment in each of the five securities till its first call date (as listed in Table 1) which is used in lieu of the maturity date (for reasons discussed in the 'Word to the Wise' section later in this article):

ETD Ticker

YTM

Time to Maturity (Years)

Equivalent Treasury Security YTM

Treasury Security Type

AVV

4.72%

2.73

0.79%

3 Yr

AEK

3.90%

3.43

0.79%

3 Yr

ARY

4.60%

1.60

0.37%

2 Yr

LYG-A

1.48%

1.35

0.12%

1 Yr

CTW

5.49%

2.51

0.79%

3 Yr

Table 2. Security Yields

The yield to maturity (YTM) for the securities is calculated using the yield function in Excel. The settlement date used is March 12th, 2014, the redemption date is the first call date listed in Table 1, the starting price is based upon security prices as of market close on March 10th, 2014 as reported here. From the above table, one can see that the returns are significantly higher than that of standard risk-free assets, i.e., treasury securities of comparable maturities (YTM is as of March 10th, 2014 and is obtained from the treasury website).

How to Use Exchange Traded Debt

Since these securities are essentially debt, ETD can replace all or part of the risk-free asset in a diversified portfolio. This will lead to increased returns in combination with the other assets with a very limited uptick in risk for the vigilant investor. For those who may not be too well versed with portfolio strategy, this is a classic way of creating an optimal portfolio that gives the maximum return for a given level of risk. Essentially, a well-diversified portfolio can be combined with a risk-free asset to yield higher returns than it would have done by itself. It is just the proportions between the risk-free asset and investor portfolio that have to be calculated to obtain the optimal portfolio. In this situation, the risk-free asset (usually treasury securities) can be replaced with higher yielding ETD to achieve even higher returns with only a marginal increase in risk.

How is the risk marginal, you may ask? Well, with ETD, the fundamentals of the actual companies do not matter. As long as the underlying company is a going concern and is unlikely to default, an investor can expect consistent payments on ETD and not be concerned with stock price or market fluctuations. An investor faces downside risk only if the company defaults or dissolves (for which there will be numerous other indicators before actual occurrence), or if the issues are called (discussed further below). The five securities discussed above are all issued by stable, established firms in the finance, insurance, energy, or communications sectors.

All of the above implies that ETD can provide almost risk free return if an investor watches out for call dates and debt ratings (expounded on further in the next section). One point to note however, is that ETD is traded flat. Unlike bonds and other debt instruments, there is no clean or dirty price and accrued interest is not paid to the seller. Instead, it is assumed that the security price reflects the upcoming interest payment. Hence, an investor can time his/her purchase to a day after the ex-dividend date to get the best price.

A word to the wise

Even though ETD is traded on equity exchanges, the payments from ETD are considered as interest - they do not qualify for the reduced tax rate and are taxed at the ordinary income tax level. Furthermore, due to the current low interest rate environment, which will probably continue for the foreseeable future (Yellen's recent comments on 'continuity' in the market as well as her signals towards an extended low interest rate environment support this premise), the discussed securities have a high chance of getting called at their call dates. One should be careful about these dates, and unwind his/her position before the date to avoid immediate capital losses (since they are currently trading at a premium and would be called at the call price of $25). For this reason, the calculations in Table 2 were based on a maturity date of the first call date (essentially, the YTM was really the YTC with no call premium). This is also why I would suggest choosing securities that have call dates even a year or two years out (in balance with liquidity, coupon rates, and debt ratings).

Lastly, since ETD is traded flat, an investor could also time her purchase or sale strategically to garner capital gains or capital losses (for tax purposes). Since the prices fluctuate around $25, these gains/losses will be marginal (depending on the volume of shares being traded by the investor) but can have an effect, nonetheless.

Conclusion

ETD is a distinctive security that provides investors with a cheaper and more accessible way to access a portion of the debt market. This type of security, especially the specific issues discussed above, can be used to replace part of the entire risk-free asset in an optimal portfolio to gain increased returns with a disproportionately lower risk.

Disclaimer: I am not a registered investment advisor; no part of the article is investment advice. Please do your own research and due diligence before investing.

Source: Exchange Traded Debt: An Analysis