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My challenge -- perhaps shared by you -- is that there is no definitive direction to the American (or for that matter, the global) economy. The market reacts to the daily news. The governments are fighting deflation risks by printing money and maintaining zero-interest-rate policies, big business is trimming costs and hoarding cash, and consumers and investors fear inflation. We all know that there is officially low-to-no inflation in the developed world, but the prices at the pumps, food (even at the big box Wal-Mart and Costco stores), utilities, and for many staples and services (including bank and government), seem to be increasing faster than published cost-of-living statistics. There was a well-publicized UK paper, that I believe is relevant for Consumer Price Index measures in other economies:

The end result is that "politicians may make bad decisions because they are using bad statistics and the general public loses faith in the statisticians because of the gap that they see between their own daily shopping experience and the official measure of inflation."

Therefore, I do not know what to believe, so I am seeking alternate strategies to manage my portfolio risks, while continuing to generate high returns. The goal of this strategy is to invest part of my portfolio to diversify away from overall economic mismanagement risk; specifically:

  1. Attain +6% yield (mandatory for my high-yield strategy).
  2. Diversify currency risks.
  3. Address inflation risks.
  4. Address deflation risks.

I am not proposing that this is a risk-elimination approach -- rather, it is exchanging an inflation/deflation risk profile for one of default and liquidity. As I do not like how the politicians are mismanaging the global economy, I am attempting to restrict the macroeconomic impact on my portfolio with a microeconomic strategy.

This approach is to use a small portion of the portfolio to develop a different financial insurance policy than those traditionally recommended. We can find many experts recommending that we hold gold, dividend-growth stocks, government bonds, and other forms of financial insurance. These should be used in conjunction with other strategies that you elect.

If holding precious metals is your preferred approach to financial insurance, let's examine our choices:

  1. We could buy gold or silver, but the yield is zero.
  2. One could buy the large gold miners, but there seems to be a question of whether they track the price of gold. Over the last few months, the market prices for the major gold miners have declined substantially, despite the price of gold trading within a range (Gold Miners Suffer Leveraged Declines Compared To Gold). Perhaps this is explained away by gold seasonality? Regardless, gold mining shares do not seem to provide either an adequate yield, or an ample opportunity for capital gains.
  3. A gold fund with yield -- such as GAMCO Global Gold, Natural Resources & Income Trust (GGN) -- may do well with inflation, but for a deflationary environment, the declining value of the assets (resource and gold mining companies) may not support future distributions. While on this topic, this fund does not seem to perform very well in low-growth environments, either. As anecdotal evidence, I have held this fund, and participated in their dividend reinvestment plan, and am around break-even after 3 years.
  4. Another SA contributor, Smarty_Pants, had previously proposed a precious metals shares, covered call strategy in one of his comments on a prior article Buying Gold Without Sacrificing Yield. Options can certainly be a vehicle to enhance your yield (and Smarty_Pants is outperforming "yours truly" with his options strategy), but this approach may not be an effective hedge of both inflation and deflation.

The proposed strategy is to buy securities which have the following attributes:

  1. Buy precious metals securities to address the risk of fiat currency devaluation. Gold, silver, and other precious metals are a store of value regardless of whether there is inflation or deflation -- it is an alternative to the fiat currencies. Precious metals miners represent the supply of the currency, and in the event of a sustained inflationary environment, should hold its value with the metal.
  2. Buy bonds to mitigate deflationary risks. "Deflation is a good time to be an owner of bonds, since the prices of goods are declining and your steady interest payments will increase your purchasing power over time" (more information is here). Use preferred shares as bond substitutes, should you not find a sufficient supply of target bond types.
  3. Stocks are typically viewed as inflation-protected. "Stocks are generally said to be the best hedge against inflation. They represent a fractional ownership in a corporation. The value of a corporation is denominated in current dollars. During inflation, prices of most assets, goods and services increase, so a fractional ownership in a corporation will be worth more in inflated dollars." (more information is here). Buy convertible bonds to attach an "insurance policy" to your bond (or preferred share) in the event of inflation. Effectively, this can convert your deflation-protected bonds into inflation-protected stocks.
  4. Instead of, or in conjunction with a convertible option, consider buying securities that pay dividends based on the price of the underlying precious metal (or the actual precious metal). This could also provide inflation/deflation protection.

Convertible securities provide value (and risks) of both stocks and bonds. To quote The Million Dollar Journey:

So now we have to look at how a convertible bond is valued. To cut to the chase: it can behave like a bond or like a stock option depending on the price of the underlying common stock. It will behave more like a bond (sensitive to interest changes) when the underlying common stock is priced too low to make exercising your option to convert to common shares a profitable decision. If, on the other hand, the common stock is increasing in value then there will come a point where the convertible bond's value will start to fluctuate more in line with the value of the common share.

My preference is to buy securities that are openly traded on an exchange. This creates limitations for the retail investor -- basically, the choice is exchange-traded debt and preferred shares -- but the great number of articles and comments related to the inequitable pricing and fees for non-exchange traded securities resonated with me, and I prefer the relative liquidity and price-transparency of publicly traded instruments -- even if they have low volumes. If you are interested in this justification, I found "Financial Innovation, Part I: Two Perception Problems and the TRACE Solution" to be a good article.

Move up the balance sheet to bonds, where possible, and to preferred shares as a second choice. In the event of insolvency, bonds, then preferred shares, will have prior claims over common shares. Therefore, this may introduce a small additional margin of investment safety.

One caution is about "mandatory convertibles." One MUST convert mandatory convertible securities -- whether at a profit or loss. A good explanatory article is "The Mandatory Convertible: A "Must Have" For Your Portfolio?"

There are a few U.S.-traded securities I have found that meet these criteria. A few have already been extinguished, which has further reduced the availability of these types of securities. For clarity, the "Yield at Issue" (plus the incremental yield if the security is selling at a discount) represents the neutral case and deflationary return. The "Conversion Description" represents the potential return -- a gain from the increased value of the underlying security -- should there be a high rate of inflation, or currency risks.

Security/Ticker

Current Price

Conversion Date

Yield at Issue

Conversion Description

AngloGold Ashanti Holdings Finance plc, 6.00% Mandatory Convertible Subordinated Bonds due 9/15/2013 (AU.PRA)

$38.26

9/15/2013

6%

0.91954 ADS shares per bond if the then current market price is equal to or greater than $54.375 and 1.14943 shares per unit if the market price is equal to or less than $43.50. For market prices between those values the settlement rate will be $50 divided by the market value. The bonds are convertible any time at the holder's option into 0.91954 ADS shares.

Freeport McMoRan Copper and Gold Inc., Corporate Bond, 8.25% due 04/01/15 (no longer available)

N/A

04/01/15

8.25%

On April 1, 2011, FCX redeemed its remaining $1.1 billion of outstanding 8.25% Senior Notes due 2015, for which holders received 104.125 percent of the principal amount together with accrued and unpaid interest.

Gold Resource Corp. (GORO)

$18.60

N/A

3.8%

A special case, where the common shareholder has the option to receive their dividends "in kind" (in either cash/silver/gold). It is currently trading at a yield.

HECLA MINING CO-7% CUM CONV PFD SER B (HL.PRB)

$56.95

Any time

7%

The preferred shares are convertible at any time into common shares at a conversion price of $15.55 per common share. The Series B preferred shares rank senior to the common stock and to any outstanding shares of Series A preferred stock.

MOLYCORP INC - 5.50% PFD CONV SER A (MCP.PRA)

$40.00

3/1/2014

5.5%

The conversion settlement rate will be 1.6667 shares per unit if the then current market price is equal to or greater than $60.00 and 2.00 shares per unit if the market price is equal to or less than $50.00. For market prices between those values the settlement rate will be $100 divided by the market value. The sale price of the common stock for the simultaneous common stock offering was $50.00 per share. The preferred shares are convertible any time at the holder's option into 1.6667 shares of common stock.

Newmont Mining Corp Convertible bonds 1.625% Series B due 07/15/17 (not publicly traded)

N/A

07/15/17

1.625%

The conversion rate of the Convertible Senior Notes is 21.6417 shares per $1,000 principal amount of notes, equivalent to a conversion price of approximately $46.21 per share of common stock.

Thompson Creek Metals Company Inc Mandatory Convertible 6.50% senior amortizing note due 5/15/2015 (TC.PRT)

$15.70

5/15/2015

6.5%

Settlement rate will be 4.5855 shares per unit if the then current market price is equal to or greater than $5.45 and 5.3879 shares per unit if the market price is equal to or less than $4.64. For market prices between those values the settlement rate will be $25 divided by the market value. (more details below)

I have provided a brief company description and a few financial metrics (courtesy of CIBC Investors Edge), followed by a description of the convertible security. As it is occasionally difficult to find information on some securities, I have referenced the appropriate websites -- please note that even the informational websites (and an excellent resource is QuantumOnLine) source the information from the respective prospectus.

Anglogold Ashanti Ltd. (AU)

AngloGold Ashanti Limited (AngloGold Ashanti) is a gold mining company with a portfolio of assets and differing ore body types in key gold producing regions. The Company also produces silver, uranium oxide and sulfuric acid as by-products. AngloGold Ashanti has 20 operations in four regions consisting of open-pit and underground mines and surface metallurgical plants in 10 countries on four continents. As of December 31, 2011 the Company's ore reserves totaled 75.6 million ounces. During the year ended December 31, 2011, it had a gold production of approximately 4.3 million ounces. AngloGold Ashanti's main product is gold. The Company six deep-level mines and one surface operation in South Africa as well as a combination of surface and underground mining operations in the Americas, Australia and the African continent. The Company's revenues are primarily derived from the sale of gold and also uranium, silver and sulfuric acid.

August, 2012 update: AngloGold Ashanti improved on cost and production guidance for the second quarter and kept its four key growth projects on track and budget despite challenging operating conditions for the global gold sector.

Market Cap: $13B

Recent Price: $33.27

52 Week Range $49.14 - $30.70

Company Website

AngloGold Ashanti Holdings Finance plc, 6.00% Mandatory Convertible Subordinated Bonds due 9/15/2013 (AU.PRA)

Liquidation preference is $50 per share. The bonds are mandatorily convertible on 9/15/2013 into a variable number of AngloGold Ashanti Ltd American Depositary Shares based on the then current price of the ADS shares for 20 consecutive trading days starting 25 days prior to the conversion date. The conversion settlement rate will be 0.91954 ADS shares per bond if the then current market price is equal to or greater than $54.375 and 1.14943 shares per unit if the market price is equal to or less than $43.50. For market prices between those values, the settlement rate will be $50 divided by the market value. The bonds are convertible any time at the holder's option into 0.91954 ADS shares.

Bond/preferred share info is here.

The share/capital structure description can be found here.

Freeport McMoRan Copper and Gold Inc. (FCX)

Freeport-McMoRan Copper & Gold Inc. is an international mining company for copper, gold and molybdenum. Its portfolio of assets includes the Grasberg minerals district in Indonesia, mining operations in North and South America, and the Tenke Fungurume (Tenke) minerals district in the Democratic Republic of Congo. The Grasberg minerals district contains the recoverable copper reserve and the gold reserve. It also operates Atlantic Copper, its wholly owned copper smelting and refining unit in Spain. FCX has its operations into five primary divisions: North America copper mines, South America mining, Indonesia mining, Africa mining and Molybdenum operations. As of December 31, 2011, consolidated recoverable proven and probable reserves totaled 119.7 billion pounds of copper, 33.9 million ounces of gold, 3.42 billion pounds of molybdenum, 330.3 million ounces of silver and 0.86 billion pounds of cobalt.

August, 2012 update: Seems to have labour, government, and other issues in many locations, including Indonesia, Congo, Chile, and Peru.

Market Cap: $34.3B

Recent Price: $35.78

52 Week Range $48.96 - $28.85

Company Website

Freeport McMoRan Copper and Gold Inc., Corporate Bond, 8.25% due 04/01/15 (no longer available)

This is provided for comparative purposes only, given the small universe of securities which qualify for this strategy.

On April 1, 2011, FCX redeemed its remaining $1.1 billion of outstanding 8.25% Senior Notes due 2015, for which holders received 104.125 percent of the principal amount together with accrued and unpaid interest. As a result of this redemption, FCX recorded a loss on early extinguishment of debt totaling $55 million ($49 million to net income attributable to FCX common stockholders or $0.05 per diluted share) in the second-quarter and six-month periods of 2011.

Bond/preferred share info is here.

Gold Resource Corp. (GORO)

Gold Resource Corporation is engaged in the exploration for and production of gold and silver in Mexico. As of December 31, 2011, the company held a 100% interest in six properties in Mexico's southern State of Oaxaca. During the year ended December 31, 2011, the company produced a total of 66,159 ounces of gold equivalent from the El Aguila Project. During 2011, the company's exploration was focused primarily on the El Aguila Project. The company classifies its mineral properties into two categories: Operating Properties and Exploration Properties. Operating Properties are properties on which the company operates a producing mine. As of December 31, 2011, the company had interest in six properties, one Operating Property and five Exploration Properties, in the southern state of Oaxaca, Mexico. In June 2011, the company acquired an additional property between the El Rey property and Alta Gracia property, referred as the El Chamizo property.

August, 2012 update: Production increased in Q2.

Market Cap: $976M

Recent Price: $18.60

52 Week Range $28.36 - $15.06

Company Website

These common shares are a "special case", where the common shareholder has the option to receive their dividends "in kind" (in either cash/silver/gold). It is currently trading at a 3.8% yield. Per their press release in March 2012:

Gold Resource Corporation is scheduled to launch its gold and silver dividend program April 10, 2012. The default company dividend will continue to be in cash, but this unique option will give shareholders the ability to convert their cash dividends into physical gold and/or silver.

An excellent article, with equally interesting comments, is "Gold Resources: Gold Dividend Means Sell".

Hecla Mining Co (HL)

Hecla Mining Company is engaged in discovering, acquiring, developing, producing, and marketing silver, gold, lead and zinc. The company operates in two segments: the Greens Creek unit and the Lucky Friday unit. Its wholly-owned subsidiary is Hecla Alaska LLC. The company produces zinc, lead and bulk concentrates at its Greens Creek unit and lead and zinc concentrates at its Lucky Friday unit, which it sells to custom smelters on contract, and unrefined gold and silver bullion bars at Greens Creek, which are sold directly to customers or further refined before sale to precious metals traders. The concentrates produced at its Greens Creek and Lucky Friday units contain payable silver, zinc and lead, and the concentrates produced at Greens Creek also contain payable gold. During the year ended December 31, 2011, the company produced 9,483,676 ounces of silver, 56,818 ounces of gold, 39,150 tons of lead and 73,355 tons of Zinc.

On August 21, 2012, Hecla announced today that it has entered into a subscription agreement to acquire 20,000,000 common shares of Dolly Varden Silver Corporation for $3,200,000. Upon completion of the transactions contemplated by the subscription agreement, Hecla will exercise control over 19.9% of the outstanding common shares of Dolly Varden. Dolly Varden is a mineral exploration company engaged in the exploration and development of silver projects in northwestern British Columbia, Canada.

Market Cap: $1.5B

Recent Price: $5.26

52 Week Range $8.10 - $3.70

Company Website

HECLA MINING CO-7% CUMULATIVE CONVERTIBLE PREFERRED SERIES B (HL.PRB)

Note that this has a very small float of about $2.5M.

Hecla Mining Company, $3.50 Series B Cumulative Convertible Preferred Stock, liquidation preference $50 per share, redeemable at the issuer's option on or after 7/01/1996 at $52.45 per share plus accrued dividends declining to $50 per share by 7/01/2003, with no stated maturity, and with cumulative distributions paid quarterly on 1/1, 4/1, 7/1 & 10/1. The preferred shares are convertible at any time into common shares at a conversion price of $15.55 per common share. The Series B preferred shares rank senior to the common stock and to any outstanding shares of Series A preferred stock.

Bond/preferred share info is here.

Molycorp Inc. (MCP)

Molycorp, Inc. (Molycorp) is a rare earth oxide producer in the Western hemisphere. The company owns developed rare earth projects outside of China. The company also owns rare earth oxide and rare metal producer in Europe. The company is the producer of rare earth alloys in the United States. It has three operating segments: Molycorp Mountain Pass, Molycorp Tolleson and Molycorp Sillamae. On April 1, 2011, the company acquired 90% interest in AS Silmet located in Sillamae, Estonia. On April 15, 2011, it acquired Santoku America, Inc. On October 24, 2011, it acquired the remaining 9.9% interest in Molycorp Sillamae. On August 22, 2011, Molycorp opened an office in Tokyo, Japan to provide customer support, as well as consulting and technical services to its customers in Japan. In June 2012, the company acquired Neo Material Technologies Inc.

August, 2012 update: Molycorp recently announced the offering of additional common and preferred shares. S&P assigned a "CCC" issue-level rating and "5" recovery rating to Molycorp's 6% senior convertible notes due 2017 in August, 2012. Molycorp is refinancing, and its common shares are subject to large short positions.

Market Cap: $1.2B

Recent Price: $9.53

52 Week Range: $58.74 - $9.56

Company Website

MOLYCORP INC - 5.50% PREFERRED MANDATORY CONVERTIBLE SERIES A (MCP.PRA)

The preferred shares were originally issued at $100/share. The preferred shares are mandatorily convertible on 3/1/2014 into a variable number of Molycorp common shares based on the then current price of the common shares for 20 consecutive trading days immediately prior to the conversion date. The conversion settlement rate will be 1.6667 shares per unit if the then current market price is equal to or greater than $60.00 and 2.00 shares per unit if the market price is equal to or less than $50.00. For market prices between those values, the settlement rate will be $100 divided by the market value. The sale price of the common stock for the simultaneous common stock offering was $50.00 per share. The preferred shares are convertible any time at the holder's option into 1.6667 shares of common stock. Distributions of 5.50% ($5.50) per annum will be paid quarterly on 3/1, 6/1, 9/1 & 12/1 to holders of record on the record date of 2/15, 5/15, 8/15 & 11/15 respectively.

Preferred share info is here.

Newmont Mining Corp. (NEM)

Newmont Mining Corporation (Newmont) is a gold producer. The company's operating segments include North America, South America, Asia Pacific and Africa. Its North America segment consists primarily of Nevada in the United States, La Herradura in Mexico and Hope Bay in Canada. Its South America segment consists primarily of Yanacocha and Conga in Peru. Its Asia Pacific segment consists primarily of Boddington in Australia, Batu Hijau in Indonesia and other smaller operations in Australia and New Zealand. Its Africa segment consists primarily of Ahafo and Akyem in Ghana. At December 31, 2011, Newmont had attributable proven and probable gold reserves of 98.8 million ounces and an aggregate land position of approximately 31,500 square miles. Newmont is also engaged in the production of copper, principally through its Batu Hijau operation in Indonesia and Boddington operation in Australia. On April 6, 2011, the company completed the acquisition of Fronteer Gold Inc. (Fronteer).

August 2012 update: Newmont reported Q2 earnings of $0.56/share well below consensus estimates. The miss is attributed to a combination of lower sales & pricing and higher costs at a number of the operations, particularly in Asia Pacific.

Market Cap: $24.2B

Recent Price: $49.54

52 Week Range: $72.42 - $42.95

Company Website

Newmont Mining Corp Convertible bonds 1.625% Series B due 07/15/17 (not publicly traded)

July 12, 2007 - $150 million of Convertible Senior issued on July 17, 2007. For the bondholders, the conversion rate of the Convertible Senior Notes is 21.6417 shares per $1,000 principal amount of notes, equivalent to a conversion price of approximately $46.21 per share of common stock. For the Company, the convertible note hedge and warrant transactions increase the effective conversion price to $60.27 per share. The convertible note hedge and warrant transactions are designed to offset the potential dilution upon conversion of the Convertible Senior Notes in the event that the market value of Newmont's common stock at the time of conversion is greater than $46.21 per share and are expected to fully offset the potential dilution up to a market value at the time of conversion of $60.27 per share.

The $1.15 billion (previously $1.0 billion) Convertible Senior Notes are due 2014 and 2017, each in the principal amount of $575 million (previously $500 million)... The 2014 Notes will pay interest semi-annually at a rate of 1.25% per annum, and the 2017 Notes will pay interest semi-annually at a rate of 1.625% per annum.

Bond/preferred share info is here.

January 3, 2012- Newmont Mining Corporation (the "Company") hereby notifies holders of its 1.625% Convertible Senior Notes due 2017 (the "1.625% Notes") and 1.250% Convertible Senior Notes due 2014 (the "1.250% Notes", together with the 1.625% Notes, the "Notes"), that they are entitled to convert the Notes into shares of the Company's common stock, subject to the terms of the applicable indenture.

Thompson Creek Metals Company Inc (TC)

Thompson Creek Metals Company Inc. is a diversified mining company. It is a producer of molybdenum and has copper and gold reserves. TCM operates in three segments: U.S. Operations Molybdenum, Canadian Operations Molybdenum, and Copper-Gold (Development). The U.S. Operations Molybdenum segment includes all mining, milling, mine site administration, roasting and sale of molybdenum products from the TC Mine and the Langeloth Facility, as well as all roasting and sales of third-party purchased material. The Canadian Operations Molybdenum segment includes all mining, milling, mine site administration, roasting and sale of molybdenum products from the 75% owned Endako Mine. The Copper-Gold (Development) segment includes development site administration from Mt. Milligan. TCM's principal producing properties are the Thompson Creek Mine (TC Mine), an open-pit molybdenum mine and concentrator in Idaho.

August 2012 update: Thompson Creek is having financial difficulties. It has completed the royalty transaction with Royal Gold. Thompson Creek intends to use the proceeds to finance the construction of the Mt. Milligan project and related costs. This should alleviate some of the funding shortfall at Mt. Milligan. However, the transaction is based on revising the company's senior secured credit facility covenants, for which TCM is currently in discussion with its lenders. According to CIBC analysts, the risk of not obtaining the amended financial covenants remains a possibility, which could lead to a ripple effect with the company's current facilities.

Market Cap: $454.1M

Recent Price: $2.63

52 Week Range: $24.60 - $14.21

Company Website

Thompson Creek Metals Company Inc 6.50% senior amortizing note due 5/15/2015 (TC.PRT)

Currently, the yield is over 10%. These "Tangible Equity Units" (tMEDS) are basically, mandatory convertible shares.

They were issued at $25 per unit, is a prepaid stock purchase contract and a 6.50% senior amortizing note due 5/15/2015 with a principal amount of $4.075312. The stock purchase contract will automatically settle for a variable number of shares of Thompson Creek Metals Co. common stock on 5/15/2015. The stock purchase settlement rate will be 4.5855 shares per unit if the then current market price is equal to or greater than $5.45 and 5.3879 shares per unit if the market price is equal to or less than $4.64. For market prices between those values, the settlement rate will be $25 divided by the market value. Prior to the IPO of this security, the last reported sale price of the common stock on 5/4/2012 was $5.53 per share.

Bond/preferred share info is here.

Conclusion

As a summary, the conversion option impacts the market price of the security, and the inflation hedge attribute. With this strategy, the neutral outcome is to receive your interest payments (and capital returned); this is also the deflationary-mitigating outcome. To attain the conversion ratio limit suggests that there is substantial inflation, and the value of the miner and respective security has increased. Additionally, it is critical to have a precious metal miner or in-kind yield to offset currency risks.

It is important for all of us to make risk trade-offs in our portfolios. This strategy may not be for you, but my intent is to provide "food for thought."

Given the limited number of choices, limited float of the bonds and preferred shares, and small capitalization of some of the underlying common shares, I have also assembled a list of similar securities in the Canadian market. These securities are relatively accessible to the retail investor, as Canadian convertible securities are generally traded on the stock exchanges. I will publish this follow-up article in Part 2 - after I put the finishing touches on the material.

Source: Hedge For Inflation And Deflation With Precious Metals Convertible Securities - Part 1 - U.S. Securities