Last week, I noted that Primus (PRS) announced a fairly significant “credit mitigation” transaction, which clipped the tail risk on about $1.2 billion in notional CDS. Because Primus discloses such events and credit losses as they occur, and the company not writing new CDS business, non-GAAP earnings aren’t really a surprise – economic results of $47.5 million came from CDS premiums (no credit events in Q2) and a repurchase of debt at a large discount.

The most interesting development is that Primus is now using its float – over $730 million at quarter’s end – to invest in investment grade corporates. On the conference call, CFO Richard Claiden said that $20 million of holding company capital was now allocated this way, and subsequently Primus Financial has started doing the same. In the second quarter, Primus’ interest income from short-duration risk-free assets was a mere 0.61%. With the iShares iBoxx Investment Grade Corporate Bond ETF (LQD) yielding 5.59%, there’s plenty of room for improvement in the yield on that capital (which is about 5.6x Primus’ current market cap). My valuation model ballparks a 100 basis point improvement in yield over the duration of Primus’ current swap portfolio as being worth 58 cents per share in terminal value. There’s value to be captured here, and investing in investment grade corporates is a natural way to leverage Primus’ credit evaluation abilities.

Primus Guaranty (PRS) announced the other day that it entered into a significant credit mitigation deal with one of its counterparties, reworking $1.2 billion in notional value of credit default swaps. According to the press release, $40 million in notional exposure written on a monoline insurer was terminated for $15 million, or 37.5 cents on the dollar. The other billion-plus is being moved to a subsidiary of Primus Financial capitalized with $36 million, which is the maximum exposure (plus future premiums on those swaps) that can be lost.

Working backwards, ring-fencing certain swaps clips the tail risk existing in the portfolio at about 3.1% – a fairly high level that’s about 50% above what I’ve modeled previously. From the press release, my assumption is that the counterparty is willing to do this to minimize credit/counterparty risk related to Primus; it’s not collateral per se, but it functions in the same way.

What an opening to the year. After a -26% decline on the S&P 500 to the start of March, a 20% rally leaves the index down at “only” -11%. All in all though, it was a successful quarter for my own small portfolio; taking off some risk in early February before my positions sold off allowed me to have a large cash balance and make an opportunistic purchase the day the S&P 500 printed its intra-day low. Overall, a focus on well-financed (note: this does not mean debt-free) companies paid off during the quarter, and enabled me to post a gain of better than 50%.

Note: This is not a perfect representation of day-to-day results, because of a slight delay in inputting trades, but the end result is correct.

One area I have been looking to invest in is convertibles (bonds or preferred stock) – the yield component is appealing in distressed securities, and the embedded call option can offer upside exposure to some decent businesses. Although I’ve been enjoying the benefits of having a higher cash balance and little equity exposure, I hold cash to make strategic purchases, not as an end itself.

Those of you who have read what I’ve written regarding Primus (PRS), (PRD) know that I’m a fan of “stress testing” in circumstances where it’s possible – basically, seeing what kind of hit is priced into a company’s stock. In this case, the company had a nice dividing line between its traditional core assets and a handful of newer investments that have been problematic.

In my last portfolio repositioning in July 2008, I first made the decision to aggressively move up in capital structure, both in terms of asset allocation and how I allocate time analyzing securities. This is a decision I have regularly revisited, but with how the macro environment has deteriorated since, my preference for debt or preferred has remained. As Mohamed El-Erian points out, government involvement invariably comes at a cost to shareholders. What he leaves out, and others have focused on, is that most government capital injections effectively subsidize an institution’s debtholders. Better to be there, in my opinion, during times of trouble.

Last week, I made my first change since July. Since then, my only investments have been in Primus Guaranty stock (PRS) and debt (PRD) – primarily the latter – and that has worked out well. In that time, I am up about 40%, while the S&P is down more than 35%. The entire time, however, the risks to the investment grade universe have grown. My estimate of a peak loss rate used for Primus’ credit default swap portfolio has risen from 1.07% to 1.52% as of the most recent quarter, and the sharp rise in the overall value of my holdings has reduced the future expected returns.

The other day, Primus Guaranty released its earnings – I still own both the holding company's debt (PRD) and the stock (PRS).

As background, Primus Guaranty is a holding company with a subsidiary (Primus Financial Products, or PFP) that was formerly an AAA/Aaa-rated counterparty selling credit default swaps (CDS). To increase acronym density, PFP is a Credit Derivative Products Company (CDPC), and as such does not need to post collateral should a CDS contract move against them. This, along with the long-dated maturities of the company's debt (first maturity in 2021), means that liquidity risk is minimal.

I do a lot of reading to try to stay on top of things – both news, as well as a number of blogs and other analysis sites. Many have been commenting on the distress in the bond markets on a number of fronts – long swap spreads, investment-grade corporates, and now highly-rated commercial mortgage-backed securities. The rapid blowout in CMBS spreads has hit lower rated tranches already, and the relative stability of the AAAs has probably led to some people being caught by surprise.

The number of high-profile defaults of late from Lehman and Washington Mutual, combined with the technical defaults of Fannie (FNM) and Freddie (FRE) and a ratings downgrade of AIG that pushed the company to the brink of insolvency due to collateral calls have all thrust credit default swaps – CDS, for short – past subprime mortgage securitizations and into the center spotlight of the financial mess. I've had a front row seat for most of this, thanks to my investment in both the common stock of Primus Guaranty (PRS) and the senior debt (PRD).

A recap of the last few weeks:

Monday, Primus (PRS) CEO Tom Jasper made a presentation at a Lehman Financial Services Conference; this is an extraordinary coincidence of timing given all the questions regarding the settling of credit default swaps [CDS] on the various pieces of Fannie (FNM) and Freddie (FRE) capital. A settling of CDS contracts (which appears likely given comments by ISDA, the International Swap and Derivatives Association) would be the largest such action ever taken, and this has people nervous.

As Primus' 8-K filing Monday suggested, however, it really should be close to a non-event for all the CDS on references above the government's new senior preferred stock. Those have become "full faith and credit" obligations of the US government, and should therefore trade at a very tight spread to regular Treasuries – and because the loss on a CDS contract equals the payment (par value) less the recovery value (extremely close to par), Primus' $215 million in notational swaps on the senior and subordinated debt of Fannie and Freddie shouldn't net out to any significant losses.

Most people who have followed my writing during the summer have seen my coverage of Primus Guaranty, a credit derivative products company [CDPC] that sells credit protection via credit default swaps [CDS]. On July 22nd, I placed my entire portfolio into Primus, via a combination of its common stock (PRS) and senior debt (PRD). I saw (and see) Primus as a company with very clear risk exposures thanks to the finite and short-lived duration of its swap portfolio, and the fact that a stress-tested loss estimate nets an equity value in the mid-single digits (i.e. about $5/share), which holds even if the company were to enter a run-off.

I've tried to clear a number of misconceptions about Primus, the most important being that the company does not face the liquidity risk that took down Bear Stearns, et al. This is not an accident of chance, but due to the capital structure of Primus – because their AAA/Aaa-rated subsidiary that sells CDS protection is a CDPC, they do not post collateral regardless of how bad the mark-to-market losses on their portfolio become. Even a ratings downgrade could not result in counterparties demanding collateral; it simply isn't how Primus does business.

I've been told several times that it's the retail investors who are buying at the top of the market and throwing in the towel at the bottom. And I have a confession to make: I threw in the towel and sold the majority of my portfolio within a week of that happening.

On July 15th, the S&P 500 tested the 1200 mark, closing down for the day slightly above there. On July 16th, the S&P opened flat, lost a few points, and proceeded to rally into the close. The market has basically been up since that point.