Preferred Arbitrage: Bank Of America's Prodigal Sons
- Instead of trying to determine the right direction, we found a way to participate utilizing arbitrage.
- Overview of the securities in which we spotted the arbitrage.
- Brief coverage of the products and the scenarios.A summary of how the trade has developed for us so far.
While everyone is thinking about how and where to invest their money, and fear the threat of a new global trade war, we managed to find an arbitrage opportunity in the form of Bank of America (NYSE:BAC). More precisely in the two preferred stocks issued by the company.
Bank of America Corporation, incorporated on July 31, 1998, is a bank holding company (BHC) and a financial holding company. The Company is a financial institution, serving individual consumers, small- and middle-market businesses, institutional investors, corporations and governments with a range of banking, investing, asset management and other financial and risk management products and services. The Company, through its banking and various non-bank subsidiaries, throughout the United States and in international markets, provides a range of banking and non-bank financial services and products through its business segments: Consumer Banking, Global Wealth & Investment Management (GWIM), Global Banking, Global Markets and All Other.
The Company's Global Banking segment, which includes Global Corporate Banking, Global Commercial Banking, Business Banking and Global Investment Banking, provides a range of lending-related products and services, integrated working capital management and treasury solutions, and underwriting and advisory services through its network of offices and client relationship teams. Its lending products and services include commercial loans, leases, commitment facilities, trade finance, real estate lending and asset-based lending. Its treasury solutions business includes treasury management, foreign exchange and short-term investing options. The Company also provides investment banking products to its clients, such as debt and equity underwriting and distribution, and merger-related and other advisory services.
Within Global Banking, Global Commercial Banking clients include middle-market companies, commercial real estate firms and not-for-profit companies. Global Corporate Banking clients include global corporations, financial institutions and leasing clients. Business Banking clients include the mid-sized United States-based businesses requiring customized and integrated financial advice and solutions.
Source: Reuters.com, Bank of America Corp.
Source: Barchart.com - BAC Daily Chart (1 year)
The common stock has performed well enough in the past year. We can monitor the almost incessant uptrend. This is all we need to know because we are concentrating mainly on the arbitrage here and digging deeper into the company itself would be irrelevant.
The Bank of America Corp. Family
The family of Bank of America is quite big. There are different type of preferred shares with various tickers and indicators.
Source: Author's database
Due to understandable reasons I will not go trough an introduction of all the securities in the group. As we can see the family is extremely big, as I already mentioned.
So, let us get to the stars of this article:
Source: Author's database
The logic behind my idea is simple and it can be briefly explained. The two instruments which are going to be involved into our trade are BML-L and BML-J. To illustrate the recent development in the market, below are daily charts showing how these preferred stocks traded recently.
- Bank of America, Floating Rate Dep Shares Non-cumul Pfd Stock Series L (BML-L):
Source: Barchart.com - BML-L Daily Chart (1 year)
- Bank of America, Floating Rate Dep Shares Non-cumul Pfd Stock Series J (BML-J):
Source: Barchart.com - BML-J Daily Chart (1 year)
The chart below illustrates how the two preferreds have traded over time relative to one another. There is no doubt that there is a strong correlation and then suddenly we can observe them decoupling without any particular reason:
Source: Barchart.com - Comparison between BML-J and BML-L
In our software this deviation looks like this:
The correlation is confirmed over a 200-day time frame and the current spread between BML-L and BML-J is highlighted on the screenshot. What we would like to bring your attention to is the number of standard deviations illustrated in the second chart:
Almost 3 Standard Deviations away from the mean. Given that this has not happened before over this time frame, we are inclined to believe that it is significant enough to justify our involvement.
Our trading logic here is quite simple, really. As both issues are traded below par value and do not have any call risk (or at least should not carry such), we are interested in their Current Yield. We can see that BML-L not only has a higher current yield but also has a better evaluation from market's point of view. So, what we can conclude here is that the investors are giving BML-L a harsh time which, I believe, is merely a deviation from the normal.
At present BML-J is trading higher compared to BML-L and this is not supported by fundamental logic. Hence we are going ''Long'' on BML-L and respectively ''Short'' BML-J. We would like to hold BML-L until it reaches its '' theoretical'' price of $23.54 which would result in a profit of $0.39.
In other words:
- Long: BML-L (100 Shares)
- Short: BML-J (87 Shares per every 100 in BML-L)
We seldom expose ourselves to directional risk and most definitely feel at home in this kind of pair trades backed by simple statistics and fundamental knowledge. The one presented in this article is nothing incredible, but surely a decent way to remain involved in the market without breaking a sweat.
Note: This article was originally published for our subscribers on 5/1/2018 and some figures and charts may not be entirely up to date.
Trade With Beta
While at 'Trade With Beta' we always seek ways to expand our arsenal of knowledge and do our best to avoid attempts to outsmart the market, we have a long track record of successful pair trades based on pure mathematics. You are welcome to join us if you wish to learn more about this approach towards Fixed Income products and have real-time access to our ideas!
This article was written by
Day trader whose strategy is based on arbitrages in preferred stocks and closed-end funds. I have been trading the markets since I started my education in Finance. My professional trading career started right before the big financial crisis of 2008-2009 and I clearly understand what are the risks the average investor faces. Being a very competitive trader I have always worked hard on improving my research and knowledge. All my bets are heavily leveraged(up to 25 times) so there is very little room for mistakes. Through the years my approach has been constantly changing. I started as a pure day trader. Later I added pair trades. At the moment most of my profits come from leveraging my fixed income picks. I find myself somewhere in between a trader and an investor. I am always invested in the markets but constantly replace my normally valued constituents with undervalued ones. This approach is similar to rebalancing your portfolio and I just do this any time there is some better value in the markets. I separate my trading results from my trading/investment results. I target 40% ROE on my investment account and since inception in 2015, I am very close to this target.
My main activity is running a group of traders. Currently, I have around 40 traders on my team. We share our research and make sure not to miss anything. If there is something going on in the markets it is impossible not to participate somehow. Some of my traders are involved in writing the articles in SA. As such Ilia Iliev is writing all fixed-income IPO articles. This is part of their development as successful traders.
My thoughts about the market in general:
*If it is on the exchange it is overvalued and our job is to find the least overvalued.
*Never trust gurus - they are clueless.
*Work hard - this is the only way to convince yourself you deserve success.
*If you take the risk it is you who has to do the research.
*High yield is always too expensive.
We are running a service here on SA. It is a great community with very knowledgable people inside. Even though we are not in the spotlight as often as we would like to our articles' results are among the strongest on SA. You can always contact me to share some of our articles and best picks so far.
Analyst’s Disclosure: I am/we are long BML-L. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
I am/we are Short BML-J.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.