PYS: The Biggest Arbitrage In Fixed Income At The Moment

Summary

  • PYS is a third-party trust that has YTM of 13.6%, while its underlying bonds have the same metric at 7.7%.
  • The product in question trades at 30% discount to the NAV of the trust.
  • The credit risk of PYS is exactly the same as the risk of the underlying bonds and is rated "B-" by S&P.
  • The large arbitrage spread allows a long-only approach with a hedging reaction.
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As the holidays are approaching, it is time to share with the public one of our top ideas for the new year. Our readers are probably familiar with this arbitrage trade, but the arbitrage keeps on widening. The undervalued product in this arbitrage is ML Depositor PPLUS Trust 6.30% R.R. Donnelley Certificates RRD-1 (NYSE:PYS), while the overvalued product is the 6.625% bond of R.R. Donnelley (NYSE:RRD) maturing on 4/15/2029, CUSIP 257867AG6.

Road map of the article

  • Explanation of the product and how a third-party trust works
  • All the metrics of the instrument in question
  • Comparison of the third-party trust with its underlying bonds
  • The yield curve of the underlying bonds company
  • A review of RRD and its recent developments and a comment on its credibility and earnings potential
  • Comparison of PYS to similar third-party trust products
  • Our fair value estimate for PYS and how we trade it

What Kind Of An Animal Are We Dealing With

The Third-Party Trust Preferred Securities (TRuPS) are actually debt instruments masquerading as a stock.

If we may break it down:

  • A Trust is created by the company or a third party.
  • The company issues Bonds which are acquired by the Trust.
  • The Trust then issues TRuPS to the public, backed by the interest income the trust receives from the bond.
  • And the final result is a third-party trust which actually has an underlying security in the face of the Bonds.

The Star Of This Article

ML Depositor PPLUS Trust 6.30% R.R. Donnelley Certificates RRD-1. Let us quickly go through the details surrounding this product coming into existence before delving into further details:

  • Underlying Securities: 6 5/8% Debentures due 2029 Issued by R.R. Donnelley & Sons Company
  • Issuing Entity: PPLUS Trust Series RRD-1 (the "trust"), formed by Merrill Lynch Depositor, Inc. and the trustee.
  • Securities offered: PPLUS Class A 6.30% Callable Trust Certificates Series RRD-1

Source: SEC.gov - Form 424B5 by PPLUS Trust Series RRD-1

Now, you might notice a slight discrepancy in the Nominal Yield between the Underlying and the Trust Preferred - PYS - and you are correct to wonder what kind of financial engineering has occurred.

Apparently, a 'commission' in the form of PPLUS Class B 0.325% Callable Trust Certificates Series RRD-1 has been snatched by Merrill Lynch.

And last but not least, we should note that the bonds in the trust are part of a $200M issue, of which, $158M is still outstanding, while the Trust holds only $60M of the aforementioned, which essentially are the underlying product of PYS.

Having covered the important facts related to this product let's have a look of the basic parameters of PYS itself:

Source: subscribers' spreadsheet.

PYS Is Virtually The Same Thing As The Underlying Bonds

To prove this, I will post several facts:

  • How S&P rates the trust and the reasoning:

Source: Standard and Poor's.

And, of course, a quote from prospectus:

The trust certificates are subject to the creditworthiness of the underlying securities issuer The trust certificates represent interests in obligations of the underlying securities issuer. In particular, the trust certificates will be subject to all the risks associated with directly investing in the underlying securities issuer's unsecured unsubordinated debt obligations.

An SEC filing:

Here, one can see how PYS interest is earned. We explained it at the beginning of the article and here is the actual payment received from the underlying bonds. $60 mln of nominal value held in the trust pays 6.625% * $60 mln / 2 = $1.9875 mln semiannual payment. 6.30% out of 6.625% goes to PYS holders, which is $1.890 mln and the remaining 0.325% out of 6.625% goes to the class B holders. There is a 300 mln and the remaining 0.325% out of 6.625% goes to the class B holders. That's it, no fancy mathematics here. If the underlying bond pays its interest, PYS pays interest.

Based on all these facts, one would really expect PYS and the underlying bonds to trade at similar YTM.

Once we have some certainty about the relation between PYS and the underlying bonds, it is time to examine the whole family of the underlying bonds.

Bonds of RR Donnelley & Sons

Source: Finra Morningstar

Yield curve of all the callable bonds:

I have separated the bonds that are callable because they have a more "normal" yield curve. Looking at this curve, it seems that market does not treat them as extremely toxic. I bet one can find a General Electric (GE) bond with a higher YTM. I don't know if the market is correct in pricing RRD bonds, but I know PYS has a yield to maturity of 14%. On the next chart, I have included the other bonds of RRD and PYS.

Yield curve including all bonds and PYS:

Source: author's spreadsheet

For some reason, the non-callable bonds of RRD have higher yields. I will not dig further into this because, for me, the fact that is interesting is how much PYS had deviated from the company's yield curve. The arbitrage here is superior to any other arbitrage inside the curve.

The RRD Company And Recent Developments

If we leave all the management talk and look at the numbers alone, RRD is a highly leveraged company that operates in a business with low margins. They have almost $7 bln of revenue and fail to be constantly profitable. The company has been losing market value as well for the last several years:

Source: Google search.

It seems that commercial printing used to be quite profitable in the last century. Currently, the margins are not that great as seen here:

The cost of revenue is constantly around 80% with selling/general/administrative expenses constantly around 12%. Add to this $2 bln of debt that eats around 2% of the revenue only for interest expenses. From a bond perspective, the revenue stream is not disastrous and bond yields prove this. The business seems to have very stable revenue stream and expenses are not deviating a lot either. All the nasty accounting surprises as the one in 2016 are related to goodwill impairments:

2016 restructuring, impairment and other charges-net: included pre-tax charges of $527.8 million for the impairment of goodwill in the commercial and digital print and statement printing reporting units within the Variable Print segment; $29.7 million related to the impairment of intangible assets in the commercial and digital print reporting unit within the Variable Print segment; $21.9 million for employee termination costs source: annual report 2016

Impairment of goodwill is not something that means much to bondholders in terms of credibility. In fact, it can be positive for not paying taxes when the company is profitable in the future. Even if the business does not improve in the future, the company looks like it is capable of meeting its debt obligations.

There was some recent refinancing, which shows that the company is somehow managing its debt and is trying to extend maturities even though at quite a high price...

On October 15, 2018, the Company issued $550 million of Term Loan B notes, due in 2024. Net proceeds from the issuance were used to retire $430 million of certain notes due in 2020 and 2021 and reduce borrowings under the credit facility by approximately $75 million.

...and here is the data related to the term loan:

Term Loan Credit Agreement

On October 15, 2018, R. R. Donnelley & Sons Company (the "Company"), entered into a $550,000,000 senior secured term loan B credit facility pursuant to a Credit Agreement (the "Term Loan Credit Agreement") by and among the Company, as borrower, the lenders party thereto (the "Term Loan Lenders"), and Bank of America, N.A., as administrative agent (in such capacity, the "Term Loan Administrative Agent"). Citigroup Global Markets Inc., JPMorgan Chase Bank, N.A., PNC Capital Markets LLC, and Wells Fargo Securities LLC acted as co-syndication agents for the Term Loan Credit Agreement.

Borrowings under the Term Loan Credit Agreement will bear interest, at the Company's option, at either one-week, one-month, two-month, three-month or six-month (or, if available to all the Term Loan Lenders, twelve-month or any period acceptable to the Term Loan Administrative Agent) LIBOR, plus either a margin of 5% or a base rate plus a margin of 4%

Source: SEC filings of the company

I will leave (for now) to the reader to decide if the whole yield curve of the company's bonds is overvalued compared to the term loan at LIBOR+5%. What is the reasoning behind this refinancing is something we can only guess. Extending maturity, improving the term structure of the obligations at a high cost might not be quite profitable and of best interest to common stockholders, but is without a doubt showing that the company is managing its debt with its vision of the future. The term loan gives more flexibility, but at some point may be a large negative to bondholders. One should never consider any kind of financing positive for the company without looking at its price, ranking, and restrictions. What should really worry any long-term holder of PYS and its underlying bonds is that the term of this loan is shorter than the term of PYS underlying bonds. The bonds being redeemed with the money from the loan were the same rank while this new obligation is above in the capital structure.

Market capitalization of the common can usually act as a buffer to bondholders, but that is not the case with RRD. As of the last report, the debt of the company is $2.18 bln while the market values the company at around $440 mln. This is a 5-to-1 ratio. On top of that, the common stock is quite volatile and a secondary offering will be very hard to price and execute and will not bring much fresh capital unless the company decides to hit its stockholders with massive dilution.

To summarize my view of the company, I will split it into 3 parts:

  • Common stock: a leveraged bet on something that is not showing much sign of improvement. A good analogy here would be to borrow money from a friend and bet Manchester United wins the premier league. These were both good ideas sometime in the past. (RRD and the bet.)
  • Bonds: As long as there aren't any shocks to the company's revenue stream, management is supposed to find a way to deal with its debt. EBITDA stays at $440 mln with annual interest payments of around $130 mln and total debt of $2.18 bln spread till 2031. There is also always some way to optimize $6 bln of expenses. What really bothers me here is that refinancing comes at a very high price and with raising yields, in general, a leveraged entity like RRD may need just a small shock to experience severe problems. Standard & Poor's rates the company's debt as B- and by definition, this is highly speculative which is my opinion as well. I view the whole yield curve of the company as overvalued and don't think that the reward justifies the risk especially in times when one can easily find an investment grade bond with comparable yields.
  • PYS: 13% YTM is more than enough for a company like RRD when you consider all the hedging reaction in place

Now the picture is getting clearer and is time to look at similar to PYS products.

Third-Party Trust Securities For Comparison

Once we understand what PYS is and have had our look at the company and its bonds, it is time for my favorite part - relative value. There are several third-party trusts we can compare with PYS:

Source: our preferred stock database

All of these securities are structured almost identically and carry the risk of their underlying bonds. Here we can see the underlying bonds and their yields:

Source: IB platform

On the next picture, I want to examine the relation of the yield to maturity of a third-party trust and its underlying security. What you see in the chart below is the first divided by the second:

Source: author's spreadsheet

Guess what, we have a champion! PYS YTM is almost 2 times higher than the yield of its underlying security. J.C. Penney (JCP) third parties are the biggest competitor, but, in this case, the underlying bonds trade at 20% yield to maturity. It is kind of normal to panic in this situation being a holder of the third-party trust. Lehman ABS Corp Bkd Trust Certs 2004-06, Floating Rate Goldman Sachs Cap I (JBK) is also high in the chart, but this one should not be in the group even. His life story is that it is redeemable while the underlying bond is not. On top of that, it became floating while the underlying remained fixed. I have included it in the chart just to explain this and to show that when there is a significant deviation, there is a reason.

As explained in the article, these third-party trusts have assets in the trust. These assets have their market price, and it is not hard to calculate at what discount or premium a certain third-party trades. This is exactly what you see in the chart below:

The only competition PYS faces is Synthetic Fixed-Income Sec STRATS 2006-04, 7.00% News Corp (GJV) and here the story is totally different. The underlying bond trades well above par, because it is not callable, while the third-party trust is callable and is pinned to par. You can see that all the stocks in the chart that have low-yielding underlying instruments trade above 90% of NAV. What I find really surprising is that ML Depositor PreferredPlus 8.375% Citizens Commun Certificates CZN-1 (PIY) is trading also higher than 90% of NAV. The only difference here is that when PYS was issued, Class B trust certificates were also issued to eat some small part of the underlying assets distributions. This does not change the picture that much:

The holders of the Class B trust certificates will not receive a distribution of the principal amount of the underlying securities unless a default on the underlying securities

And we have already shown how much value the Class B trust certificates have. They will receive roughly $200,000 per year until maturity. Even if we take into account all future payments for Class B holders and pay them today, the amount will be around $2 mln. This in no way can explain the 30% spread in discounts between PYS and PIY. There is absolutely nothing that is available to the public that can explain this.

Why Is There Such A Large Arbitrage In Such An Easy To Calculate Instrument?

First, let's take a look at how arbitrages work in low volume products:

At first, there is a small arbitrage that even traders don't pair trade. Then the arbitrage widens and traders are in for the fast easy money. But surprisingly no one big is willing to participate, because it is not worth the effort for them. This leaves the small trader wondering "what I missed this time".

Very often, it is just a matter of time for logic to prevail and it is all about timing. PYS is a fairly low volume instrument. The same applies for RRD common stock and all of its bonds. Bonds are not being traded actively by the general public. Too many people don't care at all about such low volume products as PYS. There is quite a big chance 70% of the readers of this article have never even heard about PYS. So we are in a situation that there is not much money on the table for the big players and the small traders are not really familiar with the opportunity. A low volume product like PYS catches a bad trend, some panic in the common stock and the next 50 K shares sold have the price dropping significantly. The big question that remains is if it is PYS that is undervalued or the bonds that are overvalued. One can never be certain of the direction of any financial instrument in the future and if you are sure about something, market will surprise you.

An Opportunity For RRD

The only market participant who is short the underlying bonds of PYS by default is the RRD company. It definitely makes sense for them to be buying PYS at the open market. Depending on their execution they can lock all the arbitrage potential as profits and by looking at their quarterly reports, they are not in a position to pass on this opportunity. At current prices, there are at least $15 mln on the table, which will, of course, be very hard to lock as profits even for RRD. Once they start buying heavily the arbitrage will be gone. What they can do is to constantly buy small amounts of PYS while there is a stubborn seller. If there is no one at the company who can do the job, I am certain they can outsource this duty to any trader there is out there. I am buying PYS for my own account but will have no problem buying it for RRD as long as it is not a conflict of interests. The joke aside, it is a real opportunity for the financial management of the company to retire some part of its debt at a very low price and in a very fashionable way that can earn them some financial novelty award.

How To Get Involved

Long only PYS with monitoring the bonds is the best strategy that comes to mind for the people who are not actively trading. The risk reward in this one and the potential price appreciation is quite attractive. The strategy will be to hold PYS until there is a significant narrowing in the arbitrage. If lucky enough the arbitrage will narrow by PYS moving higher. For the active traders - you know what to do.

Fair Value Estimate

  1. Optimistic: PYS trading at the same YTM as the underlying bonds. This gives PYS a price of $23. At the time the article was written and announced to our subscribers PYS had offers at $15.10. This is 50% capital appreciation potential and yes PYS has often been trading at equal YTM with the underlying bonds
  2. Normal (like other third-party trusts at the moment): Here the target is 90% of NAV. As the underlying bonds are trading at 94% of nominal value, the calculation is as follows ($60mln * 0.94 *0.90 - $2mln (value of class B ))/2.4 mln shares = $20.31. At this price, PYS will have YTM of 9.45%. This is probably what I personally would consider fair value for the underlying bonds and is in line with the highest yielding RRD bond. Here the capital appreciation potential is around 33%.
  3. Pessimistic: If we consider the underlying bonds to be overvalued by 10%, and that the only reason they are priced higher is that there isn't an active seller (a big part of the issue is held in PYS trust) then we have the following calculation (0.84* $60 mln * 0.9 -$2 mln) /2.4 mln shares = $18.07. This is a capital appreciation potential of 20%. Even 20% is quite a lot for a fixed income instrument.

My personal price target at the moment of writing is $20.31, but keep in mind this target changes as the price of the underlying security changes.

Bottom line

PYS is the biggest fixed income arbitrage I see at the moment. There is no public information available to defend the deviation from NAV. The arbitrage is so large at the moment that even an only long position can be initiated. The RRD company is highly speculative, but if earnings do not surprise us in the future, bonds may end up being just fine. While I think that the company's bonds are overvalued PYS is a strong buy for the following reasons:

  • It is almost impossible to find 13% YTM from an instrument with similar credit quality and maturity. Reader is welcome to prove me wrong
  • There is massive capital appreciation potential in this trade once some force moves this product to fair value and historically PYS has been trading close to 100% of NAV and even higher
  • This is a clear arbitrage where the calculations are easy and obvious
  • PYS is superior to all third-party trusts, further proving the arbitrage
  • There is massive hedging reaction available by shorting some of the bonds of RRD (have to note that this requires higher exposure because bonds have size restrictions for being shorted)
  • Opportunities like this do not last very long and low volume products switch from undervalued to overvalued all the time.
  • There is no publicly available information for the deviation from fair value, which makes this a true bargain. (Hopefully, not a true disaster.)

This article was written by

Arbitrage Trader profile picture
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Author of Trade With Beta
Income arbitrage ideas along with managed portfolios and pair trades

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.

Disclosure: I am/we are long PYS. 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.

Additional disclosure: I am short the underlying bonds

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