Long Only, Value, Contrarian, Bonds
Contributor Since 2009
Effective 1/9/17, I will only be posting at my old website where I started to publish investment blogs back in October 2008. There will be no ads at that website.
Before discussing my Linn bond purchase, I wanted to highlight the risks of junk bonds and whether their yields are adequately compensating investors for those risks.
The only junk bond sector that interests me now are senior bonds issued by energy exploration and production companies. In that sector, I am at least receiving some compensation for assuming credit risks.
The yields in other junk bond sectors do not, in my opinion, adequately compensate for credit risks, let alone interest rate risks due to an unexpected rise in inflation. I am talking about bonds that are not currently being priced based on the estimated recovery in a bankruptcy which has not yet been filed by the issuer.
Back in 2011, I bought a boatload of junk bonds when their yields to maturity were generally in the 10% to 15% range. I suffered a few defaults along the way, but ultimately escaped without suffering a net loss on the bonds. Junk bonds were being creamed in price during the 2011 summer, as the VIX soared over 40 and the S & P 500 corrected by almost 20%. (see Yardeni Chart-Figure 1 and VIX Interactive Chart)
It was close for awhile. Several of the questionable credits were ultimately redeemed at par value or higher due to optional redemptions. With a few more defaults, I would have had a net loss on the bonds.
I was also helped by a number of issuers redeeming the bonds early at 5% to 15% premiums to par value. Those companies were able to pay the optional redemption penalty and to come out significantly ahead by refinancing at significantly lower rates while extending the maturity of the debt.
Perhaps, investors have forgotten about default risk and bankruptcies among junk bond issuers.
David Stockman pointed out last May that CCC rated bonds (CCC+, CCC and CCC-) had an average default rate of 23% between 1981 and 2008. The peak was at 58% in 2008 according to Stockman. When one of those go belly up, the recovery is pennies on the dollar and sometimes nothing at all, with slim pickings left for the secured creditors.
An investor can go to FINRA's search page for bonds and locate bonds from a particular issuer. By clicking the Advanced Bond Search tab in the red box, I can refine the search to what I want to look for at the moment: CCC rated bonds maturing between 1/1/2018 and 1/1/2020. To keep it simple, I just used in the search the S & P credit rating from CCC- to CCC+. I then looked at some of the bonds and their respective yields:
Yields Based on Closing Prices 1/29/15:
Beazer Homes 5.75% Maturing 6/25/19 YTM 7.03%
ADS Waste Holdings 8.25% Maturing 10/1/2020 YTM 7.7%
CPI International 8% Maturing 2/15/18 YTM 6.4%
What are junk bonds on average yielding now? There are several indexes for junk bonds. Perhaps, the most inclusive is the BofA Merrill Lynch US High Yield Index. The current composite yield for that index was 6.6% as of 1/28/15.
Many of those junk bonds are selling at premiums to par value too. There are a number of ETFs offered by Guggenheim that target junk bonds maturing in a particular year. ETF Product List The junk bond ETF for 2020, BSJK, had a weighted average bond price of 102.68, as of 12/31/14 and the "distribution rate" was 5.8% as of 1/23/2015.
David Stockman, who probably needs to jettison his urge to exaggerate, or possibly just become a survivalist and cease venting doom and gloom opinions every few seconds, certainly has a negative view of junk E & P bonds issued by shale oil producers. I gathered that fairly quickly by simply reading a title to one of his articles. "What Blows Up First-Shale Oil Junk Bonds" No ifs, ands, or buts from David.
1. Bought Back Two 8.25% Senior Unsecured Bonds Issued by Linn Energy and Maturing in 2020 (see Disclaimer)
Snapshot of Order Before Trade:
Snapshot of Execution:
I would just note that all of my accounts are cash accounts. I do not buy anything with borrowed money.
The order was placed in a Vanguard taxable account, where I pay a $2 per bond commission. The total commission for this 2 bond purchase was $4.
Bonds that trade in the stock market trade flat, which means whoever owns the bond on the ex interest day receives the entire interest payment and the buyer does not have to pay accrued interest to the seller. Stocks, Bonds & Politics: Exchange Traded Bonds: New Gateway Post Most of those bonds have $25 par values.
This 2020 Linn Energy bond is available only in the far less friendly bond market. The par value is $1,000, but the prices are in tenths of par value. An order to buy 1 bond at 100 would cost $1,000 in principal amount, plus accrued interest, that has to be paid to the seller.
In this purchase, I had to pay $51.75 in accrued interest to the seller. When Linn makes its semi-annual interest payment, I will receive the entire interest payment. The broker will include the entire payment in my 1099 which requires some accounting adjustments on my tax returns. That subject is beyond the scope of this post. (e.g.Accrued Interest on Bonds and I have no training in accounting anyway)
I paid 80.653 per bond. My cost before accrued interest and the $4 brokerage commission will be $1,613.06.
If Linn survives long enough to pay me par value at maturity, then I will net the difference between the $2,000 in principal amount and that $1,613.06 cost or a $386.94 locked up profit with that one critical caveat.
I will also receive semi-annually an interest payment calculated by applying the 8.625% coupon to the principal amount. To calculate the yield, I would simply divide $8.625 by $80.653 which gives me a current yield at my cost of about 10.694%. When I combine my current yield with my profit at maturity, then I have a yield to maturity which Vanguard shows as 13.91% per annum. I know that now with that important caveat. What is that caveat again? Linn has to survive to make all of the interest payments and the principal at maturity.
If Linn files for a bankruptcy, I am most likely screwed and will likely be recovering some number well below my initial investment. With that yield, there is obviously a significant amount of risk, but what can you do in a world without yield paid by "safe" investments?
I have noticed a lot of debate about the common units here at SA and whether or not Linn will cut its common distribution. While many common units were hoping that no cut would happen, Linn took the prudent step of slashing the distribution and cutting back on capital expenditures. LINN Energy Announces 2015 Oil and Gas Capital Budget; Reduces Annual Distribution to $1.25 Per Unit
I last owned the common units in 2010: Sold 100 LINE at 25.90 (6/26/2010 Post)(profit snapshot=$971.97)
A bond owner generally does not like seeing money fly out the door to common shareholders and would be most chagrined to see a company borrow money to pay those distributions. A bond issued by a MLP or any other pass through entity is not supported by a capital cushion buildup that would normally occur with a dividend paying "C" corporation.
The bond owner is concerned with one important detail.
Is the company going to survive to pay the interest and principal amount? Given the short maturity, and the projections for inflation embodied in the 5 year TIP price, I am not concerned about interest rate risk with this bond.
The payment on this senior bond can not be deferred or cut. If Linn fails to make the full payment when required, and does not thereafter cure that failure in a timely manner, bankruptcy is probably just around the corner, a place where the senior unsecured bond owners would be trying to recover some fraction of their investment and the common shareholders generally end up with certificates having the same value as used toilet paper.
When a company is on the road to a bankruptcy, the bond prices will start to reflect the potential recovery before the filing is made.
FINRA has trade and other information for this bond:Bond Detail
According to FINRA, it is rated in junk territory with current ratings of B1 (Moody's) and B (S & P).
The FINRA page also has a chart showing the price action since issuance. The peak price was hit last May near 115 and then we all know what happened. The crude oil price went into freefall and the junk bonds from E & P producers sank in tandem. That price correction was brutal and fortunately I missed it. The cause has nothing whatsoever to do about interest rate risk. The sole reason is increased concerns about credit risks.
My first forays into E & P junk bonds started in December 2014, and this LINN 2020 was my first buy. Bought 2 LINN Energy LLC 8.625% Senior Unsecured Bonds at $81 (12/13/14 Post) I do not recall buying any prior to that time.
I go into more detail about these LINN bonds in that post.
After I bought this bond, WTI continued to slid in a major way, but this bond went up in price.
I got cold feet and sold the two bond lot. Item # 2 Sold 2 LINN 2020 Bonds at $88.5-Bought at $81 (1/14/15 Post) Okay, admittedly, the profit of $133.78 (and a few bucks in interest) is not going to pay my nursing home expenses; and this is what I call small ball, sort of like leaning into a pitch and hoping the ump does not notice until the baseball grazes the jersey.
So what changed my mind other than a price drop back to 81?
Today, and over the past few days, I have read a number of stories about huge cuts in capital expenditure budgets (e.g. Reuters)
Without making a prediction as to when crude oil supply and demand will return to a balance, causing a rise in crude prices to more favorable levels other than to consumers, it just seemed to me that the low prices will spur demand and that production curtailments will reduce the supply overhang. I do not expect this to happen quickly, but the balance may be restored quicker than the market currently anticipates. We will know more when demand picks up later in the spring and into summer, and have more details about how production has been impacted by the current prices.
I will be looking at a lot of different data to make investment decisions in the energy sector, both stocks and bonds, including the following:
Fortunately I cut back my stock allocation before the nasty hit.
2014 Dispositions Pre-October:
Unfortunately, I did nibble on some speculative plays discussed here at SA (Long Run and Birchcliff as part of my Flyer's Basket Strategy) and have become an involuntary long term holder of those two Canadian E & P companies.
I would refer to the Linn bond investment as high risk, which explains why I am risking only slightly more than $1600. I do not view Linn's credit risk to be in the extreme high risk category, and a number of E & P bonds fall into that category now.
Disclaimer: I am not a financial advisor but simply an individual investor who has been managing my own money since I was a teenager. In this post, I am acting solely as a financial journalist focusing on my own investments. The information contained in this post is not intended to be a complete description or summary of all available data relevant to making an investment decision. Instead, I am merely expressing some of the reasons underlying the purchase or sell of securities. Nothing in this post is intended to constitute investment or legal advice or a recommendation to buy or to sell. All investors need to perform their own due diligence before making any financial decision which requires at a minimum reading original source material available at the SEC and elsewhere. Each investor needs to assess a potential investment taking into account their personal risk tolerances, goals and situational risks. I can only make that kind of assessment for myself and family members.