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Update On Bond And Preferred Stock Basket Strategy As Of 9/29/15

|Includes: AmTrust Financial Services, Inc. (AFSI), ARGO

My last update was published here: Bond And Preferred Stock Basket Strategy As Of 9/18/15 - South Gent | Seeking Alpha

I still believe that interest rate risks are in a heightened state for fixed income investors, as previously discussed here: An Analysis Of The Risk/Reward Balance For Intermediate And Long Term Treasuries - South Gent | Seeking Alpha (3/18/15)

However, with inflation and inflation expectations remaining abnormally low, interest rate risk has currently become less important than other bond risks including currency, credit and country risks.

Inflation expectations are currently low, as shown in the following charts:

10-Year Breakeven Inflation Rate-St. Louis Fed

5-Year Breakeven Inflation Rate-St. Louis Fed

The break-even inflation rate is viewed as the market's forecast of the annual average CPI rate. That rate is at 1.46% per year over the next ten years as of last Friday.

That number can easily be calculated as follows simply by subtracting the real yield from the nominal yield:

Daily Treasury Yield Curve Rates (non-inflation protected nominal yields)


Daily Treasury Real Yield Curve Rates

As of 9/25/15, the 10 year TIP current yield was .71% and the nominal 10 year treasury was at 2.17%, creating a break-even spread of 1.46%. The buyer of the ten year TIP would need an average annual CPI increase of 1.46% to break-even with the buyer of the non-inflation protected ten year treasury.

Over the past 12 months through August 2014, the government's CPI index was up only .2% on a non-seasonally adjusted basis. Consumer Price Index Summary

Deflationary risks have increased over the past year due to the declines in commodity prices, the parabolic rise in the USD which lowers import prices (WSJ), the recessions in several important economies (Brazil, Russia, Canada), the slowdowns in many others with China being the most important, and the persistent sluggishness in the Eurozone and Japan: "The euro area's uninspiring recovery"-The Economist; Euro Area GDP Growth Rate | 1995-2015; Japan GDP Growth Rate | 1980-2015

It does not help that worldwide government debt has soared since the Near Depression. "Debt and (not much) deleveraging"-McKinsey & Company (global debt has increased by $57 trillion since 2007 through 2014). This issue involves in part the ability of governments to spend more borrowed money to replace significant falloffs in private demand.

I have been adding to this basket some in small amounts based in significant part on the foregoing considerations. Another consideration is simply a desire to generate tax free income in my Roth IRA accounts, when the money market accounts, which fund the purchases, generate nothing as a practical matter.

The market is forecasting a less than 50% change of a .25% hike in the federal funds rate this year. Bloomberg Business

A material increase in inflation expectations from the abnormally low levels could be devastating for longer duration bonds and bond funds given the already low current yields.

The following table includes only exchange traded securities. I do not have a table showing my existing $1,000 par value bonds bought in the bond market. The snapshot was taken during the trading day on 9/29/15:

Several of these securities are ex-distribution today (9/29/15):

RAIT Financial Trust 7.625% Notes (RFT): Ex-Interest Today For $.47656 per share

National General Holdings Corp. 7.5% Preferred Series (NASDAQ:NGHCP): Ex-Dividend Today for $.46875 per share)(own in taxable account now and have sold in Roth IRA to buy NGHCZ)

Resource Capital Corp. 8.5% Cumulative Preferred Series A (RSO.PA:NYSE): Ex dividend today for $.55375 per share)

Resource Capital Corp. 8.25% Cumulative Preferred Series B (RSO.PB:NYSE): Ex Dividend today for $.515625 per share

CYS Investments Inc. Cumulative Preferred Series (CYS.PA:NYSE): Ex Dividend Today for $.484375 per share)(accidentally omitted from prior tables)

Banc of California 7.5% Senior Note (BOCA)(Ex interest Today for $.46875 per share)

At least two preferred stocks were ex distribution yesterday:

EPR Properties 5.75% Cumulative Convertible Preferred Series C (EPR.PC:NYSE)

Morgan Stanley Non-Cumulative Preferred Series A (MS.PA:NYSE)(equity preferred floater-Stocks, Bonds & Politics: Advantages and Disadvantages of Equity Preferred Floating Rate Securities

I briefly discuss the categories of exchange traded bonds in this Update: Update For Bond And Equity Preferred Stock Basket Strategy As Of 7/31/15 - South Gent | Seeking Alpha

The pickings are slim almost seven years after the FED started its Jihad Against the Saving Class. This basket was started after Lehman's failure in September 2008 and reached its peak near $150K.

The three culprits for that decline are redemptions, a lack of viable risk/reward options to deploy redemption proceeds, and profit taking.

I am increasing slowly my out-of-pocket dollar exposure by tad here and a tad there. This basket's size was at $38.775+K in July: Update For Bond And Equity Preferred Stock Basket Strategy As Of 7/31/15 - South Gent | Seeking Alpha

1. Bought 50 AFSS at $24.75-Roth IRA:

Snapshot of Trade:

Security Description: The AmTrust Financial Services Inc. 7.25% Subordinated Notes (AFSS:NYSE) is an Exchange Traded junior bond issued by insurance company AmTrust Financial Services (NASDAQ:AFSI)

Interest is paid quarterly at the fixed coupon rate of 7.25%. Par value is $25. The current yield based on a total cost of $24.75 is about 7.32%.

AFSI has reserved to itself the right to redeem this junior bond at par value plus accrued interest on 6/18/2020 "or on any interest payment date thereafter".

This bond is senior to AFSI's common and equity preferred stocks in the capital structure, but is junior to all existing and future senior debt.


AFSI has 4 equity preferred stocks outstanding that pay qualified and non-cumulative dividends.

AmTrust Financial Services Inc. 6.75% Non-Cumulative Preferred Stock Series A (AFSI.PA:NYSE)(yield 6.79% at $24.84)

AmTrust Financial Services Inc. 7.25% Non-Cumulative Preferred Stock Series B (AFSI.PB:NYSE)(yield 7.17% at $25.28)

I sold 50 AFSIPRB at $25.56:

AmTrust Financial Services Inc. 7.625% Non-Cumulative Preferred Stock Series C (AFSI.PC:NYSE)(yield 7.5% at $25.41)

AmTrust Financial Services Inc. 7.5% Non-Cumulative Preferred Stock Series D (AFSI.PD:NYSE)(yield 7.4% at $25.28)

I view the yields of those preferred stocks to be internally inconsistent in part, based on their functional equivalence and yield-to-call numbers. For example, AFSIPRD has a 7.4% yield compared to AFSIPRB at 7.17% based on the same market price of $25.28 which was the last trade price when I was writing this section. The difference in yield can not be explained by the differing optional call dates. AFSI has the option to call AFSIPRB on or after 7/1/19 and AFSIPRD on or after 3/19/2020.

AFSIPRB Prospectus

AFSIPRD Prospectus

AFSIPRA has the lowest yield and is callable on or after 6/10/18: Prospectus

ROTH IRA and Taxable Account

AFSS is the better option for a retirement account compared to the 4 AFSI equity preferred stocks. The current yield is slightly lower than two of the equity preferred issues but the yield-to-worst would be higher for AFSS due to its discount.

The equity preferred stocks do pay qualified dividends, but that is irrelevant in a Roth IRA.

The yield calculation needs to adjust for taxes when selecting AFSS or the AFSI preferred stocks in a taxable account. For investors with marginal tax rates in excess of the qualified dividend cap, the preferred stock and junior bond yields need to be evaluated on an after tax basis. The AFSIPRD 7.4% current yield would translate into a 6.29% after tax yield, assuming a qualified dividend tax cap of 15%, whereas AFSS would have its 7.32% current yield reduced to 5.124% at a 30% marginal rate. Other considerations come into play other than current yield when making this kind of account placement selection.

Outside of the bankruptcy context, where preferred stocks frequently end up worthless, the safety of the distribution is in part determined by priority in the capital structure and whether the preferred stock dividend is cumulative or non-cumulative.

AFSI does not have the option to defer or eliminate the AFSS interest payments.

That is an important consideration particularly when its equity preferred stocks pay non-cumulative demands, which simply means that those dividends can be eliminated, just like a common stock dividend.

{This default provision, like many other recent ones, does not allow bond owners the right to accelerate for a failure to pay interest. The right of acceleration is limited to "events of default" which are defined to mean a bankruptcy or reorganization. The remedy for a failure to pay interest is for the trustee to make a demand for payment and then institute a judicial proceeding for collection. It is hard to imagine a company allowing that kind of lawsuit to happen, with no bankruptcy, since there would be no defense, prejudgment interest on all delayed interest payments would likely be assessed as an element of the damages, and the company would suffer the consequences with rating downgrades, lost access to the debt market, and other long term adverse events to its business. In other words, as a practical matter, I do not see the acceleration issue to be of significant importance. It might be relevant in certain circumstances as a means to apply pressure since the acceleration could easily and quickly result in a bankruptcy filing. That is the likely outcome anyway when the company fails to make an interest payment and the creditors sue}

AFSI can eliminate the equity preferred stock dividends once it eliminates cash dividend payments to common stock owners and refrains from any action that would otherwise trigger the Dividend Stopper Clauses contained in its preferred stock prospectuses.

AmTrust Financial Services, Inc. (AFSI) is paying a common stock dividend so the priority issue is irrelevant currently. It only becomes relevant when AFSI eliminates a common share cash dividend which certainly enhances the elimination risk of a non-cumulative preferred stock dividend.

The elimination of preferred stock non-cumulative dividends would be due to financial stress. Consequently, the preferred stocks would likely have already been smashed in price even before an elimination of the common and preferred dividends, which frequently occur at the same time. When and if that elimination occurs, the junior bond price would probably also reflect a high likelihood of a BK, but the obligation to pay the full amount continues outside of a BK. The junior bond's priority to income would become very relevant when the company takes years to recover outside of a BK and eliminated its non-cumulative dividends before starting on that long recovery path.

Recent Earnings Report: For the 2015 second quarter, ASII reported net income attributable to common shareholders of $70.7M. The combined ratio was reported at 90.5%.

Sourced: AFSI Q2 2015 8-K

The current consensus E.P.S. estimate is for $5.67 in 2015 and $6.09 in 2016. AFSI Analyst Estimates

The company discusses risks incident to its operations starting at page of its 2014 Annual Report.

This company is controversial and has drawn criticisms from short sellers about its accounting. I will simply reference some of my earlier discussions on that topic and refer anyone interested to a few SA articles:

AmTrust Financial Services: A P&C Blow-Up In The Making - Part I and other SA articles written by "Gotham Investing"

Accounting issues raised at AmTrust Financial By Alistair Capital

SA Articles by the GeoTeam

Item # 7 Stocks, Bonds & Politics: Bought 50 AFSIPRB at $24.79 (8/29/14 Post); Item # 3 Stocks, Bonds & Politics: Bought: 50 MHNC at $22.8 (2/10/14 Post).

Since I have no training in accounting whatsoever, I can not resolve those allegations one way or the other. Their presence, however, causes me to limit my exposure to AFSI in monetary terms and to buy in limited amounts only its preferred stocks or bonds. I no longer own an AFSI preferred stock.

The company discusses risks incident to its operations starting at page 37 of its 2014 Annual Report: AFSI 12.31.2014 10K

2. BOUGHT 50 AGIIL at $24.86-Roth IRA:

Trade Snapshot:

Security Description: The Argo Group International Holdings Ltd. 6.5% Senior Notes Due 2042 (AGIIL) is a senior Exchange Traded bond issued by the Argo Group US, the U.S. subsidiary of Argo Group International Holdings Ltd. (AGII). The note is guaranteed as provided in the prospectus by the parent company.

AGII is an international underwriter of specialty insurance and reinsurance products in the property and casualty market. (Profile Page at Reuters: Argo Group International Holdings) Reinsurance companies make me nervous. I will generally avoid the common stocks altogether and will dabble only in their bonds.

AGILL will make quarterly interest payments at 6.5% on a $25 par value. The issuer has the option to redeem at par value on or after 9/15/17. Unless redeemed early, the bond matures on 9/15/42. Final Prospectus Supplement The optional redemption date reserved to this issuer always creates asymmetric interest risk that disfavors the bond's owner.

Any bond with a maturity in 2042 has a ton of interest rate risk. The coupon is sufficiently low that the issuer may never redeem it early.

The bond is currently rated BBB- by S & P.

A.M. Best rates this senior bond at BBB.

This bond was sold to the public at $25 back in September 2012. The bond traded mostly between $25 to $26 until May 2013, whereupon it slid rapidly to $21 as interest rates started to spike up. AGIIL Interactive Chart The price only stabilized at close to $21 after interest rates started to go back down, starting in January 2014.

Argo Group International Holdings Key Developments Page at Reuters

AGII Key Statistics Page at YF

ARGO SEC Filings

The consensus E.P.S. estimate for AGII is $2.92 in 2013 and $3.42 in 2014. AGII Analyst Estimates

Argo Group International was formerly known as PXRE Group.

Earnings can be erratic as shown at page 46 of the 2012 Annual Report: Form 10-K

The is debt junior in priority that is summarized starting at page F-29 of the 2014 Annual Report.

Prior Trades: During the interest rate spike in 2013, I managed to buy this senior bond at $20.02, which highlights the interest rate risk issue. Item # 6 Bought 50 AGIIL at $20.2 (December 2013 Post).

I sold that lot at $24.21: Item # 2 Sold 50 AGIIL at $24.21-Roth IRA (6/28/14 Post)(profit snapshot=$186.48 plus two quarterly interest payments totaling $40.62; total return 22.33% in about 6 months)

I had bought in October 2013 another 50 share lot at a higher price.

Item # 3 Bought: 50 AGIIL at $21.11 (10/13/13 Post).

Interest rates continued to rise after that October 2013 purchase which precipitated the decline from $21.11 to $20.2. I am highlighting this 2013 history to illustrate the interest rate risk inherent in long term bonds.

I sold the lot bought in October 2013 at $24.48: Item # 2 Sold: 50 AGIIL at $24.48 (6/7/14 Post)(profit snapshot=$152.58; total return of $193.2 or 18.17$ in about 7 months).

Total Trading Gains: $339.06

Since I just bought back a 50 share lot at $24.85, I would have been better off just keeping one of the 50 share lots sold at a slightly lower price. I have a hair trigger on long bond positions based on interest rate risk concerns which have recently mellowed a tad based on recent inflation numbers and the declining trends in inflation expectations embodied in the 5, 10, 20 and 30 year TIP break-even spreads.

Recent AGII Earnings Report: For the 2015 second quarter, Argo reported net income of $27.9M or $.98 per share. The combined ratio was 95.4%.

The Combined Ratio is incurred losses plus expenses divided by premiums.

Book value per share was reported at $59.76.

Sourced: SEC Filed Press Release and 10-Q

The company discusses risks incident to its operations starting at page 15 of its 2014 Annual Report: SEC Form 10-K

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. A failure to perform due diligence only increases what I call "error creep". Stocks, Bonds & Politics:ERROR CREEP and the INVESTING PROCESS. 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.

Additional disclosure: SA does not have symbols for exchange traded bonds and preferred stocks. I have instead referenced at the top the common stock ticket symbols of AFSI and AGII even though I bought the bonds rather than the common stocks of those companies. I have zero interest in their common shares.