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Update For Exchange Traded Bond And Preferred Stock Basket Strategy As Of 10/15/15

This basket strategy was last updated here: Update For Exchange Traded Bond And Equity Preferred Stock Basket Strategy As Of 10/7/15 - South Gent | Seeking Alpha

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 IMO.

Inflation expectations are currently low: 5-Year Breakeven Inflation Rate-St. Louis Fed;10-Year Breakeven Inflation Rate-St. Louis Fed

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)

Minus

Daily Treasury Real Yield Curve Rates

The U.K. reported on Tuesday that its inflation rate had turned negative again:BBC News; United Kingdom Inflation Rate | 1989-2015

The Euro area is alternating between deflation and low inflation numbers: Euro Area Inflation Rate | 1991-2015 The September number was reported by Eurostat at -.1%. eurostat

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. I will discuss those bond market purchases here.

Basket as of 10/15/15:

This basket topped out near $150K, but had shrunk to less than $40K due to issuer redemptions and profit taking a couple of months ago. Update For Bond And Equity Preferred Stock Basket Strategy As Of 7/31/15 - South Gent | Seeking Alpha

Over the past few weeks, 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.

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.

Over the past 12 months through September 2015, the government's CPI index was "essentially unchanged", driven down by the energy prices:

Energy Deflation 12 Months Through September:

March/April/May/ June/ July/ August /September/ Annual Rate

Core CPI rose at a 2.6% annualized rate in September.

Outside of energy, there are signs of incipient inflation pressures.

Core CPI was up 1.9% over the past year. Consumer Price Index Summary

Inflation and inflation expectations are very important to fixed income investors, particularly given the current historically low yields. A small rise in interest rates can wipe out a year's worth of distributions.

The average annual estimated CPI rates remain abnormally low based on the break-even spreads of inflation protected notes and bonds:

5-Year Breakeven Inflation Rate-St. Louis Fed

10-Year Breakeven Inflation Rate-St. Louis Fed

The Cleveland FED has another method of calculating the expected average annual inflation rate over the next ten years. The current estimate is for an average annual inflation rate of 1.74% which is close to the 10 year TIP break-even spread:Inflation Expectations: Latest News Release

Median CPI was hot in September, rising at an annualized rate of 3.4%, as calculated by the Cleveland Federal Reserve: Median CPI: Latest News Release

When energy prices turn back up on a sustained basis, the FED could be faced with 3%+ inflation rates and that might be a realistic prediction with crude fluctuating in the $60-$80 price range and natural gas prices mostly in the $3 to $4 (per thousand cubic feet) range. U.S. Natural Gas Wellhead Price (Dollars per Thousand Cubic Feet)

1. Bought 50 of the ETF PFXF at $19.67:

Trade Snapshot ($1 Commission):

Security Description: The Market Vectors Preferred Securities ex Financials ETF (NYSEARCA:PFXF) owns "preferred securities" as shown below.

Sponsor's Website: PFXF - Preferred Securities ex Financials ETF | Snapshot - Van Eck Global (expense ratio after .07% waiver until 9/1/16=.4%)

Snapshots of Holdings as of 4/30/15 (from Annual Report)

A current list of holdings can be found here: Preferred Securities ex Financials ETF | Holdings That page has the credit ratings for each security. For securities that have been rated, the overall weighting is in investment grades with a scattering of mostly upper end junk ratings (i.e. BB+)

I put the phrase "preferred securities" in quotes since this fund owns traditional equity preferred stocks and some securities properly classified as junior bonds ("trust preferred") and senior bonds.

This is a large concentration in REIT equity preferred stocks.

Some of the telecommunication and utility sector holdings are higher in the capital structure than equity preferred stocks. I identified several junior or senior bonds in those sectors just by looking at the holdings page, including the following:

Qwest 6.125% Senior Unsecured Bond (NYSE:CTY) Prospectus ("The Notes will be our senior unsecured obligations" at page S-7)

Verizon 5.9% Senior Unsecured Bond (NYSE:VZA) Prospectus ("The notes will be our senior unsecured obligations and will rank equally with all of our unsecured and unsubordinated indebtedness.")

Telephone and Data Systems 7% Senior Unsecured Bond (NYSE:TDJ) Prospectus ("The Notes will be our senior unsecured obligations and will rank on a parity with all of our existing and future senior unsecured obligations.')

United States Cellular 6.95% Senior Unsecured Bond (NYSE:UZA) Prospectus ("The Notes will be our senior unsecured obligations and will rank on a parity with all of our existing and future senior unsecured obligations. ")

Comcast 5% Senior Unsecured Bond (CCV) Prospectus ("The notes will be unsecured and will rank equally with all of our unsecured and unsubordinated indebtedness.")

Duke Energy 5.125% Junior Bond (NYSE:DUKH) Prospsectus ("The Debentures will be unsecured and will rank junior and be subordinated, to the extent and in the manner set forth in the Indenture, in right of payment and upon liquidation to the prior payment in full of all of our current and future senior indebtedness.", page S-5)

FPL Group Capital Trust 5.975 Trust Preferred-Junior Bond (NEEPRC) Prospectus ("FPL Group Capital Trust I is referred to in thisprospectus supplement as the "Trust." The Trust will sell 12,000,000 of its 5 7/8% Preferred Trust Securities, referred to in this prospectus supplement as "Preferred Trust Securities," to the public and its common trust securities, referred to in this prospectus supplement as "Common Trust Securities," to FPL Group. It will use the proceeds from these sales to buy 5 7/8% Junior Subordinated Debentures, Series due March 15, 2044, referred to in this prospectus supplement as the "Junior Subordinated Debentures," from FPL Group Capital."-page S-3)

AES Trust III (AESPRC ) Trust Preferred Convertible-Junior Bond Prospectus at S-7

Nextera Energy Capital Holdings 5.125% Junior Bond (NEEPRI) Prospectus ("NEE Capital's payment obligation under the Junior Subordinated Debentures will be unsecured and will rank junior and be subordinated in right of payment and upon liquidation to all of NEE Capital's Senior Indebtedness, and NEE's payment obligation under the Junior Subordinated Guarantee will be unsecured and will rank junior and be subordinated in right of payment and upon liquidation to all of NEE's Senior Indebtedness. However, the Junior Subordinated Debentures and the Junior Subordinated Guarantee will rank equally in right of payment with any Pari Passu Securities." at page S-28)"

PPL Capital Funding 5.9% Junior Bond (NYSE:PPX) Prospectus ("PPL Capital Funding's payment obligation under the Notes will be unsecured and will rank junior and be subordinated in right of payment and upon liquidation to all of PPL Capital Funding's Senior Indebtedness, and PPL Corporation's payment obligation under the Subordinated Guarantees will be unsecured and will rank junior and be subordinated in right of payment and upon liquidation to all of PPL Corporation's Senior Indebtedness. Senior Indebtedness of PPL Capital Funding and PPL Corporation are defined under "Description of the Notes-Subordination." However, the Notes will rank equally in right of payment with PPL Capital Funding's 4.625% Junior Subordinated Notes due 2018, 4.32% Junior Subordinated Notes due 2019 and 2007 Series A Junior Subordinated Notes due 2067, and the Subordinated Guarantees will rank equally in right of payment with PPL Corporation's respective subordinated guarantees thereof" .at page S-5)

The largest weighting is in a 11.125% Frontier Communication mandatory convertible preferred stock: Prospectus Par value is $100. The mandatory conversion date is 6/29/18.

Dividends: Distributions are paid monthly at a variable rate.

I took a snapshot of the dividends paid starting in October 2014:

Rationale: By buying this security in my IB account, I may be able to successfully exit the position at any profit after collecting several monthly dividends. I would not want to own this ETF when interest rates turn up on a sustained basis.

The upside price potential is limited due to their current prices and the optional call rights reserved to the issuers that caps further price appreciation. The exchange traded bonds and preferred stocks owned by this fund have significant downside price risks.

Risks:

(1) Unexpected Inflation and a Rise in Inflation Expectations:

In early May 2013, PFXF was hovering near $21 per share. The closing price on 12/31/13 was $18.85 or slightly over 10% lower. PFXF Historical Prices That drop in price was sufficient to offset more than a year's worth of dividends. Fortunately, rates went back down in 2014 and bond investors return to complacency again. The investing world finds ways to disrupt complacency in frequently hideous ways.

During that brief 2013 rate spike period, the ten year treasury moved from 1.66% to a 3.04% yield. The 3.04% is an historically very low ten year treasury yield:

10-Year Treasury Constant Maturity Rate- St. Louis Fed

Having come of age as an investor in the 1970s, I am attuned to the havoc that can be created in bond land when inflation rates start to rise significantly. And, it is impossible to look at a long term U.S. CPI chart and conclude that deflation is a more likely future scenario than problematic inflation:

Consumer Price Index for All Urban Consumers: All Items- St. Louis Fed

Since 1955, there has been one year where CPI dipped slightly below zero and that was in 2009: Consumer Price Index, 1913- | Federal Reserve Bank of Minneapolis

2. Asymmetric Interest Rate Risk Favoring the Issuers: With a limited number of exceptions, exchange traded bonds and preferred stocks allow the issuer the optional right to redeem at par value. Usually, that option starts five years after the IPO date.

If interest rates have fallen during that five year period, and it is in the interest of the issuer to refinance at lower rates, the owner will receive the redemption proceeds and have less favorable reinvestment options for the same credit risk.

If interest rates rise, then the issuer will be content to allow the owners to keep the security that is going down in price.

The existence of the optional call right will cap the appreciation potential when interest rates have fallen to such an extent that the market believes a redemption is possible or likely.

I discuss this issue in more depth in the Appendix section to a prior post: Update For Bond And Preferred Stock Basket Strategy As Of 9/10/15 - South Gent | Seeking Alpha (Scroll to 1. Exchange Traded Bonds and Preferred Stocks: Asymmetric Interest Rate Risks" in the Appendix)

3. Credit Risks: Many of the securities owned by this fund are senior only to common stocks and junior to all bonds. The fund also owns some junk rated securities.

4. Volatility Risks: Periodically, these stocks will hit an air pocket. I am just use to it. There are several reasons for their volatility. For senior exchange traded bonds, one problem is that individual investors own them and will sell them when STOCKS hit a downdraft and bonds rise in value. The more junior securities generate even more downside volatility due to individual investor fears of distribution cuts, deferrals or eliminations as the case may be. So if a rational analysis would place the odds of a cumulative dividend deferral at 25%, the security may be priced as if the odds are greater than 75% or close to 100% even.

I discuss examples of the last major air pocket which occurred in from August 2011 when stocks were in a correction mode: Item # 1 Fear and Enhanced Volatility in Certain Classes of Income Securities

During the Near Depression, it was common to see exchange traded junior bonds and equity preferred stocks, with a $25 par value, sell at less than $10 per share. I started to invest in some of these securities during the Near Depression when they could be purchased at greater than 50% discounts to their $25 par values.

I bought one $25 par value equity REIT preferred stock in October 2008 at $2.9, creating an annualized yield of about 75% for me, but what about the investor who had bought shares a year or so earlier at near par value. The security was later redeemed by the issuer at $25 and never missed a quarterly dividend payment.

I dabble in REIT preferred stocks and have an old post discussing their advantages and disadvantages. Stocks, Bonds & Politics: Advantages and Disadvantages of REIT Cumulative Equity Preferred Stocks

Trust preferred securities have mostly been redeemed by the issuers and they were smashed to smithereens during the Near Depression as well. I have an old Gateway Post discussing that type of junior bond: Stocks, Bonds & Politics: Trust Preferred Securities: Links in One Post

I have discuss the various categories of exchange traded bonds in this blog: Stocks, Bonds & Politics: Exchange Traded Bonds: New Gateway Post

4. Sponsor's Risk Discussion:

The sponsor's summary of risks can be found starting at page 45 of the Statutory Prospectus, which can be downloaded here: PFXF - Preferred Securities ex Financials ETF | Documents - Van Eck Global

I discuss several of the risks inherent in these exchange traded fixed income securities in this post: Bond And Preferred Stock Basket Strategy As Of 9/18/15 - South Gent | Seeking Alpha (scroll to "ELB or a Commonwealth Edison First Mortgage $1,000 Par Value")

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.

Disclosure: I am/we are long PFXF.