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.
This basket was last updated here: Update For Exchange Traded Bond And Preferred Stock Basket Strategy As Of 10/22/15 - South Gent | Seeking Alpha
I have my standard introduction below. This is basically for those who randomly come to one of my posts.
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 10/30/15:
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.
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)
The general directional trends in interest rates is for higher quality and longer duration bonds to outperform.
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. Consumer Price Index Summary 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.
The last inflation report from the BLS had these Y-O-Y inflation numbers in it:
Medical care services +2.4%
Transportation services 2.2%
Services less energy services 2.7%
Medical care commodities 2.7%
The Atlanta Fed's Sticky Price Index was up 3.5% in September:
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
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.
For U.S. inflation, the most important deflationary pressure has been the decline in crude prices Y-O-Y. The substantial decline started during mid-summer 2014 and continued through February 2015.
That negative impact on inflation becomes neutral with WTI mostly moving in the $40 to $50 per barrel range next Spring. If WTI starts to trend above $60, then energy prices would start to contribute to Y-O-Y inflation numbers.
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)
I would just say now that bond investors need to be extremely attuned to changes in inflation and inflation expectations now given the abnormally low interest rates and a possibility that inflation may gain momentum starting around next Spring.
I am starting to add securities that combine some inflation and deflation/low inflation protection. Those securities will generally fall into Equity Preferred Floating Rate stocks and several Synthetic Floaters. I am referring here to securities that pay the greater of a fixed coupon or a spread to a short term rate which usually is the 3 month Libor rate.
There are other categories that involve increasing the coupon in some way that is connected to CPI or increasing the principal of a bond by CPI (e.g. TIPs). I sold my last TIPs bought at auction in 2012 when the price exceeded the likely interest payments for the next seven years plus the CPI accretion to the principal amount. I did recently buy back the CEF WIW and am currently in the hole on that one after trading it profitably for several years.
I have owned in the past exchange traded bonds whose coupons are tied to a formula based on CPI. One example is the Prudential Financial Inflation linked Retail Medium Term Senior Unsecured Note (PFK:NYSE)
I give an example of how the PFK coupon is calculated here: Item # 3 PFK (8/29/11 Post)
Links to many of my trades can be found here: Stocks, Bonds & Politics: Floaters: Links in One Post I am sporadic at best in updating that one.
I have lost interest in those CPI floaters due to the current low CPI numbers and have harvested my profits in all of them:
E.G.: Item # 3 Sold 100 PFK at $28.25 (2/17/15 Post)(gain snapshot=+$962.38)-Item # 7 Bought 100 PFK at $18.466 (6/29/09 Post); Item #3 Sold Roth 100 PFK at $26.65 (12/31/13 Post)(profit snapshot +$705.51)
The security discussed below has some inflation protection built into it but the floating rate will not come into effect until 2023 and the issuer may redeem rather than pay that float as more fully discussed below.
At the current time, I am willing to accept slightly lower yields with individual securities compared to leveraged bond CEFs that may face a triple whammy when interest rates rise across the maturity spectrum.
Triple Whammy Is an Investment Term Here at HQ:
1. Expansion in the Discount after Purchase; and
2. A Rise in Short Term Borrowing Cost; and
3. A Decline in Net Asset Value Per Share
On the flip side, I face more credit risks going with individual securities and still have interest rate risks. I just do not have the risks unique to leveraged bond CEFs.
1. Bought 50 GSPRJ at $24.75:
Trade Snapshot ($1 Commission)
Security Description: The Goldman Sachs Group Inc. Fixed-to-Floating Preferred Rate Stock (symbol-GS.PJ) is a fixed to floating rate equity preferred stock issued by Goldman Sachs.
GSPRJ will pay quarterly non-cumulative dividends at the rate of 5.5% per annum on a $25 par value. The 5.5% fixed coupon rate will be applicable from the issue date to, but excluding 5/10/23.
On or after 5/10/23, GS has the option to redeem this security at par value plus any accrued dividends. If the security is not redeemed, the coupon transitions to a floating rate on 5/10/23. The floating rate would be a 3.64% spread to the three month Libor.
The coupon rates on GS fixed coupon preferred stocks are higher, though the actual current yield will depend on the total cost paid for the stock. Goldman Sachs Group Inc. 6.2% Series B Non-Cumulative Preferred Stock (GS.PB); Goldman Sachs Group 5.95% Non-Cumulative Preferred Series I (GS.PI)
GSPRJ has a typical stopper clause, summarized at page S-3 of the prospectus, that prevents GS from paying a cash common dividend after eliminating the non-cumulative preferred dividend. In order to legally eliminate the dividends on its non-cumulative preferred stocks, GS must first eliminate the common stock dividend.
As with other equity preferred stocks issued by Goldman Sachs, GSPRJ is currently rated junk by both S & P and Moody's. S & P has it at BB+. Moody's rates it at Ba2.
This security will pay qualified dividends.
Initiation of the Floating Rate May Result in A Redemption-Comparing Current and Yield-To-Worst Yields
If the Libor rates are high enough in 2023 or anytime thereafter, GS may elect to redeem this security. The fixed-to-floating rate securities have a lower current yield than the fixed rate coupon preferred stock(s) from the same issuer. In the following analysis, I am comparing yields from two fixed-to-floating rate and two fixed coupon preferred stocks issued by GS. All of the GS equity preferred stocks went ex dividend on 10/22/15. I currently have a 150 share position in GSPRD, a floating rate equity preferred stock and 50 shares of GYB, a synthetic floater that has as its underlying security a fixed coupon GD Trust Preferred security (a junior bond) maturing in 2034.
Current Yields Calculated by Marketwatch at the Closing Prices Indicated:
Goldman Sachs Group Non-Cumulative Fixed-to-Floating Preferred Stock (GS.PK:NYSE)=5.99% at $26.6; Prospectus Supplement-Series K (6.375% to 5/10/24 and then a 3.55% spread to 3 month Libor if not called)
Yield-to Worst Yields (assumes redemption at par value at the earlist permissable date):
GSPRB: Negative. This Y-T-W would be negative since GS could call now, the stock just went ex-dividend and is selling above the value of the acrrued dividend.
Calculated by The Yield Hunter as of 10/23/15
Investors do not want a redemption when the comparable alternative securities produces less income.
If GS chooses to pay the 3 month Libor + 3.64%, it will be because it views that rate as favorable to it. To result in an increase to the 5.5% GSPRJ fixed coupon rate in existence before the activation of the floating rate, the 3 month Libor would have to be over 1.51% during the relevant computation period. A 4% three month Libor rate during the relevant computation period after that float activation would be 7.64%.
There would come a point when the 3 month Libor plus 3.64% would just be too much for GS to pay. By buying this GSPRJ under par value, I would at least make a small profit when and if this security is redeemed at its $25 par value plus the dividends paid in the interim.
On the other hand, I could be left with a coupon in 2023 that pays me less than the current 5.5% fixed rate or less than the current yield of a potentially perpertual GS fixed coupon preferred stock.
So, like everything else it is an odds game.
(1) Do I want to sacrifice a current yield differential by buying GSPRJ rather than the other three mentioned above and how do I go about evaluating that issue?
(2) What are the odds that GS will call these preferred stocks?
The other fixed-to-floating rate, GSPRK, has a higher fixed coupon than GSPRJ at 6.375% and a current yield advantage based on price of .43% annualized.
All that I can say is that I am better off owning GSPRJ, provided I bought GSPRK at $26.6 and held it until called by GS on 5/10/24. The interest rate environment that would cause GS to redeem one would likely cause the redemption of the other since both floating rates are similar.
I would be worse off holding GSPRJ where GS never calls either security; and they become perpetual for at least my remaining life term. Then I lose the annual current yield advantage of GSPRK over GSPRJ.
GS could call GSPRB at anytime now and may do so even though it has elected so far to keep it.
GSPRI, which is callable on or after 11/10/2017, is less likely to be called than GSPRB given its lower coupon. However, GS could elect to redeem both GSPRI and GSPRB on 11/10/17 provided it could do so at a lower rate after expenses.
(3) Then there is the impossible to answer question. What will be the 3 month Libor when the fixed-to-floating rate securities transition to a floating rate coupon? I am not inclined to make wild guesses about interest rates in 2023 or 2024 when it is extremely difficult to predict what they will be in 2016.
I can only say now that a call of GSPRJ at $25 would give me a slight profit based on my purhase price, and I would not mind investing the proceeds into another security when and if GS redeemed GSPRJ due to a too high 3 month Libor rate. In that respect, GSPRJ gives me an out-an escape hatch- in an situation where interest rates have moved up to high levels. The fixed coupon GS preferred stocks would be plummeting in value whereas the GSPRJ owner would escape with their $25 par values and could then reinvest the money at higher rates.
A fixed to floating rate preferred stock will have a theoretical duration less than a fixed coupon preferred stock (see page 8: cohenandsteers.com When Interest Rates Rise.pdf) I would not personally use the bond concept of duration in connection with perpetual preferred stocks unless it was likely that the issuer would exercise its right to redeem the security.
In practice, if short term and long term rates remained abnormally low after the GSPRJ option right comes into existence, the duration would remain perpetual for GSPRJ until such time as short term rates rose to a level where it would make sense for GS to redeem it.
Equity preferred stocks issued by heavily indebted financial institutions would become worthless in a BK. Their lowly status in the capital structure, superior only to common stock, creates volatility in the share price in times of economic stress. The non-cumulative feature will on occasion provide fuel for that volatility. A rise in interest rates will cause declines as more senior securities become more competitive.
A company like GS and other highly leveraged financial institutions have all kinds of inherent risks. (see discussion of risk factors starting at page 24 in the GS 2013 Form 10-K. Risk factors relating to GSPRJ are discussed in the prospectus starting at page S-8)
As an aside, Fidelity makes it difficult for individual investors to buy this security. If you try to buy it at Fidelity, you will receive this message:
IMO, there is not rational reason for this trading restriction which is becoming far too common at Fidelity.
2. Bought Back 50 NLYPRD at $24.39:
Trade Snapshot ($1 Commission):
Security Description: NLYPRD is an equity preferred stock issued by the Mortgage REIT Annaly Capital Management (NLY). that pays cumulative and non-qualified dividends at the fixed coupon rate of 7.5% on a $25 par value. NLY has the option to redeem this security on or after 9/13/17.
Prospectus (change of control provision summarized starting at page S-3 and S-18)
The company summarizes risks starting at page S-9 of the NLYPRD prospectus.
Advantage of Preferred Over Common: For as long as NLY pays a cash common share dividend, NLY can not defer payment on its preferred shares.
The common share dividend has been repeatedly cut as income has been trending down. Annaly Capital Management Inc (NLY) Dividend History In the 2010 third quarter, NLY paid out a $.68 per share common dividend, down just one cent from the 2009 third quarter. The high point was hit with a $.75 per share dividend for the 2009 4th quarter. The dividend was cut again in the 2013 4th quarter to $.30 per share.
As a preferred stock owner, the NLY common share price plunge over the past few years, and dividends cuts do not matter as long as NLY continues to pay a cash dividend to its common shareholder. NLY has to pay a common dividend to maintain its tax status as a REIT as long as it has net income. So long as that cash dividend continues, the preferred shareholder has to be paid in full.
This is a link to a document published by LDR Capital Management regarding REIT preferred stocks: PreferredSecurityPrimer.pdf
However, given NLY's leverage and debt, I seriously doubt that the owners of its preferred shares would receive anything in a bankruptcy. In the event of a BK, NLY's preferred stocks would likely become worthless. So, the downside risk is a zero share price which is the same for the common stock.
Prior Trades: I have flipped this preferred stock on two prior occassions:
Item # 1 Sold 50 NLYPRD at $24.82-Roth IRA (11/14/14 Post)(profit snapshot=$83.47+ 3 Dividends Totalling $70.32; total return 12.46% in about 10+ months)-Item # 4 Bought Roth IRA 50 NLYPRD at $22.87 (2/10/14 Post)
One of the risks is highlighted by those trades. I sold 50 shares at $26.01 and bought them back at $22.87 a few months later.
The preferred stock of a REIT has none of the positive characteristics of common stock, including an ownership stake in the business and the payment of qualified dividends, and has all of the negative attributes.
The fixed coupon preferred stock, like NLYPRD, has that nominal similarity with a bond but compares negatively with bonds in all other important respects.
The preferred security is junior in priority to all bonds and senior only to common stock. Unlike a bond, there is no maturity. The protection against a call is limited to generally five years after issuance and then the issuer has the option to redeem or stick the preferred owners with a non-competitive yield in a rising rate environment.
An appropriate description of the issuer's call option right is tails I lose and head's the issuer wins. If rates fall, the issuer will redeem and refinance at or after the call date depending on interest rates at that time. If rates rise a lot, the issuer will be happy to stick those owners with a non-competitive yield that can most likely only be sold for a loss when bought today in an abnormally low and artificial yield environment.
If NLY does call this security, and assuming that I still own it which is doubtful, I would at least receive a small profit on the shares based on a purchase price below the $25 par value.
So, I am in a drop of the hat trading pattern for these securities. I do not need much of a profit to sell the shares, particularly when the shares were bought near par value, after collecting one or more dividend payments and being able to sell the shares profitably. This is just another example of small ball.
Mortgage REIT Preferred Are Viewed Here at HQ As More Risky in General Than Equity Reit Preferred Shares:
Accoring to REIT.Com, the average debt to total assets ratio for equity REITs is about 34.1%. REIT.com
It is at least conceivable that an equity REIT preferred stock would have at least some value in a BK, though I am familar with at least one example where the preferred ended up worthless. That was a special case since the REIT was loaded up with debt in a private equity buyout (Innkeeper's Trust).
While other investors may differ with my opinion on the matter, I am consequently more nervous about preferred stocks issued by Mortgage REITs than by traditional REITs.
Both suffer from the risk associated with the absence of a cash cushion. After all, money is flying out the door every quarter to the common shareholders. To maintain the REIT tax status, at least 90% of the net income has to be paid out to the common shareholders. For an owner of an equity preferred stock, I would obviously prefer having most of that money retained by the corporation.
Both types of REITs are leveraged with debt, but there is a huge difference in debt to total asset value ratio. An equity REIT may be carrying both senior unsecured debt and/or mortgages, but the amount of debt will generally be 50% or less of the fair market value of the assets owned by the traditional REIT. The REIT could experience a dramatic decline in property values and still have something left for a preferred shareholder in a BK.
While the mortgages owned by the REIT are more liquid than the property owned by the traditional REIT, the possibility of a downward spiral leading to a bankruptcy and a total loss for preferred shareholders is far greater with the Mortgage REIT due to their greater leverage than the far less leveraged traditional REIT. "Should Investors Unload Their Mortgage REITs?" - Advisor Perspectives
The Mortgage REIT will have a much greater dependency on short term debt. In a credit crisis, similar to the one recently experienced, liquidity can dry up pretty quickly, leading to a liquidity driven adverse event.
I would also have a concern about a quick and unforeseen spike in short term interest rates, particularly one occurring at the same time as a decline in value of the paper bought by the Mortgage REIT with borrowed money.
Taking the potential downside risks and the upside which will likely involve almost exclusively the receipt of income, I will only invest small amounts in preferred stocks issued by Mortgage REITs.
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.