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Update For Exchange Traded Bond And Preferred Stock Basket Strategy As Of 11/11/15

Nov. 12, 2015 8:19 AM ETGS1 Comment
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Closing Prices 11/11/15:

TLT: $118.43 -0.25 (-0.21%) : iShares 20 Year Treasury Bond ETF

LQD: $114.84 -0.01 (-0.01%) : iShares Investment Grade Corporate Bond ETF

PGX: $14.86 +0.06 (+0.41%) : PowerShares Preferred Portfolio ETF

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This topic was last updated here: Update For Exchange Traded Bond And Preferred Stock Basket Strategy As Of 10/30/15 - South Gent | Seeking Alpha

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 11/11/15:

Inflation expectations are currently abnormally 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

Interest rates started to turn up in mid-October: Daily Treasury Yield Curve Rates On 10/14/15, the ten year treasury closed at a 1.99% yield and has now risen to over a 2.4% yield. While that does not seem like much, particularly when a 2.4% yield is still extremely low by histoircal standards, the percentage loss is nonethless large.

There is a meaningful risk in bond land now that the market has substantially underestimated inflation pressures building in the economy, the pace of a Fed's tightening cycle, and the likely real rate of returns over the next 5 to 10 years based on current bond yields.

One response to that possible material miscalculation is the purchase of securities that will likely rise in value when short term rates increase in a sustained upward cycle.

Below, I will be discussing the purchase of a Synthetic Floater, a niche category of exchange traded bonds. I discuss the various categories of exchange traded bonds in this old post: Stocks, Bonds & Politics: Exchange Traded Bonds (5/30/12 Post)

1. Bought Back the Synthetic Floater GJS at $18.4:

Trade Snapshot ($1 Commission)

Security Description: The Synthetic Fixed-Income Securities Inc. Floating Rate STRATS Series 2006-2 is a complicated security. GJS is a synthetic floater in the Trust Certificate ("TC") form of ownership. This security will make monthly interest payments at a .9% spread over the 3 month treasury bill up to a maximum coupon of 7.5% and paid on a $25 par value.

The GJS TC represents a beneficial interest in a 6.125% senior unsecured bond issued by Goldman Sachs that matures on 2/15/2033 that is owned by a grantor trust administered by an independent bank trustee.

Assuming GS survives to pay off this bond's $1,000 par value at maturity, then the owners of GJS will receive their $25 par value. GJS consequently matures on the same day as the underlying bond.

The trustee will collect the coupon payments on the 2033 senior bond from Goldman Sachs and swap it with a brokerage company for the payment due the owners of GJS. The brokerage company is called the swap counterparty. If the brokerage company files for bankruptcy, then the swap agreement with the trustee is terminated and the trustee will start to pay the 6.125% coupon payments to the GJS owners rather than the .9% spread to the three month treasury bill. That benefited the owners of the synthetic floater JBK when the swap counterparty, Lehman Brothers, filed for bankruptcy. Item # 5 Bought 100 JBK at $16.15 (7/20/2009 Post)

GJS Prospectus

2033 Bond Prospectus

The bond's prospectus has a make provision that makes it unlikely that GS will redeem this bond:

Quote: "We will have the option to redeem the notes, in whole or in part, at our option at any time, at a redemption price equal to the greater of (1) 100% of the principal amount of the notes to be redeemed or (2) as determined by the quotation agent described below, the sum of the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed, not including any portion of these payments of interest accrued as of the date on which the notes are to be redeemed, discounted to the date on which the notes are to be redeemed on a semi-annual basis assuming a 360-day year consisting of twelve 30-day months, at the adjusted treasury rate described below plus 20 basis points, plus, in each case, accrued interest on the notes to be redeemed to the date on which the notes are to be redeemed. ... The quotation agent will select a United States Treasury security which has a maturity comparable to the remaining maturity of our notes which would be used in accordance with customary financial practice to price new issues of corporate debt securities with a maturity comparable to the remaining maturity of our notes." (emphasis added)

That make whole payment would be huge given that the sum of both the principal and all remaining interest payments is being discounted at an abnormally low treasury rate.

When I bought GJS, the underlying 2033 senior unsecured GS bond was trading near $118 creating at that time a yield-to-maturity of 4.6%. Bonds Detail

If GS survived to pay off the 2033 bond at maturity, the buyer of that bond at $118 would suffer a loss that would decrease their current yield number. The current yield at $118 is about 5.19%.

The current yield of GJS is close to the .9% float since the 3 month treasury bill is at or near zero:

However, their is a profit built into GJS at $18.4 when and if GS redeems the 2033 bond at its par value. If the average annual 3 month treasury bill rate was 2% to 2/15/33, then the average annual current yield of GJS would be about 2.9% and the YTM would be about 5.32% using the Morningstar Bond Calculator. At an average annual rate of 3%, the YTM becomes 6.57% and 7.84% at an annual average 4% three month treasury bill rate.

The trade-off is that the investor has to accept a much lower current yield when buying GJS rather than the $1,000 par value underlying bond.

3-Month Treasury Constant Maturity Rate-St. Louis Fed

Prior Trades:

2009 Trades: +$412.68

Bought 100 GJS at 12.25 June 2009-SOLD GJS at 13.06 August 2009

Bought 100 GJS AT $13 October 2009-Sold 100 GJS at $15.6 in the Roth IRA November 2009

2010 Trade: +$64.08

Bought: 50 GJS at $14.6 August 2010-Sold 50 GJS @ $16.20 October 2010

2013 Trade: +$154.48

Bought Roth IRA: 50 GJS at $13.77 December 2012-Sold 50 GJS at $17.14-Roth IRA June 2013

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.

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