1. Pay Back Dutch Government=Buying Junior Security=Mandatory Payment Event: In evaluating the current situation in Europe as it involves the EC's burden sharing policy, I have focused just on Aegon and ING since I own hybrids from both firms. The same kind of analysis can be undertaken by anyone for the other firms.
A key point was to identify what kind of securities have to be purchased in order to pay the government back, and then to classify those securities in the chain of priority compared to the hybrids. To summarize what I have said in other posts, the Dutch government bought from ING securities that were pari passu with common shares:
"The securities are pari passu with ordinary common equity meaning the Dutch State will rank exactly the same as common shareholders." ING to strengthen core capital by EUR 10 billion - ING
That summary says that ING can buy back those shares at 150% of the issue price. After 3 years, ING can convert the shares into common shares. ING announced that it wanted to raise 6 to 8 billion Euros by selling assets to pay the Dutch government back as soon as possible. From all of that, I conclude that ING would have to buy back a Junior Security to pay back the Dutch government. And, then, just relate that point to the wording in the prospectus about what can trigger a Mandatory Payment Event. In effect, to implement the burden sharing policy for ING's hybrids, the EC would have to tell ING and the Dutch government that repayment has to be postponed so that ING could screw the hybrid owners by delaying their coupon payments a few quarters. To call such an approach asinine would be extremely generous.
Aegon is further along in paying back the government, recently raising 1 billion Euros by selling stock with the expressed intent of paying the Dutch government back. In Aegon's case, the majority shareholder bought securities from Aegon using the proceeds received from the Dutch government as a loan. As I interpret this transaction based on the few details that I have seen to date, to pay back the government, Aegon would buy back those securities from its majority shareholder who would then pay down its loan from the Dutch government. The securities sold to the majority shareholder are described in Aegon's Annual report as being at the same priority level as common stock: "These securities rank equal to common shares (pari passu)" (page 159-Form 20-F). So, I reach the same point as I just explained with ING except by an indirect route through Aegon's majority shareholder.
2. Bond Investing Process: Since I was 16, and I am now almost 58, I have been a Stock Jock. I am still one, though lately I have transitioned to a Bond Lover. For me, until recently, buying any kind of bond was equivalent to admitting that I had become old. In 2007, I started to buy InterNotes sold by my brokerage at par value with funds generated by selling stocks and stock mutual funds. I built a ladder of short term bonds, starting the ladder in 2010 and extending it out to 2015. I used bank certificates of deposit sold by the broker to fill in the shorter periods. This was part of a significant reallocation out of stocks as a result of warnings signals being given, such as by my new VIX Asset Allocation Model in August 2007: VIX Chart from 2007: Alerts and Triggers Major Disruption of Cyclical Stable Bull VIX Pattern Also, I have a natural tendency to lighten up anyway after a big move, particularly in the 3rd and 4th year of the move. My brain is sort of imprinted with how long bull moves last without a serious correction, as in the period between 1982 to 1987. Another factor was the concerns raised by the mortgage issues in the U.S. that started to rise in a clear manner in February 2007. That problem just started to hit me daily in the head saying wake up you old geezer. Whatever, that is not my point here. I did not have a bond investing process when I started to invest in bonds.
This is what I did. I first decided to implement a ladder strategy. I then started to buy InterNotes at par value. I focused almost exclusively on the rating given to the bond by Moody's and S & P without looking at the company except in a superficial way. So, I bought around 10 International Lease Bonds for example based on the credit rating of AAA. I bought 2 CIT bonds based on its investment grade rating. I also bought bonds from CAT, GE, Prudential, and many others based on their investment grade classification. I thought back then I was following a process. I was not and instead I was using a crutch of relying on Moody's and S & P to properly analyze the credit worthiness of the borrower. I no longer do that.
Instead, I will start with the same kind of research that I will do to buy a common stock. I want to become familiar with the company and the risks it faces, paying close attention to balance sheet and refinancing risks. The purpose is to arrive at a tentative conclusion about whether or not I even want to take the risk by buying the bond and then how much risk am I willing to take in terms of money invested in the bond. If I had done that analysis in 2007, I would not have bought any CIT bonds because I recognized even then that there was an issue with CIT just based on the premium spread in yield to other similarly rated bonds. I would have substantially reduced by International Lease bond investments too, but probably would not have avoided buying altogether in 2007.
Once I complete that process, I want to understand the bond that I am contemplating buying. Some of this process is discussed in earlier posts:
To summarize, you have to read the prospectus to answer some key questions:
1. Is there a maturity date!!!!!!!! And if so, when is it. A long bond has more risk than a short bond. A perpetual bond is always viewed unfavorably which necessitates a far lower weight by that factor alone. That is one reason why my positions in European hybrids are small.
2. What is the priority of the bond or bond like investment: Equity preferred stock, junior bond, senior bond or secured debt ( a few secured debt issues are traded as exchange traded bonds Exchange Traded Bonds:)
3. Is a deferral permitted? If so, for how long? A junior bond will generally be cumulative. Many, though not all, equity preferred shares would be non-cumulative. So, you want to know about cumulative vs. non-cumulative too. Cumulative is always the better option than non-cumulative. No deferral allowed-period-is always better than deferral is permitted if certain preconditions for deferral are met.
4. If a deferral is permitted, what are the conditions that must be in place before it would be a legal deferral? Usually this would be an elimination of dividend payments on a Junior Security.
5. How frequent are the payments?
6. How are the payments taxed in the U.S.? Qualified dividends or interest?
7. What are the credit ratings from the 3 firms, and the trend of ratings and are any negative watches in effect?
8. are there any usual tax issues associated with the security that might dictate whether the security needs to be bought in a retirement account for a U.S. investor. The clearest type of such cases would be a zero coupon bond or a TIP.
9. can I make money in two ways by buying at a significant discount to par value, which became a key consideration for me when I started to follow this process in October 2008.
10. It is critical to stay involved researching the company after an individual bond position is taken.
The foregoing are just the major points that I always try to address now.
Some emails to me have suggested that I am some kind of bond guru. Considering that I have been focused on buying bonds with my investment process outlined above since October 2008, I am at best a neophyte individual bond investor with no particular expertise in it. I just taught myself whatever I needed to know to develop a comfort level in buying individual bonds. Now, I am comfortable doing it. I would have to say, however, that I am not impressed with so called professional managers. I would add that I can not recall buying a single bond prior to 2007, and most of what I bought in 2007 was the Internotes sold by brokers to individual investors without following the bond investment process.
I would add this caveat. You can follow the process, and make an intelligent and rational decision. And, as in blackjack, you could still lose. It could blow up in your face. The point of the process is to minimize mistakes and to also cut down some on those potential Black Swan type events which always creep up for individual securities.
Today, I am devoting most of time today to family business again. So, this is my last blog today.
Added: If the EC requires the state aid to be restructured retroactively now to avoid a Mandatory Payment Event, this would be an extreme act of Bad Faith. The EC has already damaged its financial institutions with its burden sharing policy, causing debt downgrades, and raising financing costs long term. It would also be an extreme act of bad faith for the EC to influence a firm like Aegon to postpone paying the Dutch government back in order to be able to stiff the junior bond holders, particularly after AEG sold stock stating that it intended to use the proceeds to pay the government back. The burden sharing policy announced in late July 2009, and applied retroactively to aid previously given as early as October 2008, is an act of bad faith in my opinion, just not an extreme act of bad faith.
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