Wednesday, October 8, 2008

3 month Libor and Floating Rate Preferred Issues

Added June 7, 2009:  I discuss floating rate securities throughout this blog.  I have added a Gateway Post that collect links to my discussions on all of them: 

This linked chart contains historical Libor rates: LIBOR Rates History (Historical)

*****************original Post:

The floaters tied to 3 month LIBOR are becoming more interesting by the day. This rate has jumped from 4.15 a week ago to 4.52 yesterday, indicating severe stress in interbank lending. While this may calm down in a few weeks, it is showing no signs of a let up yet. The Met Life floating rate preferred is tied to the greater of 1% over 3 month LIBOR or 4%. If 3 month LIBOR reached 5% and stayed at that level for the fix period of the floater, then the effective yield at today's close of 9.05 would be 16.57%, calculated as follows: .06% x $25 (par value)=$1.5 in annual interest for 1 share divided by $9.05 cost per share equals 16.57%. Using the same assumption for AEB, the Aegon floater, the interest rate at its closing price of 5.44, down 11.97% today, would be 27% calculated as follows: .05875% (5% LIBOR assumption + .875%) x $25 par value=$1.46875 divided by $5.44 cost= 27%. This floater has a 4% guarantee. Some people think that the 4% guarantee is calculated based on your cost which is just wrong. AEGON and MET LIFE have to pay based on the par value of the note and both of these notes are selling at substantial discounts to par value which juices the yields in a big way based on current prices. I would have no interest in these securities at prices anywhere near par value or even $15. At the current prices, I am being compensated for the risk. I can take the risk because I raised cash to high levels last year and this year and have no debt. These securities could go to zero and I would not feel the pain. Others may not be in a position now to take these risks. Everyone's situation and tolerance for risk is different. Under certain circumstances, I will take risks like I did today because the long term rewards are so high. The floating rate preferred stocks give you a guarantee which is good at the current price, a 4% guarantee on a $25 preferred is worth 8% at $12.5 cost, much more than that of course at $5.5. The float provision protects the investor if the LIBOR 3 month rate rises, as it is doing now, by giving you more than the guarantee.

I also took a small position in one of the least favorable floaters, a new issue by Bank of America which fell below 10 today. The symbol is BAC-PE or BACPRE. It has a $25 par. It has no maturity, which I do not like. Interest floats at the greater of a 4% guarantee or .35% over 3 month LIBORr. The 4% guarantee on many of these floaters is good at their current depressed price but the .35% is so paltry on the LIBOR part of the computation, comparing unfavorably with virtually all other floaters. The chart reveals a preferred stock under heavy stress, trading at around par value after issuance but then falling off a cliff in mid summer 2007 when the stock market started to react negatively to the sub-prime news, and eventually hitting a low below 10. I suspect that some of the decline in BACPRE and the other floaters has been caused by heavy individual ownership in a bear market for stocks and the fact that a year ago these floaters were paying close to 6% based on a $25 par value calculation when the Libor part of the equation was the applicable one when LIBOR was over 5%. Now, the guarantees have kicked in when Libor fell from over 5% to 2.8% during the summer of 2008. This would look like a dividend cut to many small investors. As stated, the guarantee provides a good yield at current prices and the float tied to LIBOR is just a bonus. It will cause all of the floating rate preferred issues that I have discussed to pay more interest if it stays at or above current levels during the respective fix periods discussed in the applicable prospectuses. Goldman Sachs also has one (GS-PA) that I like less that the Met floater, since it has only a 3.75% guarantee and floats at .75% above 3 month LIBOR, closing at a higher price today at 12.70. 

Other reasons for the decline is the lack of trust for virtually all financial institutions which does not need further elaboration. If one of these firms fail, then a preferred stock issue is likely to be worthless. I believe the Aegon floater is the only one that is cumulative which would be relevant in the event of a solvency event short of bankruptcy that causes a postponement of the interest payments. For me, I have put funds raised from selling the common of Goldman near 200 or thereabouts and used part of it to buy GS-PA, and the same is true for MET-PA. I own BAC with dividends reinvested and intend to hold during this current crisis and may add in the 15 to 20 range. I view the assets being acquired, from Countrywide to Merrill Lynch to be a long term positive with short term discomfort. I may be wrong but I am going to give it a lot of time.

In full disclosure, I own shares of METPRA, BACPRE (AND SOME SENIOR DEBT OF BAC AND LASALLE ACQUIRED BY BAC) , BAC AEB AND GSPRA and will NOT BUY additional shares EXCEPT FOR BACPRE, BAC AND METPRA at or below the current prices. This is not a recommendation to buy or to sell. Trade at your own risk, and perform research about this security by reading the prospectus at and further studying the financial health of MET LIFE, BANK OF AMERICA, AEGON AND GOLDMAN SACHS (symbols MET, BAC, AEG, & GS, RESPECTIVELY , at yahoo finance) before making any investment. Consult with your financial advisor prior to making any purchase. In this blog, I am merely describing my reasons for purchasing this security and the potential pitfalls that I identified prior to purchase. This security may not be suitable for others based on their unique financial position and risk profile. THE PROSPECTUSES ON THESE FLOATERS CAN BE FOUND AT SEC.GOV I am not putting this warning for the ones who normally read what I have to say for so many years in my emails which were as frequent as these blogs, of course, but for that one person who may by accident stumble across these blogs. BEWARE, I AM AN OLD FOGY!!.

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