Thursday, November 27, 2008

Article in this Week's Forbes on Trust Certificates/Trust the Government?

1. Confused Article In Forbes About Trust Certificates:  There is an article in this week's Forbes which contains the first discussion of Trust Certificates that I have seen in a financial publication and it is not very good.  The author is Richard Lehmann  He mentions that one of the hardest hit areas is "preferreds-not preferred stocks but bond issues packaged as interest-paying and exchange traded preferred securities that usually have a $25 par value".  They are not preferred securities but Trust Certificates.  The Certificates represent an undivided beneficial ownership interest in the assets of the Trust, and the property of the Trust consists of bonds from one issuer.   To avoid confusion, it is best to avoid describing the Trust Certificate form of ownership as a preferred security.  The Trust Certificate represents that undivided beneficial interest in the assets of the Trust.

Lehmann is accurate in saying that the yields on the trust certificates are often one to three points higher than the yields of the underlying bonds.  Actually, during periods of stress in the stock market, these certificates can trade to yield as much as five percent more than the underlying bonds contained in them.  I know that because I have bought some with that yield advantage.  I always check the price of the underlying bond before buying a TC.  He attributes this mispricing to several factors, including the false assumption that the original creators of the trusts, firms like Lehman and Merrill Lynch, may have some involvement in them now, other than possibly as a co-trustee or having an obligation to file annual reports with the SEC. He is correct in saying that the original creator of the trust is irrelevant.  He also points out the low trading volume which keeps institutions out of the market but I have seen some mutual funds own these TCs including Loomis Sayles retail bond fund.

The most important factor causing the mispricing in my view is that the trading is dominated by individuals, who may not fully understand these securities, are often influenced by swoons in the stock market to sell what is in effect a bond which makes no sense, or possibly some sales in this thinly traded market are individuals being forced to raise cash as a result of margin calls caused by steep declines in their stock portfolios.  Whatever the reason, and I watch this everyday, pricing is frequently inefficient.   I see days like those in mid July or the meltdowns in stocks during this November or October, and the mispricing  of many of these securities become even more pronounced, generally on light volume of a few hundred shares. This kind of reaction occurs oddly on days when the bond market is rallying and the stock market is in the crapper big time.  In short, if the sales are not forced due to margin calls, then they are irrational. 

My main problem with the article in Forbes is the three issues that he recommends.  I am aware of all three, having looked at them and passed on each of them.   He mentions one that contains a Motorola bond XFH.  It is a $25 par value with a 8.2% coupon currently selling at about 12.5.  The institutional bond market prices the underlying bond at a price to yield about 13% and this TC containing the same bond yields over 17%.  All of that is fine and good except this particular Motorola bond matures in 2097.  One of the upsides for an individual buyer is capturing the spread between the price paid and par value at maturity.  This is an illusion for a $25 par value security maturing in 2097.   I would disagree with anyone recommending a bond maturing so far in the future.  I am also  skeptical of Motorola's future.  I did look and almost bought another TC containing a Motorola bond maturing in 2028, which is an acceptable range for a long bond, as long as you know the dangers of long bond investing going beyond credit worthiness.   The symbol of this TC that I have thought about buying  is XFJ and it has a 8.375% coupon and trades now at about 13 after gaining a buck last Friday.  It just went ex interest.  The yield of these two TCs is about the same but the one which is not recommended by the Forbes columnist matures almost seventy years sooner, a much better alternative for an individual to say the least.  

 He also mentions a Credit Suisse bond traded in a TC, DKY, trading to yield 10% at a $17 price whereas the AA- bond trades to yield 7.2%.  I am wary of buying bonds in an investment bank which is why I do not own this one or the other one he recommends from Goldman Sachs, PJI.  I would simply say that anyone interested in the Credit Suisse bond traded in TC form will need to compare the price of DKY with another TC which contains the same bond originated by another broker, PYE.    As of last Friday, PYE was cheaper than DKY and would consequently give a buyer more yield, bang for the buck.  PYE was originated by Merrill Lynch and DKY was originated by Morgan Stanley.

If anyone can find a material difference, let me know. This is the link to PYE prospectus: 

This is the link to DKY prospectus:

Any discussion of buying in this market needs to discuss the fact that the same bond is often found in two or more TCs and the prices of those securities will often vary considerably from one another, creating yet another inefficiency that can be exploited by those with knowledge about them. 

Another issue with these TCs is that some of them contain a senior bond and others contain the less desirable  so-called "trust preferreds" which are in reality junior subordinated debentures similar to those issued by banks which I discussed in connection with my earlier buy and sell of KEYPRA. (2nd paragraph of TAX LOSS SELLING TODAY  and for the buy KEYPRA) There are many important differences in these two types of securities.  I have mentioned that I frequently trade the TCs containing AON junior debentures. These securities are junior to AON's senior debt which simply means that the senior debt has to be paid before the junior debt holders and senior debt has a higher priority claim on the firm's assets in the event of a bankruptcy.

There is another important distinction.  Interest payments on "trust preferreds" are deferrable,  often for long periods, sometimes for up to five years,  whereas that right is not an option on a senior bond.  A failure to pay a senior bond holder will be the first step toward bankruptcy.  This makes the AON junior bonds less desirable than a senior bond from the same company or another company with similar credit characteristics.  I am currently comfortable holding the AON TCs KTN and KVW because of my current view about AON's credit.  The Motorola bond is a senior bond as is the Verizon and AT & T bonds, as well as many others, that I have discussed in this post over the last two months. 

2. Safe Levels of Melamine in Infant Formula: For those willing to place blind trust in the actions of any government, and did not learn any lessons over the past eight years, for ignorance can foster a form of bliss and contentment, this story is instructive.  The FDA had previously made statements that there are no safe levels of melamine for infants.  The FDA did not voluntarily disclose to the public that it had found trace amounts of melamine and cyanuric acid in infant formulas sold in the U.S.  If   melamine and cynauric acid combine, "they can form round yellow crystals that can also damage kidneys and destroy renal function."FDA Draws Fire Over Chemicals In Baby Formula -  After the Associated Press got the agency to disgorge the data pursuant to a Freedom of Information Act request, the FDA now responds that the trace amounts are no problem.  

I am naturally a skeptical person and I am always trying to find out as much as I can about the government lying to its citizens.  I am not being political here.  I remember the Gulf of Tonkin resolution and the false claims used by  LBJ to secure a war resolution from Congress concerning the Vietnam WarGulf of Tonkin Resolution I was in graduate school during the Watergate era and watched the hearings.   I did a lot of reading on American history in college.  It was easy to become a cynic.

3. Lying About the Use of Aluminum Tubes: For some reason this story about the FDA brought to the forefront on my memory, for reasons that are inexplicable, W's claim about aluminum tubes and the alleged Iraqi nuclear program used to justify the invasion of a country that had not attacked us.  Some say that W was just a victim of bad intelligence.  I beg to differ.

Even before Congress approved the war resolution, W knew that the aluminum tubes that had been captured in route to Iraq could not be used as centrifuges to enrich uranium.  The tubes had been examined by the leading American experts in centrifuge enrichment at Oak Ridge and W had been told that they could not be used to enrich uranium. 

As it turn out, there was a guy name Joe at the CIA who was not an expert on the use of centrifuges who disagreed with the real experts and W went with Joe.  Then the American public and Congress are told the story based on Joe's opinion and Congress is given a report that contains Joe's opinion in the body of the report, with a footnote saying the Department of Energy disagreed.  Congress being afraid to challenge W just before an election hardly raised a question about this or any other claim known to be false, questionable or exaggerated by W 's administration.

I first read about this issue in several articles in the Washington Post and later in the congressional report on the use of intelligence to justify the war. To me, I view W's claim on the aluminum tubes to be a lie. Some do not know the distinction between a lie and the truth, and would characterize the claim by W, being based as it was on Joe's opinion, to be a true statement. I do not understand that belief.  The truth would be to tell the American people that the experts said the aluminum tubes could not be used in the enrichment process and other experts said the tubes were for use in conventional rockets which is what they actually were, while someone who was not an expert claimed otherwise.  Joe was the CIA's guy on export control.   But if W had told the truth, you could not use those tubes as part of your case for war based on Iraq attempting to develop an nuclear bomb that it was going to drop on the U.S. any day, for the best and most reliable evidence was that the tubes were not part of a nuclear program and W knew it.  See, generally, ( 

As an academic, Wood said, he would not describe "anything that you absolutely could not do." But he said he would "like to see, if they're going to make that claim, that they have some explanation of how you do that. Because I don't see how you do it"

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