When the trust is created, it may have a coupon that is larger or smaller than the coupon of the underlying bond and any difference in coupon is taken into account by adjusting the amount of bonds delivered to the Trustee. The market for these stock certificates is dominated by individual investors which creates opportunities to buy investment grade bonds at much cheaper prices when they are embodied in a Trust Certificate than when the underlying bonds contained in the Trust Certificate are traded in the institutional bond market.
The one that I am going to discuss today is a Trust Certificate containing an AT & T bond (common stock symbol is T) The stock symbol of the Trust Certificate (TC) is JZJ. It was a trust originally created by Lehman but this has no relevance now. The TC JZJ represents an interest in a SENIOR AT & T bond currently held in trust by U.S. Bank Trust. It is a unique TC in that the call prohibition of the underlying bond will soon expire, the credit rating of AT & T has gone up several notches since the bond was originally issued, and the underlying bond is an investment grade bond yielding 8%, more than the TC coupon, and could go higher in the event of a downgrade by the rating agencies. The later provision, paying more in the event of a downgrade, is something A T & T could avoid now by calling it and refinancing on better terms . The maturity of the underlying bond is 11/15/2031. The coupon on the TC is 7.125% per annum which can be decreased by .25% for each upgrade in rating of the bonds but not lower than to 6.375%. In the event of a downgrade, the coupon yield would be increased by .25% for each notch. As a result of several upgrades in the debt rating since this TC was created, the coupon has fallen to the minimum guarantee level of 6.375%. So while AT & T may not have any interest to call a 6.375% bond, which is the current yield of the TC at par value, it may want to call a 8% coupon bond which is the underlying bond in the TC and that bond has unfavorable enhancement features. If the underlying bond is called, that would result in a call of the TC and the payment of $25 plus accrued interest in November 2008. This may not happen but it is certainly possible. The credit markets may just be too chaotic to do a refinancing in November 2008 but at some point soon I suspect that people will be running to buy AT & T paper. The corporate bond market is certainly in chaos now. While there is no guarantee that the underlying bond in JZJ will be called at $25 in less than 2 months, which would be pure gravy, a home run, it would nevertheless pay interest at close to 9% at it closing price today of $17.60. Interest is paid semi-annually at about .80 for 1 TC or $1.60 per year. At a total cost of $17.6, the yield at the current coupon rate of .06375% would be 9.09%. If the debt is downgraded one notch, the coupon rate would go up .25% and so on for each downgrade. This gives you some downside protection by increasing your yield in the event of downgrades." (see post Oct. 6th,Trust Certificate JZJ AT & T BOND)
I later bought a Trust Certificate containing the same AT & T bond at 12.5 (JZE), but with slightly different features on the minimum guarantee. JZE: MORE DETAIL That security was bought with a limit order, filled near the close, probably being sold by an individual investor in a state of panic. It is my belief that the opportunities in this market are created by severe mood swings among the individual investors who are the primary owners of these securities. As of Friday, the underlying AT & T bond contained in JZE and JZJ was being priced at about a 6 to 8% discount to par value, depending on the size of the trade. When I bought JZE, it was trading at a 50% discount to par value which juiced the yield to me way up based on my costs.
I have discussed the dangers of buying long term bonds some in these posts and many times in my emails. The following is an excerpt from an email sent before I started writing these posts:
U Then, there are variables unique to trust certificates, what I call relationship issues: (1) what is the relation of a trust certificate yield to maturity compared to the underlying bond yield in their respective markets (meaning the NYSE for trust certificates and institutional bond market for the underlying securities) with spreads greater that generate a 3% interest differential in favor of the trust certificate given special attention (2) what is the relation of the yield to maturity of one trust certificate originated by one brokerage to one issued by another, where both hold the very same bond (e.g. XFL and PJL).; (3) what is the relation of trust certificates with obligations from the same issuer with different coupons but the same or closely similar maturities (e.g. KTN, KVF, KVW, DKK); (4) the often unique trading patterns of a particular trust certificate including patterns that emerge before and after ex interest dates and durations of anomalies, some are shorter than others (PKK has usually longer duration anomalies than JSV) and (5) the existence of major trading anomalies usually at or near the height of individual investor’s anxiety about common stocks that spill over into the trust certificate’s highly inefficient market whereas bonds may become more desirable during such market events but the trust certificates fall in value, often precipitously, due to individual investor panic or forced margin calls on stocks. "