Sunday, November 2, 2008

Trust Certificates: Issues with Long Term Corporate Bonds

Some of my earliest posts were about trusts containing long term corporate bonds that were sold primarily to individual investors in the form of Trust Certificates, representing a proportionate interest in the bonds contained in the trust.  My primary reason for starting with Trust Certificates was that they were being seriously mispriced by the market in early October.  Each of these trusts contain a bond and the bond trades in the market.  By comparing the price of the bond and the Trust Certificate containing that bond, there was a huge price disparity in the way the same bond was being priced. I took selectively took advantage of those pricing anomalies.  This is my first summary of Trust Certificates that will be a prelude to the subject matter of this post:
  " For several years between 2000 and 2005, several brokerage firms created trust certificates containing corporate bonds.  Normally, a bond in the institutional bond market will trade in units of 1,000 so that a buy of 5 at a par of 100 would cost $5,000.  Many individuals will not trade in this market and the creation of trust certificates was done to attract individual investors to the bond market.  For trust certificates, the brokerage firm would create a trust, appoint a national bank as the trustee, and then bonds of a particular corporate issuer would be delivered to the  Trustee.   The bonds would then be divided into $25 par value Trust Certificates that would have the same maturity as the underlying bond in the trust.  Each Trust Certificate represents a proportionate interest in the bonds contained in the Trust.    These Trust Certificates are then listed on the  stock exchange and trade like stocks, but they are in fact bonds. 

     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:  

       "Since Trust Certificates, for the most part with a few exceptions, contain long term corporate bonds, the same set of variables applicable to any long bond need to be considered prior to purchase:  (1) long bonds have the highest risk/benefit in maturity spectrum due to swings in interest rates, (2) what is a normal spread between similarly rated corporate issues and comparable maturities for treasury bonds (e.g. a 20 year treasury may be around 4.25% and even a lower tier investment grade bond would normally, in the current market, sell 4 to 5% higher whereas highest tier investment grade bonds may be 1 to 2% higher; (3) credit risk is critical so the buyer of these securities must always monitor interest coverage and earnings; (4) is the company in a business that may suffer an abnormal amount of earnings problems in the current economic climate like a homebuilder, bank or auto company or benefit from it like natural resource companies; (5) is the fed tightening or easing, and is inflation heating up or under control (6)  the likelihood of a call before maturity where purchase is at or above par value (7) likelihood and amount of potential capital gains when the security is purchased at a significant discount to par arising from a narrowing of the discount over the short term, the additional percentage return created by the amount of the discount and the likelihood of circumstances that would induce at call prior to redemption and (8) favor the shorter term security if it has an equal or greater yield to maturity than another security from same issuer, with otherwise similar terms.   

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. "                                               





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