Sunday, December 7, 2008

Investment Grade Corporate Bond Spreads/ CPI FLOATER: OSM

1. Investment Grade Corporate Bond Spreads Relative to Treasuries Widens To Record Levels:  Investment grade corporate bonds had a positive month in November as an asset class. Those bonds  yield an average of 6.39% over treasuries which is the largest spread since Merrill Lynch started keeping this date in 1996. Invest  (investment grade corporate bonds returned 3.6% in November after losing 7.4% in October according to this Bloomberg article) Part of the reason has to do with the stampede to treasuries driving down the yield of the ten year treasury to 2.7% and the 30 year to 3.1%.  It is impossible for me even to consider loaning the U.S. government money for 10 years at 2.7%.  Oddly, most of the dysfunction in the investment grade bond market started with the massive sell off in the stock market after the Lehman Brothers bankruptcy, when senior bonds tanked along with common stocks in an irrational flight from virtually all asset classes to U.S. debt yielding a negative real rate of return. The assumption has to be that the next ten or thirty years will be like the last two months, or the next six, and it is difficult to fathom the basis for such prognostications so common among market participants.  

2.  Stimulus and Inflation: With all of the stimulus being injected into the financial systems around the world, it would seem prudent to predict that inflation will end up being the concern in a couple of years and for several years thereafter. The massive fiscal stimulus that the Beanpole plans for infrastructure projects, moreover, may just start to kick into first gear at about the time the economy starts to recover, sending the economy more into overdrive as opposed to picking it up off the floor. 

3.  Sallie Mae Bond: OSM: There are some corporate bonds that float interest payments based on the Consumer Price Index.  I have a small position in one of them, a medium term note issued by Sallie Mae (SLM) and maturing in March 2017, a little over 8 years from now. Prospectus:
Additional terms of this medium term note are contained in a general prospectus dated in August 2003.  The symbol for this floater is OSM and it is traded on the stock exchange, closing last Friday at 9.85 with a $25 par. Without getting into too much detail on the obtuse calculations, this one floats 2% over the CPI and pays interest monthly. If you took the next interest payment later this month of $.15 and multiplied it by 12, the current yield would be over 18% (OSM Stock Quote -showing as of 12/5/08 a 18.4% yield) but that would not be an accurate way to look at it, for that $.15 monthly interest payment will not hold for the next 12 months.Since the rate will change with subsequent CPI readings, including some of the recent low readings, I would expect the interest payment to fall soon and possibly throughout most of 2009 below the current monthly interest rate as CPI decreases.  If held to maturity in 2017, I would expect the monthly yield to vary, both up an down.  If someone can tell me what CPI will be in 2012, I would like to know. The current price of OSM is being adversely impacted by deflation expectations as well as credit concerns with Sallie Mae.

4.  Steve Romick Recommends Sallie Mae Bonds: One investor (Steven Romick) interviewed in SmartMoney for the January 2009 issue, received yesterday, suggests that the bonds of Sallie Mae (SLM) maturing in 2010 may be good investments (page 65).  After the Fannie and Freddie debacles, it is hard to put much faith in a GSE these days, but a lot of SLM's student loans are federally guaranteed as that investor points out.   Still, I would not risk more than $2000 of my money on Sallie debt and my current position is at 150 shares so I may add no more than 50 at some point on a meltdown not caused by bad news specific to SLM or student loans in general but more due to an aberration or anomaly connected to supply/demand of the often thinly traded OSM. A limit order well below the market can frequently be filled in this type of security.

5.  OSM Discount to Par Value as Impacting Potential Return: Besides providing some current income, there is a very large discount to par value currently with OSM, almost $1500 on 100 shares purchased at 10. This is important to me when considering a bond purchase. I amortized that spread over the remaining 8.3 years to maturity which gives me about $181 per year, or 18% annualized return based on a $1,000 cost, assuming of course payment at maturity. If Sallie survives until March 2017, the annualized return could be over 25% per year depending on the inflation rates over then next 8 years and capturing the spread at maturity.  For me, when inflation is a concern and a positive consensus has formed about Sallie's creditworthiness, then this type of security will be priced in such a way to generate virtually no interest for me. I would prefer to wait for the crowd to come to a consensus that deflation will be the soup du jour, and then I look for investments whose value may increase with inflation,  particularly intermediate term bonds selling at deep discounts to par value where most of my return would probably consist of capturing the spread between cost and par at maturity even with a return of inflation.  I would also view these inflation linked bonds including TIP to be an integral part of my bond portfolio.  Some say that I am a contrarian. Maybe,  I just prefer to buy low and sell high, and to make money in two ways rather than just one.  

I am considering another one similar to OSM for purchase and will discuss it with more details only if I decide it is a worthy addition to my portfolio.  I am not inclined to buy it at its current price but almost decided to buy it a few days ago at $12.5 but I was having one of my deer in the headlights days.  It is a CPI inflation linked note issued by Prudential (PFK). I noticed that it recently traded at 1/2 of its par value before improving last week to over 15 as investor's regained a measure of confidence in life insurance companies.  

6. Lincoln National Three Bagger: My only exposure to life insurance companies is senior bonds and some shares of Lincoln National which amazingly has almost tripled since my last purchase on 11/24/08, so maybe I should not fire my Head Trader. Time to Fire my Head Trader: He Bought LNC   What on earth explains this kind of price swing other than a severe form of emotional instability that extends far beyond any reported cases of insanity? Or, maybe I should fire my Head Trader for not buying a 1000 shares at 6 rather than his admittedly totally wimpish 30 shares. 

7.  James Stewart Mentions FINRA Site:  Since I am on the investment grade corporate bond topic, I would also draw attention to James Stewart's column in the January issue of SmartMoney, at pp. 38-39.   He mentions that FINRA site as a place for individual investors to research bond issues.  I go to that site to check quotes and to find the CUSIP number of bonds that I may be interested in buying. FINRA - Investor Information - Market Data - Company Information  (after entering common stock symbol, a page will pop up with the stock quote and you can scroll on the right side under "search" to "bond" to get all of the available bonds for that company)  I previously mentioned this site as a place to get quotes on the underlying bonds contained in TCs that I have discussed since the inception of my blog. Stocks & Politics: JZE AND JZJ: UNDERLYING AT & T BOND DATA at FINRA

In this article, Stewart mention several A rated or better paper maturing in five years or less as possible investments in his bond portfolio.  Of those that Stewart mentions, I already have in my portfolio senior bonds issued by Prudential, General Electric, Caterpiller, HSBC and Hartford  maturing in less than five years,  I do not have Chubb but I went to the FINRA site to find the CUSIP number for it after reading his article. I may add it later this month. I do stagger these short bonds so that several come due every year.

8.  Rating Agencies Loss of Credibility: Stewart also states in this article that the rating agencies "may" have lost "some" of their credibility.   I would have used stronger language to describe their credibility.  My skeptical view of them is not just based on them acting as enablers for the current financial crisis by rating toxic trash as AAA which was the precondition necessary for the trash pools to be sold to investors around the world,  nor is it just based on the fact that the rating agencies are paid by the issuers of the debt that they rate.  It is not just their failures to catch major company failures like Enron and Worldcom or the many cases of financial fraud.  It is not even articles like the one appearing on the front page of the NYT on Sunday, yet another article on how the financial companies created the current crisis.  I am hardly surprised by this article's summary of the ratings given to a pool of mortgages assembled by Goldman Sachs containing 338 million of second to subprime mortgages, which Moody's and S & P obligingly rated AAA for the 169 million upper tier slice in August 2006.  How could that crap be sold otherwise-really, get with the program?

By August 2007, that AAA slice was bumped down to BBB and then to junk in December 2007, then more into junk and not even traded anymore according to the Times. Why should anyone be surprised by any of this?  Does anyone really believe that it was ever AAA? No, my main reason for refusing to rely on them is that they still insist that they are unbiased, professional, and trustworthy, and that nothing is ever done to influence or to pressure, directly or indirectly, the independent judgments of the analysts' rating the debt notwithstanding the fact that the ratings agencies are paid by the companies issuing the debt. The NYT article, part of its Reckoning series, pokes a few holes in those claims, and I have seen read many other articles that have done the same over the years, with the following being links only to the more recent ones.

Each person has to reach his own judgment on these matters, and speaking for myself only, I just try to place a minimal amount of credence in the ratings given by either Moody's or S & P when making a decision on whether to buy a particular bond. Instead, I try to make my own assessment as best as I can with the information available and easily accessible over the internet to all investors.  

9. Trust Certificate PJS: One of the TCs that I purchased earlier, PJS, contained a senior bond from First American.Some Nibbles Got Filled: JZE, PJS, INZ and FAX The FINRA link for the underlying bond in this TC is  FINRA (symbol FAF.GA, CUSIP 318522AA7) 

I think that I gave the other links in the prior post referenced above)  I am not too interested in that bond except that I did receive a favorable price of $7.2 on 10/10/08 juicing my yield to 26% currently plus the spread between cost and the $25 par value at maturity in 2028.  

 I am not a financial advisor but an individual investor trying to navigate my way through a difficult market. In these posts, I am acting as an unpaid financial journalist and an occasional political commentator.   I am also aggregating financial news stories that I view as important and providing any reader of these posts, assuming there are more than a couple, with links to those articles, sort of a filtered, somewhat intelligent, free search engine.  Any discussion made by me of particular securities  is not a recommendation to buy or to sell.  Trade at your own risk.  Consult with your financial advisor prior to making any purchase or sale. I will try to identify my sales too but it may take a few minutes after I implement them to create a post explaining my reasons.  The sale may before or after the post.  Before buying or selling any stock, even one recommended by a trusted financial advisor,  please research it and make up your own mind which is what I always try to do.  Research would include reading reports, reviewing financial records, earnings estimates, sec filings and prior earnings releases and news.  In this post, and all others by me, I am merely describing my reasons for purchasing  or selling securities, and the potential pitfalls that I identified prior to purchase or the reasons for a sale.  The securities mentioned in this and all posts written by me may not be suitable for others based on their unique financial position and risk profile.  Always read the prospectus before buying a Trust Certificate, bond, preferred stock or other bond or bond like investments.    

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