Thursday, January 8, 2009

Functional Equivalence in Bond Trading/Hedge Funds & Independent Adminstration

One of the institutions burned badly by the Madoff scandal, the private Swiss bank UBP, is finally taking steps to insist that hedge funds use an independent administrator. This would be just one of many different steps that has to be undertaken simply to reduce the possibility of fraud, or at least make it more difficult. The suggestion made by James Stewart about insisting on a large accounting firm is another, although I was generally very critical of his column in the WSJ. Brief Return to HG HQ TRADING DESK: Look at PFX/MORE THOUGHTS ON FII/STEWART SHILLING FOR INVESTMENT ADVISORS IN MADOFF SCANDAL? 

I would never allow anyone to manage my money. If I did turn some over to hedge fund, I would insist on an independent administrator and an independent custodian. I would also want to be sure that the accountant was actually verifying the securities held at the independent custodian and not attempting to limit the scope of their audit function in some material respect. Do you know precisely what the accountant is doing?  If they are limiting a review mostly to a review of the fund's books, then I would just skip it. I would want an audit that would verify the existence of the securities held by an independent custodian, cash balances at banks, etc. It would be just inconceivable to give money to any fund without serious and extensive checks and balances.

There is certainly no rational reason to expect favorable economic news for at least the next six months. I said in an earlier post that I can not yet see a ray of light at the end of this tunnel. TOO Early To Celebrate? Real Estate Morass in Brentwood

While there was a couple of weeks or so when the market shrugged off bad news, it is starting again to react as if the bad news will never end. 

Wal Mart did warn about its 4th quarter earnings this morning. MarketWatch On the positive side, while December sales were disappointing, Wal Mart nevertheless did report an increase in same store sales for December Many other retailers were not so fortunate.  

I sometimes try to read between the lines. What does Obama mean that he wants to tackle out of control spending medicare spending? Sometimes a politician may just mean waste and fraud but the waste and fraud have a way to outlast the term of any President, even one who actually intends to do everything necessary to control it.  I am still waiting for that one to come along.   

Maybe I am just being cynical but this is just mostly politician talk. I think the real thrust of his plan to control entitlement spending may be aimed at health care providers and the drug companies.  If there is anybody going to get skinned by the Dems, they would be the most likely targets of cost control programs. It will not be the ones receiving the benefits. But if you want to cut some social security funded disability payments, you might start with the 97% of union workers for that Long Island railroad who receive disability benefits partially funded by social security that the NYT has been exposing for months, with this link being just the last article. The Disability Board That Couldn’t Say No -

The only way to slow down fraud is to start an extremely vigorous criminal prosecution program, staffed by the best prosecutors that can be found or recruited from the private sector. If it costs 500 million, then it might just be the best 500 million that the U.S. government has ever spent. I was listening to Cramer tonight arguing for some really serious criminal prosecution of the Wall Street mob. 

To date, I am not even aware of any criminal investigations even being undertaken. I would disagree with his recommendation, made in jest, that a new prison be built to house them. Really, I think that we need to do renditions to the worst penal systems in the third world countries that have not spent a dime on correctional facilities in at least 100 years.  Is there any doubt that criminal activity was widespread? 

GXP was accidentally left off the list of my electric utility holdings given in a recent post.PROGRESS ENERGY

I am going to amend that earlier post to add it.  

1. Functional Equivalence: I mentioned functional equivalence in bond trading in an earlier post and that may need some explanation. It basically means that two or more bonds are similar in most material respects except for yield, with the other material factors being the identity of the issuer, maturity date, and priority. Possibly I need a better phrase to describe what I am talking about. A few examples may help to clarify what I do on a regular basis now. 

One kind of equivalence are the four AON bond TCs (DKK, KVF, KVW AND KTN), where there is some difference in the coupon but otherwise it is the same AON junior debenture maturing in 2027. 

Another example would be some Liberty Media bonds contained in TCs PYL, PKK and PIS where there  is a slight difference in maturity dates and the coupon (e.g. the bond in PKK matures on 7/15/2029 whereas PIS and PYL mature on 2/1/2030, which to me is a distinction without a difference) The coupon however ranges for those Liberty Media TCs from 6.7% for PYL to 8.75% for PIS. What is relevant is the yield at the current cost. 

When exchanging one bond for another based on differentials in pricing for functionally equivalent securities, the first determination is yield based on price. PIS closed on 1/7/09 at $13.85 and has a 8.75% coupon. PKK closed at 15.41  on 1/7 with a 8.5% coupon.  

Assuming it made sense based on all the variables,  an owner of PKK might sell it and buy PIS. Both are TCs containing senior bonds from the same issuer maturing at about the same time, with the higher yielding one selling for about a buck and half cheaper. I own both PIS and PKK, as part of my junk bond allotment that I allow myself and both are properly characterized as speculative positions, perhaps less risky than DKR but Liberty Media bonds still carry a lot of intermediate and long term risk of default. Here are the relevant links to the SEC filings:

You can match the right sec filing with the correct symbol by linking the series numbers, LMG-1, LMG-2, and LMG-4. 

The closest form of functional equivalency would be the Verizon TCs XFL and PJL, which are in all respects identical, containing the same senior bond, maturing at the same time and with the TCs having the same coupon. Trust Certificates PJL and XFL: Verizon Bond DKK is identical in its material terms to KVW.  Pricing Discrepancy in Aon TCs And there are a few others that have no material difference like the ones discussed containing the Credit Suisse bond. Article in this Week's Forbes on Trust Certificates/Trust the Government? 

The difference is the identity of the brokerage company that originally set up the grantor trust and deposited the bonds into the trust, now controlled by an independent trustee. This is not relevant. The bonds are not owned by the brokerage company that set up the trust.  The investors who buy the Trust Certificates are the beneficial owners of an undivided interest in the bonds contained in the trust. 

The ones that may be harder to equate would be ones that come from technically different issuers, like different subsidiaries of the same parent. I have discussed two different first mortgage bonds issued by separate subsidiaries of Entergy (ETR), an electric utility operating in the South. One was a first mortgage bond issued by Entergy Louisiana (EHL), a lien on its assets, and the other was issued by Entergy Mississippi (EMO) supported by a lien on its assets. I am simply not capable of making a distinction between those two subsidiaries as to the fair market value of the secured assets. There are several more first mortgage bonds in this Entergy class including for example one from Entergy Arkansas. Then you have a bunch of different kinds of senior bonds issued by subs of the Southern Company, including Georgia Power and Alabama Power. Some of these even have insurance backing in addition to being senior obligations but I am not aware of any publicly traded first mortgage bonds issued by these subs.  

So, to each his own, I would consider under the right circumstances selling a position in a first mortgage security issued by one Entergy sub and using the proceeds to buy or add to another, where I increase my yield and increase the size of the discount to par value, assuming no material difference in maturity between the two issues.  

You then have bonds from the same issuer with the same priority where the one with the shorter maturity yields more than the longer one. I would generally consider shortening the maturity for long and intermediate term bonds particularly when there may be other advantages like a larger discount to par.  

Cumulative REIT preferred stocks from the same issuer are functionally equivalent, or least the ones that I trade.  There may be some difference in the coupon. The issue is not the coupon but the yield at the price that you would have to pay at the time a decision is made to buy.  There is no difference other than yield in my opinion between CUZPRA and CUZPRB, or between FRPRJ and FRPRK for example. You have the same credit issues, none of them have maturity dates, all of those just mentioned are cumulative. and have the same priority.  

You can see the same kind of functional equivalence in other types of preferred stocks, like INZ and IND issues by the Dutch company ING Group that I have discussed and the AEGON fixed rate preferred stocks, where the difference is yield at the time of purchase. The prospectuses for these issues are provided in previous posts for comparison. If anyone finds a material difference other than yield at the current price, then let me know.    

There are many more examples but this is all for today. When the investor makes a decision on functional equivalence between two securities, and wants to buy just one, then the one with the best yield would be my first choice. So, for example, if I wanted to buy a senior Liberty Media bond in a TC, which I do not want to do now, I would not buy PKK at yesterday's closing price but PIS at yesterday's closing price. This may change today, or tomorrow, or the day a decision is made to buy one. The decision is made at the time the order is going to be placed. I would of course check the pricing of the underlying bond at the FINRA site before I did anything, to try an determine any discrepancy in pricing between the TC and the underlying bond, as well as read the prospectus, research Liberty Media thoroughly, including its outstanding debt and maturity schedules, and so, or just all of the factors discussed in excruciating detail in these posts which can never be sloughed off by reading what somebody else says, or listening to what someone says, but only by doing all of the analysis & research yourself. 

There is no excuse for laziness if someone desires to venture into area.  I am simply alerting anyone interested to the possibilities that exist

  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.  Information contained in my posts has been obtained from sources believed to be reliable but cannot be guaranteed.  These posts by me do not constitute investment advice, nor shall they be construed as a guarantee of future results, or as an offer of any transaction in securities.   All content in these posts is provided for informational and entertainment purposes only, and it is a form of entertainment for me. 

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