Nerd Talk by LB this Morning 5/20/09

Headknocker sounded reveille at 5 A.M. again this morning, saying to staff "enough of this beauty sleep crap, five hours is more than enough, get cracking". LB said to itself in a barely audible whisper that there had to be some kind of Rule about working in a sweat shop, and thought about looking in the phone book to see if there was some state agency where it could file a petition for redress of grievances against the Headknocker. RB said that might not be a wise idea after LB explained the issue more fully in its petition. Headknocker is allowing the Nerd, LB, to hang loose with its nerd talk for this morning only. LB wondered how many listeners it would have for a morning talk show about the following subjects, RB replied one or two, if the show was broadcast worldwide:

1. Steepening Spread in Yields Between the 2 and 10 Year Treasuries: Another indicator that is signaling a beginning of an economic recovery is the widening spread between the yields of the 2 and 10 year treasury. The WSJ has a helpful article and a chart on this subject. WSJ.com

I have mentioned that the longer dated treasury paper was going down in price and up in yield notwithstanding the Fed's massive buying campaign in its quantitative easing effort. What will happen when that buying stops? The short rates like the T Bills and the 2 year treasury note are the most impacted by the FED's easing policy, keeping the Fed funds rate near zero. The longer end of the curve is starting to react as you would expect, anticipating an economic recovery and at least a possibility of inflation down the road which is the primary enemy of longer dated debt securities. After all, if inflation causes the ten year to rise to 6% for example, what will that do to the security held by an investor paying just 3%. The steepening of this spread is one sign that the market at least is starting to anticipate a recovery. The short rates will narrow the spread some after the Fed stops the free money for everybody policy.

2. Merrill Lynch Floating Rate Equity Preferred Issues, now BAC: One of the floaters that I do not own changed its symbol after BAC acquired Merrill Lynch. I briefly mentioned this one in a prior post.

Bary's Column In This Week's Barron's: Floating Rate Preferred Stocks METPRA GSPRA HBAPRF BACPRE MERPRL/ Gross interview ForbesThe new symbol is BMLPRL and this is a link to the prospectus: Term Sheet

This one pays the greater of 4% or .5% above 3 month LIBOR.

QuantumOnline also mentions another one originally issued by Merrill, BMLPRJ, that has a better LIBOR float at .75% and the same minimum of 4%. This is a link to the prospectus:Final Prospectus Supplement

BMLPrh is worse at a 3% minimum with a .65% 3 month Libor float. BMLPRG, with a 3% guarantee and a .75% float, is also inferior to BMLPRJ. All of these equity preferred are now rated junk by the rating agencies. QuantumOnline has them listed under the equity preferred that pay qualified dividends. Preferreds eligible for the 15% Tax Rate Table - QuantumOnline.com

Now, it is time to get down and be nerdy. BMLPRJ closed yesterday at $10.08. BML-PJ: Summary for BANK AMERICA DEP J - Yahoo! Finance BMLprh closed at $8.98, so a buck lower for a perpetual equity preferred that has a 1% less of a guarantee and .1% less on the Libor provision. To me, if you gave me a choice of one, at the closing prices from yesterday, then I would make the decision based on my anticipated holding period. The 1% extra on the minimum would be worth $25 per year on a $100 shares, so figure 4 years to recoup the price difference but only when the guarantee is the applicable rate. The differential on the LIBOR calculation is more complicated since the BMLPRJ float would kick in when the Libor was over 3.25% and would increase that rate by .75%. On the other hand, BMLprh's float provision would kick in earlier when the 3 month Libor exceeds just 2.35% but would kick that rate up .65% rather than .75%. So it would be complicated until both floaters were being based on the float well above the guarantee and then the difference would be easy, just .001% x $25 par value=$.025 for 1 or $2.50 for 100 shares, so not much difference. The $100 difference in price for 100 shares would not be worth $2.50 more a year when the penny rate is calculated based on the the spread over LIBOR only when the LIBOR rate gives the better yield to both than the guarantee. Ultimately, it depends on your forecast of short rates over the likely holding period when making a choice.

3. Equity Preferred or Synthetic Floaters Floaters in periods of High Inflation:

A major reason to buy a floater is to provide some protection against inflation, the main enemy of the bond investor, along with credit default issues. I am not aware of any equity preferred floater that has a cap on the dividend payable. This has to be contrasted with the synthetic floaters which have a cap, usually in the 7 to 8% range. That cap would always be hit with the float provision rate at level lower than the cap rate. The Gateway Post for the floaters can be found at Links to Discussions on Floaters in One Post

For those of us old enough to remember, inflation can be a serious problem at times. The last serious bout of inflation was in the later 1970s and early 1980s when the 3 month T Bill rate ultimately climbed to over 14%. The Fed data, which starts in 1982, shows 14.28% in 2/1982, falling to an 8 to 9% range in the later part of 1982 and 1983, climbing back to over 10% in 1984, and then declining to a 7 to 8% range in 1985. Those were the days for savers like Headknocker.federalreserve. There was another spurt in 1989 to over 8%, but this is the last period where the 3 month T bill rates exceeded 8%.

I would seriously doubt that anyone making a pricing decision on a floater now is even thinking about the return of 4% short rates, and the possibility of a 10% rate anywhere in the future is out of sight, out of mind. The focus is just the here and now, short rates are low, and the present is more important to investors than working out alternative scenarios for the future, trying to ascertain what may reasonably work in the future depending on the scenario that comes into play.

Take two securities, both have a minimum guarantee of 4% and both have the same 1% over 3 month LIBOR as the alternate rate which comes into play only if that gives the investor a higher yield than the guarantee. One of those securities is a synthetic floater, paying distributions taxable as interest to a U.S. taxpayer, and it has a cap of 8%. This means that the investor will hit the maximum rate payable with Libor at 7%. The other security is an equity preferred, paying distributions currently taxable as a qualified dividend subject to the maximum 15% tax rate, and it has no cap. Say for example the Libor now at around 1% was instead 10%. The equity preferred with no cap would then be paying 11%. The synthetic floater would be stuck at the 8% cap, or a 3% difference in the rate. This is one advantage to the equity floater, along with the more preferential current tax treatment. Also, many of the equity preferred issues have a better guarantee and float provision. The problems with equity preferred issues include, as I have said many times, a lack of a cumulative dividend feature (AEB is an exception) and their lowly priority status in the event of bankruptcy. Some investors may prefer them to floaters that have more seniority in their claim to a bankruptcy estate. Many of the synthetic floaters are linked to senior debt issues except for the ones like those linked to trust preferred issues of Goldman Sachs or J P Morgan.

I do not own any of the Merrill equity preferred floaters, though I would consider a nibble on one of them, meaning a 50 share purchase only. I will wait to see about the pricing later this morning. I certainly do not want to pay much more than the closing prices from yesterday.