Friday, September 25, 2009

Synthetic Floaters

Added July 7, 2009: A reader pointed out to me that one of the floaters discussed below, JBK, is no longer a floater, since the swap agreement creating the floating rate security was with Lehman. With Lehman's bankruptcy, the swap agreement would be terminated and the holders of JBK would then receive the fixed coupon payment of the underlying security which is the same junior debenture that is the underlying security in several Trust Certificates. Goldman Sachs 6.345% Junior Debenture Maturing on 2/15/2034

Added 7/27/12: Due to what happened upon the redemption of GJN, investors need to re-evaluate the risks of synthetic floaters. Sold 50 JBK at $22.75/Reassessment of Current Synthetic Floater PositionsThe Egregious Swap Termination Fee Paid to the GJN Swap Counterparty

I talked with Floyd Norris about what happened to the GJN investors and he wrote an article about it: A Wells Fargo Security Goes Wrong for Investors -

***********original post:

The synthetic floaters can be found at quantumonline under Third Party Trust Preferred. Third Party Trust Preferred Securities Table -

This post is not intended to be a substitute for a review of the prospectuses for these securities, or as an alternative to reading my more detailed discussion of these securities in prior posts. Instead, I am merely summarizing only a few key provisions in each of these securities.

All of these securities are in Trust Certificate form:  Stocks, Bonds & Politics: Trust Certificates: New Gateway Post Trust Preferred and Trust Certificate Distinguished In each case, the float is created by a swap agreement. If the swap agreement is terminated, then the investor will then receive the interest payable by the underlying security in the TC. In some cases, the underlying security may be a Trust Preferred, as in the TCs tied to bonds issued by J P Morgan and Goldman Sachs, and some are linked to senior bonds, such as the one from Proctor & Gamble. Trust preferred issues are junior bonds and have liberal deferral of interest provisions. Trust Preferred Securities: Links in One Post

A more detailed discussion of these securities can be found in my earlier posts which are linked in this Gateway Post: Floaters: Links in One Post Synthetic floaters are to be distinguished from floating rate equity preferred stocks: Advantages and Disadvantages of Equity Preferred Floating Rate Securities

Due to tax issues associated with synthetic floaters, I intend to hold them in retirement accounts. (As of 12/19/09 I own PYT, GJN, GJP, GYB,GJL, GJT, & GYC and I have sold my positions in GJR, GJO, PYV, GJK and GJS)

I have decided to de-emphasize those with no guarantee, so I quickly bought and sold GJS and GJO after changing my mind about their desirability compared to others with a guarantee. The ones without a guarantee are attractive to me only at a substantial discount to par value, something like a 70% discount.

Synthetic Floaters with a Guarantee:

As with the equity preferred floaters, these synthetic securities pay the greater of the minimum rate or the float rate. And, all of the foregoing have a $25 par value and a maturity date. Buying these securities at a discount to par value will increase both the minimum yield and the value of the float provision. The prospectus link is also provided:

Dominion Resources: GJP Min 3 % Max 8% or 1.15% over 3 month Treasury (mat: 6/15/2035)

Goldman Sachs: GJJ Min 3% or .65% over 3 month Treasury Max 6.5% (MAT: 10/15/2013)

Goldman Sachs: PYT Min 3% or .85 over 3 month Libor Max 8% (MAT: 2/15/2034)

Goldman Sachs: GYB Min 3.25% or .85% over 3 month Libor Max 8.25% (Mat: 2/15/2034)

Goldman Sachs: JBK Min 3.5% MAX 7.5% or .75% over 3 month Libor (Mat: 2/15/2034)(no longer a floater, now a fixed rate coupon TC)

SBC (now AT & T) GYC Min 3.25% or .65% over 3 month Libor Max 8% (Mat: 6/15/2034)

IBM : GJI Min 3% or .5% over 3 month Treasury Bill Max 6% (Mat: 11/29/2012)

J P Morgan GJK Min 3% or .7% over 3 month Treasury Max 6.75% (Mat: 3/15/2014)

J P Morgan PYV Min 3.25% or .83% of 10 year treasury (cmt) MAX 9.25% (mat:3/15/2014)

J P Morgan GJN Min 3% or 1% over 3 month Treasury Max 8% (Mat: 8/1/2035)

Daimler North America (guaranteed by Daimler AG) GJL Min 3 or 1.25% over 3 month Treasury (Maturity 11/15/2013) Redeemed December 2010

No Minimum Guarantee but with a Maximum:

Proctor & Gamble GJR .7% over 3 month treasury bill MAX 7.5% (mat: 8/15/2034)

Allstate: GJT .8% over 3 month treasury bill Max 8% (Mat: 4/1/2036

Goldman Sachs GJS .9% over 3 month treasury bill MAX 7.5% ( Mat: 2/15/2033)

Wal Mart GJO .5% over 3 month Libor MAX 7.5% (Mat: 2/15/2030)

Even if the 3 month treasury bill fell to zero, and it recently came close to zero, a security like GJT would in effect have a minimum of .8% over zero. If an investor purchased this $25 par value security with a total cost of $9, then the effective minimum yield at a zero treasury bill rate would be 2.2% (.008% x $25 par value=$ .20 divided by $9=2.22%)
I think that it is helpful for an investor to compare a synthetic floater with an equity floating rate preferred from the same issuer. This comparison is possible for both Goldman Sachs and J P Morgan issues. I will just compare GYB and GSPRA, since I currently own both securities.

On Friday GYB closed at $12.95 and GSPRA finished at $15.44. First, lets look at the minimum yield based on a total cost at those prices:
GYB: Min 3.25% x $25 par= $.8125 per year in interest for 1 share divided by $12.95=6.274%
GSPRA Min 3.75% x $25 par=$.9375 per year in dividends for 1 share divided by $15.44=6.07%
My buy was at $11.

So, even though GSPRA has a higher minimum, the difference in the cost basis using last Friday's closes causes it to have a lower yield. You always have to compute yield based on your cost, so a lower coupon security from the same issuer can have a higher yield than another with a higher coupon just based on the cost differences.

GYB has a better LIBOR float at .85% versus .75% for GSPRA.
GSPRA pays a qualified dividend but that is a distinction without a difference if GYB is put in a retirement account for a U.S. investor.

Here is the kicker. GSPRA has no maturity date. GYB matures in 2034, about 25 years from now. While that is a long time, it does mean that I will also almost double my money when par value is paid at maturity, assuming GS survives until then in addition to the interest payments. Like a number of perpetual preferred issues, GSPRA may never be redeemed at par value. So this explains why I have gravitated to include some of these synthetic floaters in my retirement accounts.

The two advantages of GSPRA at its current price is its qualified dividend status, which is meaningful only if the U.S. investor has non-retirement brokerage accounts, and the lack of a cap on the dividend yield, that is not likely to be relevant for years to come.

Another factor is that GYB is linked to a junior debt security issue from GS and consequently a holder of that security would have priority to Goldman's assets over the owner of GSPRA, an equity preferred, in the event of a bankruptcy. This may not make much of a difference in the event of a bankruptcy, as shown by the Lehman failure, but it is conceivable that a junior debt holder might actually receive something, whereas all equity holders would most likely be holding worthless paper after the collapse of a bank or investment bank, which is just my opinion.

I also believe that the floaters will be priced higher when short rates move from their currently depressed levels, which are due to a worldwide easing by central banks, and start to return to more normal levels. Many of the credit concern worries seem to be lifting already.

2. DKR: I believe the TC DKR which contains the Hertz senior bond went ex interest last week.

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