Comparing Prudential Floating Rate Bonds Tied to CPI and Fixed Rate Coupon Bonds Maturing in 2018/ CIT Rescue?

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Added 12/13/2009: For anyone interested in how Prudential would calculate the monthly interest payment on PFK, its exchange traded CPI floater, it would be the same type of calculation done by SLM for another CPI floater that I own, OSM, except with a different float. I performed several different calculations for OSM in these posts from December: Item # 1 Stocks & Politics: OSM 

I also show in a later post specific examples related to PFK in item # 5 : Hyman Minsky & the Economic Profession/Savings Bonds/Correlation of Asset Classes/Sold CYB

Links to discussions of a long list of floating rate securities traded on the stock exchange can be found Floaters: Links in One Post.  That list includes CPI floaters,  Synthetic Floaters, and  Equity Preferred Floating Rate Securities.

***** ORIGINAL POST

1. Prudential Financial CPI Linked Notes: I have previously discussed an exchange traded note from Prudential that pays interest linked to CPI (PFX). Pricing Supplement No. 122 dated March 31, 2006 The note matures on 4/10/2018 at a $25 par value. Bought PFK in IRA

Bought 100 PFK/

Over the weekend, I came across two similar notes from Prudential, with a slightly higher float provision than the 2.4% provided in PFK. One has a float of 2.5% over CPI. This is a link to the prospectus for the bond: Pricing Supplement, No. 240 Dated June 11, 2008

The FINRA information about this bond can be found at FINRA - Investor Information - Market Data - Bonds - Bond Detail This bond matures on 6/11/2018. Interest is paid monthly, and is not callable prior to maturity. The other has an even greater float, 2.75% over CPI, and its prospectus can be found atPricing Supplement, No. 246 Dated July 21, 2008.

This one matures on 8/10/2018. (the FINRA information on this bond:FINRA - Investor Information - Market Data - Bonds - Bond Detail)

While these bonds appear to have been sold to retail investors originally, I do not believe that either of them trade on the stock market, which is the case for PFK. Also, I suspect that the par value is $1,000 but have not confirmed it. And, based on the FINRA data, they trade infrequently. Nonetheless, I will monitor them for the purpose of determining a pricing discrepancy in their favor, compared to their more easily traded exchange traded cousin, PFK. I do buy and sell bonds in the bond market.

These bonds are close to be functionally equivalent. All are CPI floaters, maturing in 2018 and bear the same credit risk. PFX would be the easiest for an individual to buy since it trades like a stock. The other two may be options for investors who are comfortable buying and selling bonds.

(a) Comparison of Prudential CPI Floaters with Fixed Rate Coupon Bonds Maturing in 2018: So, even with a single issuer, there are frequently many alternatives. I found these two CPI linked bonds, because I wanted to check the prices for fixed rate coupon Prudential bonds maturing in 2018. I wanted to know how the pricing of a fixed rate coupon bond maturing in 2018 compared to the PFK. I found two fixed rate coupon bonds maturing at around the same time as PFK, which had some recent trading activity. One PRU bond, with a fixed rate coupon of 5.75%, matures on 4/16/2018. FINRA - Investor Information - Market Data - Bonds - Bond Detail I also checked the trades on another one, with a 6% coupon. FINRA - Investor Information - Market Data - Bonds - Bond Detail Both of those fixed rate coupons were selling a far lower discount to par value than either the exchange traded CPI floater or the other CPI notes referenced above. PFK at a $18.5 price is selling for about a 26% discount to its par value, which is more favorable than these fixed rate coupon bonds maturing in 2018. The fixed rate coupon bond would pay me more now, and for at least the next several months, due to the simple fact that CPI has been low, or declining, for the past several months. But, should the inquiry end there?

Some may go with the fixed rate coupon based on this kind of here and now valuation. I try to focus more on what is a reasonable forecast for the future, and is the price a good one now with that forecast. I will attempt to make that kind of judgment with all securities. The past and the present are only useful as aids to predict the future. It is not that I or anyone else has a crystal ball, but there are reasonable ranges for a future data set. I would not be comfortable trying to predict the inflation rate in 2015 or even for 2013 and 2014 combined. I am comfortable with an average forecast over a long period of time.

Rather than comparing the current yield this week or this month or even this year for the floater and the fixed rate, I try to ask myself what would be a conservative average inflation prediction for the next nine years, starting from today. Then, with that forecast, how does PFK compare now with the fixed rate coupons from the same issuer and priority. I am using now a forecast of 2.5% as the average inflation rate for the next 10 years. Others may have a higher or lower number, but I have to go with my number. I would not be surprised if it turns out to be higher, and would be surprised by a lower number. If I add the 2.4% float to that average 2.5% forecast, I arrive at an average interest rate for PFK over the remaining nine years of 4.9%, recognizing that some years will be higher and some lower, with the next year almost certainly lower. That interest is calculated based on a par value of $25 which gives me an average penny rate of $1.225. If I am able to buy that security at $18.50, then my average yield becomes 6.6%. This would be slightly higher than the current yield of the fixed coupon Pru bonds with a similar maturity (remember the FINRA yield includes both current yield and yield based on being paid par value at maturity).

I can earn significantly more at maturity by buying PFK than I can with the fixed rate coupon bonds, just based on their respective discounts to par value. And, if I am wrong about the inflation forecast, and it turns out to be significantly higher than 2.5%, then I will have the potential of being paid more interest over the entire life of the bond, which is not an option for a fixed rate coupon bond, even though I am being paid less now for the floater. So buying the CPI floater, at a larger discount to par value is in effect a hedge against greater than expected inflation down the road with greater capital gains potential.

For purposes of risk management, I limit my overall exposure to securities issued by a particular company. Generally, I will not have more than 1% of my investable assets in securities issued by one firm. For Prudential, I do not own the common stock, and have elected instead to own only its senior bonds. I own presently short term bonds maturing in 2012, 200 shares of a TC JZH which contains a bond maturing in 2033TRUST CERTIFICATE JZH: PRUDENTIAL SENIOR BOND, and 190 shares of PFK. I am at my limit for Prudential. My current view is to sell at some point 1/2 of the long bond, due to my concerns about inflation, and to use those proceeds to buy more of PFK, as the opportunity may arise.

2. CIT Rescue: The WSJ is reporting this evening that some large bond investors with stakes in CIT are close to lending this troubled firm 3 billion which would buy CIT some breathing space to work out more deals later to starve off bankruptcy. There is an incentive for large bondholders to try to keep CIT afloat. Many undoubtedly hold shorter term bonds, like I do, and hope to be paid in full for those bonds which would not happen in the event of a bankruptcy filing tomorrow. My two bonds, one maturing in December and the other next March, were being priced Friday at around 42. Needless to say, I would appreciate being paid par value in a few months at maturity. Also, with some breathing room, it is conceivable that CIT could survive, but I would not bet on it. The deal has yet to be finalized according to the last WSJ story, and may still fall apart. The terms are steep-10% over 3 month LIBOR with some of CIT's best assets as collateral. We will probably know by tomorrow.