1. My View of European Hybrids: There are always options for your capital. I am a lender, not a borrower. Say a person comes to me, asking for a loan with a long and complex loan agreement already prepared on a take it or leave it basis. I know that this person is generally a solid credit, pays on time, but sometimes runs into a tight spot. The borrower says, by the way, I will not promise to pay the principal back unless I feel like it. I say: "Is that a Joke", a common response for the LB when confronted with something outside the realm of its comprehension. Then the borrower says that their spouse can decide when and if a payment of interest in made on the loan, even if the borrower can afford to make a payment. And, what's more, the borrower wants the right to defer interest payments anywhere from the next quarterly payment until the end of days. And, the borrower says I am not going to pay you much in interest, even less than someone who actually agrees to pay the principal of the loan back with a similar credit history. And, then with a stern look the borrower says that you can not sue me for failing to live up to one of my few actual obligations unless you hire a lawyer in the Netherlands and file suit in my native land. Then after you spend more in legal fees than I owe you and win your case, I will pay you what is owed. What is my or your response? As difficult as it is to understand, some of the self proclaimed professional investors, running large amounts of money for institutions and funds, might jump at the opportunity to lend under those circumstances.
When discussing these European hybrids, I have emphasized their negative characteristics throughout this blog. A positive for a U.S. taxpayer is the taxation of their distributions as qualified dividends, which may soon end for those taxpayers who actually benefit from that advantage now. As a consequence and for the most part with a few exceptions, I have demanded a deep concession in price before I would buy one, and then I would not buy much. And by discount I mean buying ISF at less than $5 or INZ at less than $7, AEB at $8 or less, all with $25 par values. If investors start to demand more than 10% from this point forward for any new hybrid issued by the most solid firms, and considerably more for those who may defer coupon payments as a result of this last financial crisis, then the cost of capital would be too high to remain competitive, and the far too generous terms for the borrower would have to be changed dramatically to perk any interest in buying the security at rates the institution could afford to pay and remain competitive. And by a change in terms, I can only speak for myself. I would want a term of no less than 10 years with a promise to pay the loan back, extreme limits on deferral rights, a right to sue in the U.S. to enforce the terms, and a much higher rate than most of these instruments issued in the past pay.
The RB has been saying throughout the foregoing commentary that the LB was being too harsh and rigid as usual. The RB was saying it would want to use the proceeds from the INZ sell last Friday to buy AEB in a retirement account on further weakness. LB says that the proceeds from INZ are in a taxable account and the RB replied that it did not care about that-don't sweat the details is its motto, never say never, be flexible, relax, & have some fun watching RB's favorite bungee jumping securities.
2. Already Sold Enough Into the Rally: After figuring up the total amount of funds raised by recent stock selling, netted with a small number of minor purchases, I decided that I did not want to raise a significant amount of capital now by more stock selling, and I did not want to plow the proceeds back into stocks without a pull back in prices. One important factor for deciding to refrain from additional significant selling was that the funds raised so far have been deposited in a tax free money market account earning .1% as of last Friday. In case you missed it, there was a period in front of that 1, as in 1/10th of 1%, as in $10 in interest for $10,000 per year. Instead, I will just continue to do some backing and filling waiting for a better opportunity hopefully in September.
3. Sold PICO at $33.06 (see Disclaimer): For some reason that remains unclear to the LB, the RB bought 30 shares of PICO at $29.52 even though the LB was too busy to do a proper analysis of the company. Trading Rule for Disfavored Asset Class: Sold BDNPRC and Late Buy of Just 30 Pico RB's Water and Land Story: PICO?/ Non-Confirmation Means Vix Does not Confirm a market Move After trying to get a handle on PICO's valuation or even how to value the company, the LB decided that it did not have enough information to come up with good valuation criteria for this kind of company, did not want to add to the position for that reason, and promptly sold the 30 shares over RB's strenuous objections.
I've been asking myself many of the same questions you pose about the European perpetual capital securities. Who in their right mind would ever view these as a viable product? You've clearly presented the negative case.
ReplyDeleteBut what is the positive case, and for whom is it positive? Are the hyrbid issues at this point merely trading vehicles, with money to be made on the ups and downs of the share prices? Or is there some long-term benefit to holding them in a tax-sheltered account, collecting the perpetual interest payments? Do you think Aegon will ever redeem them at par value, and why would they?
At this point I am underwater on this investment, but I like the ongoing income and expect that it will continue for the foreseeable future. At some point, if I need to, I should be able to exit my positions without realizing a loss. That is really the best outcome I can look for, having bought too close to par.
Reading your blog is a great learning experience for me. Thanks.
Cathie: The Aegon fixed coupon, perpetual hybrids will probably never be called due to their extremely favorable interest rates and terms of those securities. In fact, I would have to say that I would be shocked if one was called in my lifetime. There is no reason why Aegon would call them and pay off the principal. Possibly, with the floating rate AEB, and assuming Aegon returns to investment grade, there could be a call after a prolonged period of a strongly inverted yield curve, where the short LIBOR rate is say 15% and the long term corporate rate is say 6%. As an owner of AEB, I will not hold my breath waiting for that to happen.
ReplyDeleteYou lose the benefit of the qualified dividend by buying them in a retirement account. My general approach is to put the hybrids in a taxable account and buy bonds paying interest taxed at my highest marginal rate in the retirement account. However, my last buys of INZ, ISF and AEH, were bought in a regular retirement account, and AEB in the Roth. That was more a balance of the risk of deferral with an unwillingness to pass them up entirely due to their yields at single digit prices, mostly in the $4 to $6 range.
If anyone would agree to lend you money at say 6 1/2% with no obligation to ever pay the principal back, why would you volunteer to pay it back. Or, maybe you feel like missing a few payments because things are a little tight, so you defer paying the interest and say to the lender-well that is just tough luck. These instruments are just too sweet for the firms to call them for redemption.
So, If I venture into one of them again, it will be for a trade, where a purchase is made at a much deeper discount to par value than the current prices.
As a general rule, and rules for me always allow for some exceptions, I prefer to accept less and move up the seniority ladder to the senior bonds, where deferral is not an option or to limit most of my junior bond buying to U.S. firms that have agreed to pay the principal back on a date certain with a time limit on any deferral which is usually five years. If you are reading a bond prospectus for a U.S. company, and it talks about deferral rights, then you are looking at a junior bond. I own a few but I own mostly senior bonds from U.S. firms.
I do not think that it is a wise investment rule to avoid hybrid securities and, instead, move up the seniority ladder to the senior bonds, where deferral is not an option, or to limit most of the junior bond buying to U.S. firms that have agreed to pay the principal back on a date certain with a time limit on any deferral.
ReplyDeleteIn my opinion, an investment in hybrids makes sense, as long as the price is "right". This means that there must be an adequate premium (compared to the coupons of senior bonds). Such premium should, in my view, be appr. 200 basispoints (2%) for healthy financial institutions.
I understand that investors have finally realised that the optional deferral rights do not only exist on paper, but can become reality, especially in times of financial crises when governments and the EC exercise heavy political pressure. However, as evidenced by last year's issuance of hybrid securities, this does not mean that investment interest for hybrids has dried up. Allianz, for example, was able to issue a hybrid bond (AZM) in June 2008 with a coupon of 8.375%. This is 1-2% above historical averages for the company. The security is currently trading near par, which means that investors still regard a 2% premium above historical levels as sufficient.
As to ING and AEGON, their financial strength is inferior to Allianz, especially in the case of ING. As a consequence and due to the increased coupon deferral risk (which I regard as much higher for ING hybrids than for AEGON hybrids), the yield premium for AEGON and ING hybrids should be higher than for the hybrids issued by financial institutions that are currently considered healthy. However, I do not believe that the prices for Dutch hybrids need to fall into the single digits to present interesting long-term investment opportunities.
Let's take AEGON: The company is in better shape than ING and slowly returning to profitability. If the financial markets do not deteriorate substantially from here, it can be assumed that AEGON will soon achieve reasonable returns on equity. It will also repay 1 million Euros to the Dutch state before December, thereby triggering a Mandatory Payment Event which will secure coupon payments on the hybrids for the following 4 quarterly payment dates. This, the fact that the hybrids are cumulative, and the assumption that a return to long-term profitability will make coupon payments beyond 2010 likely, leads me to the conclusion that current price levels constitute an interesting opportunity for a long-term investor. A trader might want to wait and be able to buy at even lower prices if the EC actually forbids coupon payments (either in the case of ING, Lloyds, RBS or - less likely - AEGON).
I understand that the existence of an unlimited optional deferral right constitutes an investment risk. However, this and last year's deferral practice (or should I say the absence thereof) shows that even the "bad" financial instituions choose not to defer payments, because they want and need the access to the capital markets to fund their operations. A deferral is clearly counterproductive and would permanently damage such access. This is the reason why the few cases of coupon deferrals that actually took place so far were not the result of "free" corporate decisions, but rather forced by regulators and/or the EC.
michaelandfred: Based on your comments, I would assume that you have bought one of the more hybrids again. I still own most of mine, and I disclose my positions and trades. When I criticize the hybrids, I am talking against my existing positions.
ReplyDeleteAs long as one chooses their entry points carefully, and trade the volatility, then opportunities can arise with the hybrids as I have made clear in maybe a dozen or more posts (e.g. http://tennesseeindependent.blogspot.com
/2009/05/embracing-volatility-as-risk-management.html http://tennesseeindependent.blogspot.com
/2009/06/reit-cumulative-preferred-links-in-one.html In those posts, I discuss how I traded the hybrids and REIT preferred stocks, both disfavored asset classes, to realize gains, collect dividend payments, and to lower my cost basis using FIFO accounting. In fact, there are a large number of posts devoted to this very subject. So, I assume that you have me confused with some other writer in your first sentence.
I wonder how many of those Allianz investors who bought that issue last year at par value in 2008 stayed for the ride down to $8 this March That is one of the better issuers of hybrids. The ones who bought hybrids issued by KBC or Allied Irish may not be so fortunate. But, is it time to buy now or to sell AZM? ING also launched a hybrid in 2008, IGK, with a similar coupon at 8.5%, it sank below $6 in March with a $25 par value. Yes, I have said many times that the RB loves these bungee jumpers.
Many of the investment grade senior bonds that I have bought have enjoyed large rallies too. Under my dynamic asset allocation approach, you buy whatever gives you the best opportunity at a given point in time. This requires an understanding of the relative strengths and weaknesses of particular securities. http://tennesseeindependent.blogspot.com
/2009/06/examples-of-dynamic-asset-allocation.html
In the Fall of last year, senior investment grade corporate bonds, mostly in TC form, could be bought with yields in the 10 to 15% range, some at 25% to 50% discounts to par value. A yield to maturity of 20% was not uncommon, with some purchased at yields over 20%. So, when I reference holding senior bonds, I am talking about senior bonds that are investment grade that pay be as much or more than the hybrids, which I intend to hold. And, the senior investment grade bonds have maturity dates. I have mentioned in the blog that those opportunities are no longer with us after the huge rally in corporate bonds and the narrowing of the spreads between investment grade corporates and treasuries. But, unlike securities that I assign to a disfavored asset class, like the hybrids, non-cumulative equity preferred stocks and REIT cumulative preferred stock, I will keep most of what I bought at favorable prices in the Fall of last year.
For a time, junk bonds presented interesting speculative opportunities, like a Hertz bond that I bought DKR or FCZ a Ford Motor Credit. Even though those kind of investments have doubled or tripled since I bought them, I still own most of them.
I would agree with you that ING appears to be in worse shape than Aegon, but the market is not making that distinction in hybrid yields. Today AEV was priced to yield 12.68% and IGK at 12.84%, or nothing material. So an investor has to make a choice, do I buy a security which may have the payments deferred under a newly announced burden sharing policy and has no maturity date or do I buy a security like a junior bond with a 2027 maturity from a Hanover Insurance company with a yield to maturity of 12%, rated BB+ by Fitch, higher than the current rating of the perpetual hybrids from Aegon? http://cxa.marketwatch.com/finra/
BondCenter/BondDetail.aspx?ID=MDAxMDRQQUMz That is just an example. Finding junk rated securities with maturity dates with similar yields to the hybrids is no problem.
I would add to my observations that an investor is invariably faced with a large number of choices among alternative investments. I will go anywhere and buy anything. No matter how much money you have, there is always a question of a capital allocation. Do I buy this security or that security. For example, if I told a reader that you could buy an investment grade senior bond with a yield to maturity greater than the Aegon or ING hybrids, junior securities with unlimited rights of deferral provided certain preconditions are met, which have no maturity dates, which would you choose, taking into account that investment grade bond is senior in the capital structure, with no right of deferral, and has a promise attached to it to pay the principal back whereas the hybrids carry no promise to ever pay the principal back and come with an enhanced threat of deferral caused by at least two conditions, the absence of a common dividend and the EC newly announced policy of burden sharing. Or would a gamble on the recovery of the common shares be a better use of the capital. It was not long ago that I own the common of ING, selling the shares for over $30 and I could have bought those shares back recently at just $3. At least with the common, I have an equity share in the business. Or do I forget about that and buy my Baby Berkshire shares back that I just sold. The capital allocation decisions are certainly thick with choices.
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