Friday, September 25, 2009

Inflation/WBS, CBL/Medicare Funding/BMLPRH vs. BMLPRJ

1. Webster Financial (WBS)(owned-Lottery Ticket): WBS is one of the better performing bank LTs, more than doubling so far from my 50 share purchase at $4.58 in March: Items 6, 7 and 8: Buy of 50 WBS: Lottery Ticket/The Long Tail Contract/ Webster was upgraded yesterday to outperform from market perform yesterday by the analyst at RBC Capital Markets.

2. CB & L Properties (CBL) (owned-Lottery Ticket): On the other hand, another LT, CBL, was initiated by Oppenheimer at underperform with an $8 target. I understand where the analyst is coming from, this stock has had a huge rally since my purchase at $3.07 in November: LATE DAY TRADES: GCI, CBL, FR, SLG, NYT, NWSA And, I have not had a kind word for this heavily indebted REIT. Still, I am mostly trying to ignore it, reinvest my dividends to buy additional shares, and just wait and see what happens.

3. House Passes Bill 406 to 18 To Cancel Increases in Medicate Premiums vote 737: While I understand the political pressure to cancel the modest premium increases for Medicare insurance, from an average of $96.40 now to $104.20, it is also emblematic of why the Medicare system is going broke at a rate faster than expected, with the last estimate projecting an exhaustion of the fund in 2017: /tr2009.pdf Whenever a new estimate is made, the time for exhaustion moves closer to the present, and it is interesting that the fund will be exhausted at about the time the baby boom generation starts to claim their medicare benefits. Congress is incapable of dealing with the trillions in unfunded liabilities, and is only capable of doing what is politically expedient at any given moment, even if their action makes the long term funding problem worse. The beneficiary premiums are already heavily subsidized. Part of the funding comes withholding taxes on the entire labor force. Trustees Report Summary Medicare (United States)

Medicare costs reached 432 billion in calender year 2007. 2008 Medicare Annual Report, Financial Portion

4. Microsoft (owned): BING increased its search market share in August to 9.5% in August from 8% in July.

5. Treasury Inflation Protected Bonds: The WSJ has an article in yesterday's paper about the surge of interest in TIPS. I thought that article was a good introductory article about the TIP. I would highlight a couple of points. The yield on a non-inflation protected 10 year treasury note has been falling lately and is currently 3.38%: Markets Data The 10 TIP, which will be auctioned early next month, will have a lower coupon. The difference between the TIP coupon (real yield) and the nominal treasury yield is the break even rate, the amount that inflation would have to rise on average for the investor to break even by buying the TIP compared to the non-inflation protected security. Between 1914 to 2000, the inflation rate in the U.S. averaged about 3.5%, though the trend since 1990 has been averaging under 3%. Hoover Institution Historical Inflation Rates US Historical Inflation US-Inflation-by-year The break even on the 10 year is currently around 1.7% to 1.8% depending on the day. (3.38% nominal yield on 10 year minus 1.62% TIP yield=1.76% break even as of 9-23 on 10 yr) Treasury Inflation-Protected Securities (TIPS) - Markets Data Center - That break rate is the market's current forecast of the average rate of inflation for the next 10 years. Advantages and Disadvantages of Treasury Inflation Protected Securities:

Another point is that the TIP has not really been tested under conditions of a prolonged period of high inflation. It is possible that the a bond bought now with say a real yield of 1.62% may not hold up under those conditions, as investors demand more of a real yield under such circumstances causing the prices of older TIPs to fall in value. Since I am buying TIPs now directly from the Treasury and will hold them until maturity in a retirement account, I am not going to worry about that possibility. The two 10 TIP bonds that I bought at the last auction have gained about $60 dollars in value. This purchase is discussed in detail in Item # 4 10 Year TIP Auction/Sold Pepsico/ Sold General Mills/SOLD 1/2 OF PIS POSITION/Sold Almost 1/2 of GRTPRG Position.

Although I own the TIP ETF from Ishares, I intend to gradually pare it and buy TIPs directly from the treasury at auction. My first pare most likely will be when the price crosses 103. Bond mutual funds and bond ETFs do not have maturity dates. That point needs to sink into everyone's head. FINRA - Investor Information - Smart Bond Investing

Pimco also recently started several TIP ETFs with different maturities: PIMCO ETFs

6. BMLPRH vs. BMLPRJ: Both of these equity preferred floaters are obligations of Bank of America. Which is the better buy? At first glance, BMLPRJ appears to be better. Based on yesterday's closing prices, BMLPRJ has a higher yield, and the terms are clearly superior to BMLPRH:

BMLPRJ: greater of 4% or .75% above 3 month Libor
BMLPRH: greater of 3% or .65% above 3 month Libor

BMLPRJ: Yield of 6.37% at $16.05 BML.PRJ Stock Quote
BMLPRH: Yield of 5.77% at $13.29 BML.PRH Stock Quote

BMLPRJ Dividend at Current Rate of $.26 per quarter=$104 per year for 100 shares
BMLPRH Dividend at Current Rate of $.19 per quarter=$76 per year for 100 shares
(penny rates are from Marketwatch and are probably rounded)

So, the LB must have been of its rocker to buy BMLPRH yesterday. Maybe, let's drill down and see.

The current yield advantage of BMLPRJ is .6% at an additional cost of $276 per 100 shares compared to BMLPRH, with both securities paying their respective guarantees.

I would first observe it would cost me $276 now to receive that additional $28 per year so it would take about 10 years to recoup the price difference, assuming I did not invest the $276 in another income generating security and kept it in my piggy bank.

I want to assume now that the Libor rate rises to 5%:

BMLPRJ 5.75% at $16.05= 8.956% (.0575% x. $25 par value divided by cost per share)
BMLPRH 5.65% at $13.29=10.628%

So the price paid for the two securities has a dramatic effect in favor of BMLPRH when both securities are no longer paying the guarantee but their applicable percentage float above 3 month Libor. The .1% better float for BMLPRJ compared to BMLPRH is just overwhelmed by the effect on yield caused by the original cost difference.

Now, what am I going to do with that $276 that I saved by buying 100 shares of BMLPRH? Let's buy more shares of BMLPRH with it. This gives me 120.77 shares of BMLPRH vs. 100 shares of BMLPRJ (fractional shares can not be bought on the exchange so someone less precise than the LB could use 121 shares in the following hypotheticals)

BMLPRH: 120.77 shares x current penny rate of $.76 per year=$91.78
BMLPRJ: 100 shares x. $1.04 current rate per year=$104
I will call that a $12 advantage in favor of BMLPRJ.

I previously said that it was not worth an extra $276 to receive just $28 per year more, since it would take 10 years to recoup the difference in cost with that additional savings. That is one way to look at it. If I look at it from the perspective of what that $276 could earn by investing in additional shares of BMLPRH, then possibly I could justify BMLPRJ with that extra $12 per year, provided 3 month LIBOR did not rise to activate the float of both securities or rise high enough only to activate the float of BMLPRH. Or, I could invest that $276 in another higher yielding security to narrow the current difference.

At 5% Libor, the comparison would flip:

BMLPRH: 120.77 shares at $1.4125=$170.59
BMLPRJ: 100 shares at $1.4375=$143.75
Difference in favor of BMLPRH=$26.84

So, in this hypothetical of a 5% 3 month LIBOR, I wiped out in one year over two years of that $12 per year advantage for BMLPRJ.

At a 7% LIBOR, the difference becomes more pronounced:

BMLPRH 120.77 shares at $1.9125=$230.97
BMLPRJ 100 shares at $1.9375=$193.75
Difference in favor of BMLPRH=$37.22

This difference would wipe out 3 years of that $12 per year initial advantage for BMLPRJ.

Another factor that would narrow the initial advantage of BMLPRJ is that the LIBOR float will kick in sooner with BMLPRH, thereby increasing its penny rate at a time when BMLPRJ is still at a guarantee. Since the guarantee of BMLPRH is 3%, the LIBOR float is activated at 2.36% or more, which starts to increase the penny rate dividend above the guaranteed rate, thereby narrowing that initial difference. The Libor spread starts at 3.26% for BMLPRJ.

So, let's take one last example and assume a 3% 3 month Libor rate:

BMLPRH 120.77 shares at $ .9125 = $110.20 now at 3.65% rather than the guarantee of 3%
BMLPRJ 100 shares at $1.04= $104 still at the guaranteed rate of 4%

So, it has already flipped in favor of BMLPRH at 3% LIBOR.

This is a chart of the historical Libor Rates: LIBOR Rates History (Historical)

My point is that the analysis is a lot more complex with these floaters than what you may think initially. You have to consider the differential in cost per share, and how that impacts yield under different scenarios. After all, one reason to buy and hold the floater is to provide protection in inflationary times, when short rates are rising, and to provide a guarantee when short rates are low, two reasons not just one.

Of course, this analysis does not justify buying any of the Bank of America floaters, but only an analysis relevant to choosing one over the other once a decision has been made to purchase one. These type of securities have several disadvantages: Advantages and Disadvantages of Equity Preferred Floating Rate Securities

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