Tuesday, November 10, 2009

Added 50 of the TC DKK/Bought 70 PYT at $15.75/Sold All Shares TIP ETF/Started Hedge for Corporate Bonds/Added 50 of ABWPRA

1. Added 70 PYT in IRA at $15.75 (see disclaimer): I added 70 shares of PYT at $15.75, brining my total to 170 shares in the retirement accounts. This would be an average up for this synthetic floater, with the previous buys made at $11 in April and $13.34 in August. Bought 50 PYT Bought 50 PYT in Roth I am replacing the 100 shares of GJS sold last Friday at $15.6, for about a $250 profit, with more PYT. Since these transactions are occurring in a retirement account, I am not concerned about paying taxes on the gain from GJS. Based on the kind of analysis that I do with the Goldman Sachs floaters (Analysis of Prior Question about Goldman Sach's Floaters), PYT is a better buy at $15.75 than GJS at the $15.6 price. While GJS is tied to a senior bond and PYT is linked to a junior bond, both bonds are long term Goldman Sachs' obligations with GJS maturing in 2033, just a few months earlier than PYT. The critical differences from my point of view is that PYT has a better float provision and pays a guarantee. To summarize the applicable terms, PYT pays the greater of 3% or .85% over 3 month LIBOR. GJS has no guarantee and pays .9% above the 3 month T Bill rate. GOLDMAN SACHS FLOATERS While the past may not be prologue, I would expect a float based on 3 month LIBOR to yield more than one based on the 3 month T Bill. So, even though the PYT is at .85% and GJS is at .9%, I would expect the PYT to generate a higher penny rate over time due to the historically higher 3 month LIBOR rate compared to the 3 month treasury bill. Anyone can do this comparison. Over twenty years, I would estimate (guess!) that a .85% over LIBOR would generate about .3% to .4% more than .9% over the 3 month T bill based on the twenty year average historical spreads. {Compare LIBOR Rates History (Historical) with www.federalreserve.gov} And, the guarantee will give PYT the yield advantage compared to GJS during periods of low short term rates, as now. Based on a total cost of $15.75, the 3 % guarantee would result in a yield of 4.76%. The LIBOR rate float provision would be triggered when the 3 month LIBOR rate crosses 2.15% during the applicable computation period. (see also: /GJS VS. PYT NOW Analysis of Prior Question about Goldman Sach's Floaters Synthetic Floaters)

I hold the synthetic floaters only in retirement accounts. This is a link to the prospectus for PYT: www.sec.gov As explained in prior posts, this synthetic floater is linked to a fixed rate coupon junior GS bond in TP form, and this is the link to the FINRA information about that bond. FINRA - Investor Information - Market Data - Bonds - Bond Detail The Goldman 2034 TP is a typical Trust Preferred issue. There are several trust certificates that are linked to this same bond, some are synthetic floaters and others are fixed rate coupon TCs. LINKS TO FINRA INFORMATION ON UNDERLYING BONDS IN TRUST CERTIFICATES I know of 10 separate Trust Certificates that are linked to this Goldman junior Trust Preferred bond. And one of those started out as a synthetic floater, JBK, and became a fixed rate coupon TC when Lehman went bankrupt. New Information about JBK Bought 100 JBK at $16.15 Bought 50 of the TC JBK Like all synthetic floaters, a termination of the swap agreement which creates the float out of the fixed rate coupon bond will result in the owner of the trust certificate receiving the fixed rate coupon interest payments, which is what happened with JBK.

PYT pays quarterly distributions with the last payment made in August.

2. Added 50 of the TC DKK at $23.34 Yesterday (see Disclaimer): DKK is a trust certificate containing a typical Trust Preferred issue, in this case one issued by AON Capital and guaranteed by AON. The asset of the trust is a junior subordinated debentures maturing on 1/2027 with a coupon of 8.205%. This TC has a 8% coupon: www.sec.gov This is one of the several functionally equivalent TCs with this same bond, and those TCs include KTN, KVW, and KVF. This is a link to the FINRA information on the underlying bond: FINRA - Investor Information - Market Data - Bonds - Bond Detail I currently have positions in 150 shares of KTN, bought in both the retirement and taxable account, during one or more of the meltdown phases near $14, 200 shares of KVW with the last shares bought around $16, and now 100 shares of DKK. That is my limit. Both KVW and DKK have 8% coupons, and KVW was selling at a higher price yesterday. At some point, I might reduce my holdings in these functionally equivalent TCs containing the same AON security by selling 100 shares of one of them, but I am in no hurry. Possibly, if one of them went over par value, I might do a pare. The yield at my price paid yesterday for the 50 shares of DKK will be about 8.5% with interest paid semi-annually in June and December, with the next ex date in a few weeks.

I have discussed the AON TCs throughout this blog, and would just link some of those discussions here:

This is a link to my gateway post on Trust Certificates: Trust Certificates Links in One Post

A discussion of the importance of functional equivalence in trading Trust Certificates can be found in this Post: Functional Equivalence in Bond Trading

A discussion on how someone who makes money writing a newsletter did not assess functional equivalence when making a recommendation on trust certificates: Article in this Week's Forbes on Trust Certificates Continued Discussion on Trust Certificates & Forbes Article/DKR

While DKK was priced better than KVW when I placed my trade yesterday, it was priced to yield just slightly better than KTN which has a higher coupon. One difference, which can be the deciding factor in that kind of situation, is the spread between bid and ask and the anticipated difficulty of filling an odd lot order. Those factors were in favor of DKK yesterday.

The functional equivalence analysis for these four TCs is simple. If I want to buy one, then which one has the best yield at my purchase price at the time a decision is made to enter an order. (The analysis on all of the Goldman Sachs floaters is far more complex.)

Of those 4, the worst yield yesterday at the time that I place my trade was KVF. DKK had the best yield.

3. Sold Remaining Shares in TIP ETF at $104.68 Yesterday (see disclaimer): I will eliminate this holding when I decide that I would not buy additional shares at the current price. I reached that conclusion yesterday with the TIP ETF and sold my remaining shares at $104.68. This is the second time that I have gone to zero on this ETF within the past two years. The remaining shares were bought in 3 small lots at between 93 and 100, plus reinvested dividends. TREASURY INFLATION PROTECTED BONDS (TIP) Bought 30 TIP at $99.25 /Bought 30 TIP I do own some shares in the Vanguard Inflation Protected bond fund, (VIPSX) which I have not discussed in this blog, and I have not yet sold any shares in that one. I have also bought this year some 10 year TIPs at treasury auctions in my Roth IRA. 10 Year TIP Auction Until I can receive a better real yield, I have no intention of submitting another bid at auction.

What precipitated the sell yesterday was that the real yield was falling to about 1.25% on the ten year TIP, the maturity that I use for evaluating the TIP ETF. This ETF has a weighted average maturity of 8.91 years-currently according to its sponsor. iShares Barclays TIPS Bond Fund (TIP): Overview I would not buy a 10 year TIP with a coupon of 1.25%, so I sold the remaining TIP ETF shares that I own a good profit for this kind of investment.

4. Started Hedge for Corporate Bonds by buying just 30 shares of PST at 52.45 (see Disclaimer): Everyone has opinions about the prices of long U.S. treasuries. I for one am not about to lend money for ten years to my government for a tad under 3.5%. Apparently, there is no shortage of institutions and governments who appear to be willing to fund our government's trillion plus dollar deficits at the current abnormally low rates. I just think that is bizarre. But it does not matter what I think, except that I have to act based on my own opinions. While I am not willing to buy long treasuries, nor place a "bet" on their eventual decline, I will create a hedge for my extensive corporate bond holdings by shorting the long treasuries.

I do share the opinion of those who maintain the long treasuries are due for a fall. The Treasury bubble But, like all bubbles, you can go broke betting on them to pop. I will sometimes use the current elevated treasury prices to hedge my corporate bonds, by assuming minor positions in securities that will increase in value if and when treasuries fall in price. Prior to yesterday, I had bought and sold profitably two double short ETFs for the long treasuries, PST and TBT. Sold PST/ Sold TBT I have noted in several prior posts the shortcomings of these double short ETFs, with the most important issue being tracking. Hedging Bond Positions Hedging If I had a margin account I might prefer just to short the long treasury ETFs. But, I have a cash account and never have bought a security using borrowed money.

The double short ETF PST attempts to go up twice whatever the 7 to 10 year treasury index goes down, and vice versa. It will most likely start to lose tracking after one day according to its sponsor: ProShares ETFs - UltraShort 7-10 Year Treasury - PST - Overview Once I buy a double short for a hedge, I will follow the tracking issue everyday. For ease of making the comparison, I will compare PST to the long ETF for the 7 to 10 year treasury: IEF: Summary for ISHARES BARCLAYS 7-10

I will only attempt to partially hedge risk with a short type position. My main way to hedge risk is to sell what I view as in need of a hedge. For my corporate bonds, I want to hold them, and even add to the current overweight positions some, so my alternative for that category is to start adding shares of the double short ETFs for the long treasuries as my hedge. My limit is 100 PST and 200 TBT. I recognize and appreciate their danger.

5. More Lectures on Responsibility from the Chinese: Maybe the U.S. will also need to become accustomed to being lectured about responsibility from our chief lender: MarketWatch The Chinese Premier told the U.S. that China hopes the U.S. will effectively discharge its responsibilities and to bring the deficit to "an appropriate size". I do not think the Chinese view a 1.4 trillion dollar annual budget deficit to be the appropriate size. I view this rhetoric as relevant.

6. Fed Ends Buying Program for Treasuries: The Treasury has ended its 300 billion dollar program of purchasing U.S. debt securities. MarketWatch Permanent Open Market Operations Treasury: Frequently Asked Questions - Federal Reserve Bank of New York The Fed will continue buying mortgage securities and agency debt, about another 350 billion, in the upcoming months. But, the natural question to ask is who is going to be buying all of that treasury paper that has to be floated now to fill the gapping budget hole?

7. Added another 50 ABWPRA at $21 Yesterday (see Disclaimer): I discussed this TP in my post from yesterday. After buying 50 in a taxable account, I added the other 50 later in the day to the ROTH IRA account. Bought 50 of the TP ABWPRA I am sufficiently comfortable with this bank to own 100 shares of this Trust Preferred. This one has about a 9% yield at my cost. I am already monitoring it for a potential common stock purchase. Morningstar has it rated 4 stars.

For anyone interested in priority issues compared to the government's preferred stock issued by Associated for TARP funds, this is a link to Associated Banc-Corp's agreement with the Treasury: EX-10.1

"Junior Stock” means Common Stock and any other class or series of stock of the Company the terms of which expressly provide that it ranks junior to the Preferred Shares as to dividend rights and/or as to rights on liquidation, dissolution or winding up of the Company. “Parity Stock” means any class or series of stock of the Company the terms of which do not expressly provide that such class or series will rank senior or junior to the Preferred Shares as to dividend rights and/or as to rights on liquidation, dissolution or winding up of the Company (in each case without regard to whether dividends accrue cumulatively or non-cumulatively)." (page 32)

"(c) Preferred Shares. The Preferred Shares have been duly and validly authorized, and, when issued and delivered pursuant to this Agreement, such Preferred Shares will be duly and validly issued and fully paid and non-assessable, will not be issued in violation of any preemptive rights, and will rank pari passu with or senior to all other series or classes of Preferred Stock, whether or not issued or outstanding, with respect to the payment of dividends and the distribution of assets in the event of any dissolution, liquidation or winding up of the Company." page 7

This agreement is far more convoluted than the others that I have read and suffers greatly from being over lawyered and unnecessarily complex. But, as I interpret it, the government's preferred dividend would have to be deferred in order to defer the interest payment for ABWPRA. I believe that the underlying bond in the TP ABWPRA is not deemed a class of Preferred stock of Associated Banc within the meaning of the above quoted clauses in the agreement with the Treasury and consequently it would be senior to the government's "senior preferred". Associated pays interest on the junior bond to the Trust, who then pays the interest to owners of the preferred stock in the Trust.

The primary reason for reading the agreement with the government is to determine the classification of the securities issued to the government in relation to other outstanding securities.

The most important provision to fully comprehend in resolving the issue of priority of distributions is the stopper clause. This is a summary of the stopper provision in ABWPRA:

"During any period in which we defer interest payments on the junior subordinated debentures, we will not and our subsidiaries will not do any of the following, with certain limited exceptions:
                                  - declare or pay any dividends or distributions, or redeem, purchase, acquire,                                    or make a liquidation payment on any of our capital stock;  
                                - make any payment of principal of interest or   premium, if any, on or repay, repurchase or                                        redeem any of our debt securities (including  other junior subordinated debentures) that  rank equally with or junior in interest to the junior subordinated debentures"
The exceptions are found at page S-21. The Preferred stock issued to the government is considered Tier 1 capital stock. FORM 8-K

8. More General Discussion about Trust Preferred Securities: For those who are not familiar with the Trust Preferred security, I have a Gateway Post that provides a brief introduction to them. Trust Preferred Securities: Links in One Post Some investors may be thinking of traditional preferred stock, which is a form of equity rather than debt, when I use the term Trust Preferred. This is how others describe these instruments. A Trust Preferred is in effect a junior unsecured bond. Regular Preferred and Trust Preferred Distributions will be taxed as interest not as dividends. A company will form what is called a Delaware Trust. Preferred stock in the Trust is sold to the public, usually with a $25 par value. Common stock in the trust is owned by the company that forms it. That stock represents a beneficial interest in the assets of of the trust which is normally a junior bond from the same entity that forms the trust. The sell of the preferred stock generates the funds to purchase the bond. So use of the term "trust preferred" creates an erroneous impression sometimes. The preferred stock is an indicia of a beneficial interest in a junior bond held in a trust for the benefit of the owners of the stock. All of this is done in part to slice what would normally be a $1,000 par value bond traded on the bond market into $25 par value securities that can be bought and sold on the stock exchange, thereby rendering the security more amenable to individual investors. There are other advantages to a bank holding company connected with using the Trust Preferred structure. Trust-preferred security - Wikipedia The bank holding company can deduct the payments as interest, but the securities are treated as equity for regulatory purposes.

The Federal Reserve requires several characteristics to be present before it will allow a bank holding company to include TPs as part of Tier 1 capital. One requirement, found in all of the prospectuses that I have examined, is a deferral right for a minimum of five years for distributions. Another is a long maturity, generally 30 years from the date of issuance is deemed to satisfy this requirement. There are other requirements not pertinent to the buyers of these securities. A third is that these securities have to be subordinate to all other debt. These requirements explain the deferral provisions, the low priority, and the long maturity. But, unlike the hybrids issued by the European financial institutions, the American institutions do have maturity dates for their TP securities, and a long one of 30 years is still better than no maturity at all. And, the American government has not come close to announcing, let alone implementing, a burden sharing policy for hybrid owners. Another distinction is that the American TPs do have limits on the period for deferrals, generally five years, and period limits are absent in the European hybrids.

Given the preference rights which come into being after an FDIC bank seizure, I would expect a seized banks' TPs, common stock and traditional preferred stock to be rendered worthless after an FDIC seizure. In addition, any bank that actually defers payments on a TP issue is in dire straits, and most likely teetering on the brink of seizure. This may change in the event the U.S. government adopts a burden sharing policy similar to the one adopted by the European Commission, when the government forces a deferral as a precondition to state aid. The most recent large bank failure, the bank holding company for UCBH, was preceded by a deferral of interest payments and the elimination of the non-cumulative preferred dividends.

9. Other Transactions on Monday Deferred to Later Discussion: I engaged in several more transactions on Monday, which I do not now have time to discuss. Possibly, I might mention a few of them in passing in Wednesday's post. I did sell another mutual fund in the Roth IRA on Monday. I am transitioning that account primarily to bonds and bond like investments. I am shooting for an average current yield of 10%, which I may be able to achieve due to the large number of securities bought during the meltdown, where the yields exceeded 20%. The ones that I have been adding recently have been largely in the 8 to 11% yield area, except for the current yields of the floaters like PFK, OSM and the synthetic floaters that pay less now. I also initiated Monday a hedge on the Euro by buying EUO at $17.17 (see Disclaimer), and I will discuss in Wednesday's post my reasoning for doing that.

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