Sunday, December 6, 2009

Aegon Hybrids: Gateway Post

Added: I sold my last remaining Aegon hybrid, AEB, on 9/30/11: Sold 100 AEB at $18.42-Last Remaining European Hybrid

Throughout this blog and from its earliest days, I have discussed the hybrid securities issued by Aegon and ING, two large financial institutions based in the Netherlands. Last April, I wrote a gateway post for the ING hybrids that contains links to my discussions about them along with a general overview. ING Preferred Stocks (Hybrids): Links in one Post

Aegon is primarily a life insurance and pension company. It owns Transamerica in the U.S. For those unfamiliar with this company, Reuters has a general description of its operations. Reuters also has a page briefly summarizing key recent developments. Another source of information about the company can be found at the SEC web site Search Results. Aegon is required to file its annual report with the SEC and this is a link to its last Annual Report (Form 20-F for a foreign company): Form 20-F

The European hybrids are similar to the Trust Preferred securities issued by U.S. financial institutions with some important differences, both good and bad from my point of view. The term "hybrid" refers to the fact that these securities have both bond and equity characteristics. The Aegon hybrids are bonds, and a list of them can be found at the Aegon web site, along with their respective prospectuses: Capital securities - AEGON Group (AEGON constantly changes that address so the link may not work now) The prospectuses can also be found at the quantumonline website: Preferreds eligible for the 15% Tax Rate Table - So this is where the confusion starts sometimes with U.S. investors. Why do so many U.S. investors call a bond from a European company a preferred stock? Don't we know the difference? Maybe not, but to appreciate the quandary of the U.S. taxpayer it is important to understand that our tax code is the most complex document ever written in the history of the human race, and part of the labeling in the U.S. is connected with the classification of the payments for tax purposes which can frequently be quite bizarre. As I just mentioned these securities are called hybrids, and their equity characteristic is important to a U.S. taxpayer. The Aegon hybrids, which are bonds, pay qualified dividends to a U.S. taxpayer that are taxed at the maximum rate of 15%. Now, I can only personally verify that point for AEB, which is the only Aegon hybrid owned in a taxable account prior to 2009. I did receive a 2008 1099 from my broker classifying the entire distribution from AEB paid in 2008 as a qualified "dividend". The quantumonline site lists them in the category of preferred stocks that pay qualified dividends.

Aegon describes these securities in the following general manner at page 285 of its Annual Report:

"The securities have been issued at par. The securities have subordination provisions and rank junior to all other liabilities. The conditions of the securities contain certain provisions for optional and required coupon payment deferral and mandatory payments events. Although the securities have no stated maturity, AEGON has the right to call the securities for redemption at par for the first time on the coupon date in the years as specified, or on any coupon payment date thereafter."

They are listed in section 18.17 of the Annual Report under "Other Equity Investments". For regulatory purposes, they are viewed as equity capital rather than bonds.

The hybrids will be the most junior bonds issued by Aegon.

These bonds have no maturity date which is another key difference with the Trust Preferred securities issued by U.S. financial institutions.

This is a brief summary of the bond and equity characteristics of Aegon hybrids:

Equity Characteristics:

1. The security, like common stock, is perpetual. Generally, at Aegon's option, the hybrid may be called after a certain date specified in the prospectus. Legally, it may never be called or redeemed, so there is no promise to pay par value at a time certain which would be a bond characteristic. (a U.S. bank TP would have a maturity date)

2. The Aegon hybrids pay qualified dividends. (A U.S. bank TP would pay interest)

3. The security is considered to be part of capital for regulatory purposes. Recently, the European Commission has made it clear that it may require the owners of the "hybrid" securities to "share the burden" with common equity owners when a firm receives "state aid" of the kind doled out like candy by governments around the world late last year. This policy is expressed at (26) on page 8 of this document: .pdf In short, if the firm who receives state aid can not pay the hybrid dividends out of profits, then the EC may require the firm to defer payment on the coupons. This subject has been a frequent topic of discussion in this blog and I will link near the end of this post some of the links discussing this policy. But, this policy in effect emphasizes the equity characteristic of these securities, and could require the hybrid owners to suffer along with the common shareholders in situations where the financial institution is in need of state aid.

Bond Characteristics:

1. The dividends are cumulative. If Aegon elects to defer the dividend, a non-mandatory deferral, the dividend is not eliminated but simply accrues, which has tax consequences to a U.S. investor, and earns accrued interest at the coupon rate, similar to what happens when a U.S. bank defers the coupon payment on one of its Trust Preferred securities. There are very few non-REIT securities that pay cumulative qualified dividends. This is the primary attraction of the European hybrids for a U.S. taxpayer, along with their yields which are generally higher than most TP issues. {the Aegon hybrids permit perpetual dividend deferrals provided there is no activation of the stopper provision, whereas a U.S. bank TP would cap the deferral right (and I am talking just about legal rights here) at 5 years}

2. The hybrids would be senior in priority to common stock and equity preferred stock, and junior to any other bond issue from Aegon.

3. The Aegon hybrids, unlike the ones from ING, have a provision common to some junior bond issues from American financial companies. It is called the "Alternative Payment Mechanism". This provision needs to be read by anyone investing in Aegon hybrids

This is how Aegon summarizes this provision:

"We will satisfy any Mandatorily Deferred Payments and Optionally Deferred Payments (with any interest accrued on such deferred payment, as applicable) using proceeds raised by the Alternative Interest Satisfaction Mechanism. In addition, we may elect at any time to satisfy any Payment using the Alternative Interest Satisfaction Mechanism. Applying this mechanism means that we will issue Common Shares for cash in an amount as required to provide enough cash for us to make full payments on the Capital Securities in respect of the relevant Payment. We will calculate the number of Common Shares that we must issue to raise the full amount of money due on the Capital Securities on the relevant Payment date. You will always receive Payments made in respect of the Capital Securities in cash."
(See page S-5 ). Thus, if Aegon defers payment it has to make an effort to sell stock, raise some money, and use those funds to pay the hybrid owners. It is better to have this kind of provision than not to have it. A detailed description of this obligation can be found at pages S-23 to S-25. This kind of provision needs to be read until it is comprehended since you will run into it with other securities and it can be important.

4. Another important provision is the stopper provision and the events which can trigger a mandatory payment of the hybrid securities. A stopper provision can also be found in equity preferred prospectuses, so it is not unique to bonds. It is extremely important in the European hybrids due to the European Commission's burden sharing policy. The Aegon stopper can be found at pages S-22 to S-23 of the AEB prospectus: Basically, a stopper provision (also called a dividend pusher) will require the payment of a hybrid distribution (the period of time will vary) whenever the firm makes a payment on or purchases a security junior in priority to the hybrid, with certain limited exceptions.

Like the ING hybrids, the Aegon hybrids fell in value precipitously during the financial meltdown, falling at times to the low single digits. Par value on this securities is $25. For instance, I bought (and still own) AEH at $4.63 which will give me a yield in perpetuity (until called) of almost 35% per annum. Buy of AEH in IRA That buy was on March 12, 2009 and the security closed last Friday at $16.54 to yield about 9.64% at that price: AEH Stock Quote - Aegon N V PFD PERP 6.375 The coupon is 6.375%. Of course, the penny rate is calculated by multiplying .06375% x. $25 par value to arrive at $1.59375 per share per year. Then you would divide that amount by your total purchase cost to arrive at your yield. Some investors believe their yield is the coupon rate and that is of course not true unless you bought the security at a total cost of $25. At my cost of $4.63, the yield is calculated by dividing the penny rate by my cost which results in a 34.42% annual yield. But I did not buy at the absolute low which was $2.96 which would give that fortunate person a 53.85% annualized yield. It was amazing.

Most of my discussions about Aegon hybrids have dealt with AEB, and I own 350 shares bought during the panic phase at between $4 and $8. The last shares were purchases at $4.8 in February: Buy of 50 AEB at 4.8/ This security is unique. Off hand, I can not think of another exchange traded bond that pays cumulative dividends at the greater of a fixed coupon rate or some percentage over 3 month LIBOR (or any other short rate). I was just amazed at the price this one reached and commented on it several times during the meltdown period. This security pays the greater of 4% or .875% above 3 month LIBOR. I wished that I had bought more shares, but how many were buying anything at all during that period? I call this kind of security a "floater". It provides some inflation and deflation protection in the same security. Inflation or Deflation: Bond Alternatives/ The deflation protection is provided by the fixed coupon guarantee, and the value of that 4% guarantee is increased by buying the security at a discount to par value. It was worth $1 per year on the $25 par value, which translates to a 20% guarantee at a total cost of $5 or 33.3% for those buyers at $3 earlier in the year. The inflation component is the LIBOR float. As inflation starts to increase, and the central banks end their abnormally low interest rate policies, the LIBOR rate will increase. When it exceeds 3.125% during the relevant computation period for AEB, the float will provide a greater rate than the guarantee and thus becomes the applicable payment provision. Historical rates for the 3 month LIBOR since 1989 can be found at this web site: LIBOR Rates History (Historical)

AEB closed at $14.6 last Friday. At a total cost of $14.6, the guarantee equates to a 6.85% yield. AEB So, the first decision for anyone interested in buying a Aegon hybrid is whether to choose AEB with its built in inflation protection component or one of the fixed rate coupon Aegon hybrids. I also own AEF, a fixed rate coupon hybrid, and it yields at Friday's close about 9.71%. AEF Stock Quote - Aegon Nv PFD PERP 7.25% This is a decision everyone has to make for themselves. You are giving up almost 3% in current yield to buy AEB. I have opted to own both, seeing the value of AEB in my fixed income portfolio along with a ton of other floaters.

Before anyone invests in a bond, an assessment has to be made of the firm's credit worthiness. Many so called professional investors rely on Moody's and S & P to do their homework. I would view that reliance as a crutch by lazy people masquerading as professionals. First, I will look at the firm's finances, debt, maturity schedules, and prior earnings history to make my own assessment. Some firms are just too dicey to even make a small investment. Even if I am willing to buy after making this assessment, I may be sufficiently concerned about the credit worthiness to limit by exposure to relatively small amounts. So, another purpose in making this evaluation is to render a judgment on how much I am willing to risk, a balancing of the risk first, then the potential reward. The risk is always the first consideration. For Aegon, I decided my limit would be no more than $7,500. I am willing to take up to a $10,000 hit from a single firm's failure, and not a dime more. Part of this assessment is done by reading analyst reports from S & P, Morningstar, Barclay's, Value Line and other firms that are rating the common stock. Frequently, I will not want to buy the common stock, but I will buy a bond issued by the firm. I do not currently own ING or Aegon common stock.

Another important consideration is whether the firm is paying a common stock dividend. As long as that dividend is being paid on a Junior Security, I am secure. Once that payment is eliminated, I am in an enhanced danger of have my dividend deferred having lost the protection of my security blanket, payment on a junior security. Aegon has eliminated its common stock dividend. However, it recently made a payment on another junior security which triggers the stopper provision for 4 quarters.

This is a link to other posts group by Topic:


European Commission/ Burden Sharing/Mandatory Payment Events

Earnings and State Aid:
Aegon and the European Commission (Resolution of State Aid Issue-August 2010)

Links to the current prices and prospectuses:

Dividends are paid quarterly in March, June, September and December. The payment for December has already gone ex dividend.

The Marketwatch links above contain the coupon rates for the fixed rate hybrids. Is that the important number? Or, for the functionally equivalent fixed rate coupon hybrids issued by Aegon, is the important issue the yields at their respective prices at the time a purchase decision is made?

Aegon also has a few hybrids that trade on the Amsterdam exchange, priced in Euros. Capital securities - AEGON Group For someone like me, it is conceivable that I would consider at some point buying one of those securities but not now. The first consideration for me in making that kind of decision would be a very strong U.S. dollar compared to the Euro and then I would look at pricing discrepancies between similar issues traded only in Europe compared to those traded in the U.S.

One last issue is that I have yet to seen any action by the European Commission on Aegon's restructuring plan. Aegon (story dated 11/13/09)

I often refer to dividend declarations found at the WSJ dividend page. This information changes daily. A link to the WSJ containing information about Aegon's declaration would provide that information only for that day.

Snapshots of some trades in just AEB, AEH and AEF: 

2011 Taxable Account  Realized Gain 100 AEB +$1,142.51
2011 Roth IRA Realized Gain 100 AEB +$1,213.76
2010 Taxable AEB Realized Gain +$772.04
2010 Regular IRA 50 AEB +$81.11
2010 Taxable 50 AEF +$236.59
2011 Taxable 50 AEF +105.13

2010 Roth IRA Realized Gain 50 AEF +$260.06

2011 AEF 50 Shares +$113.48

2011 Regular IRA AEH 30 Shares +$537.83
2014 AEB 50 Shares +$49.98
2017 AEH 30 Shares +$32.96
2017 AEB 50 Shares +$166.46

Total: +$4,712.23