Saturday, September 11, 2010

Spread in Yields Equity Preferred Stocks & Senior Bonds/Bought: 50 RNST at 13.70 & 50 HPQ at 38.2/Bought 200 BTZ in ROTH IRA at 13.23 & SOLD 100 BTZ

A column in the business section of mentions two of the Royce closed end funds that I own, RVT and RMT, as potentially good buys.

I heard one of the Fast Money traders recommend buying TLT for next week-to each his own. TLT declined 47 cents on Friday to close at $102.32.

CVB Financial (CBVF) has finally come clean about recognizing a major loan loss. After receiving a subpeoena from the SEC (MarketWatch), and being sued in a number of class action lawsuits, the bank finally admitted that its largest borrower was not able to make principal and interest payments. I sold my shares last January after reading a story in MarketWatch about this bank and its largest borrower. It did not smell right. See: Sold 50 CVBF at 9.65 & Item # 5 CVBF It is not surprising that this bank released this news late on a Friday. SEC Filed Press Release If the shares fall enough in the coming weeks, I may consider buying back some shares but I would not buy more than 30 as a LOTTERY TICKET PURCHASE.

1. Differential in Pricing Between Equity Preferred Stock and Senior Bonds from the Same Issuer: How much of the current spread in yield between an equity preferred stock and a senior bond is attributable to the differences in the taxation of their respective distributions. Except for REIT preferred stocks, equity preferred stocks pay qualified dividends and the maximum tax rate on qualified dividends is 15%, at least for distributions paid before 2011. A senior bond pays interest taxable at the highest marginal tax rate of the the taxpayer which may rise in 2011. The Tax Foundation - List of Tax Provisions Scheduled to Expire on December 31, 2010

It is uncertain at the present time whether the qualified dividend tax rate will continue for any taxpayer after 2010. For taxpayers who are at, or near the highest marginal tax rate now, there is a clear tax benefit realized by owning a security paying a qualified dividend in a taxable account and a senior bond in a tax deferred retirement account. But what happens to the pricing of preferred stocks when their distributions are taxed at the same rate as interest paid by senior bonds?

This is a relevant issue now. Even if Obama is successful in allowing the Bush tax cuts expire for the top 2% or so, those individuals are a primary source for preferred stock demand due to the current tax deferential compared to securities paying interest. If Congress stalemates on the extension of the Bush tax cuts, resulting in the end of qualified dividends for everyone, then those investors who are in tax brackets between 15% and the highest marginal rate would have less reason than now to buy a preferred stock rather than a senior or junior bond from the same issuer.

In a totally efficient pricing environment, the spread in yield between the preferred stock and the senior bond would increase under either scenario (elimination of qualified dividends for everyone or just the wealthy), to account for the lost value of the dividends favorable tax treatment to many potential purchasers on the demand side of the equation as well as existing owners on the sell side.

I have recently had a discussion with a reader on this topic, and have used two securities from Goldman Sachs to illustrate my point. The following is a quote from my email:

"The removal of the qualified dividend status for equity preferred stocks will result in their distributions being taxed in the same way as senior bonds. That would in a perfect pricing environment require an adjustment in the differential in pricing with the junior security falling in value. I suspect that the non-cumulative equity preferred stocks would also be viewed as even more risky after losing their tax benefit. One support for their current price is their qualified dividend status. If you remove that support, then I would expect the price to fall, all other things being equal. That kind of junior security will also react more violently to the downside than a senior security on credit concerns.

What would be a fair differential between a senior bond and a non-cumulative equity preferred stock from the same company when the distributions from both securities are taxed at the highest marginal rate? There are securities where the current differential can be observed now. For example, GS has a fixed coupon, perpetual, non-cumulative equity preferred stock, GSPRB and senior bonds. GSPRB is currently selling at over its $25 par value and has a 6.15% yield. Goldman Sachs Group Inc, GSPRB Stock Quote - (NASDAQ) GSPRB, Goldman Sachs Group Inc Stock Price The 2033 GS senior bond closed today at $106.488 which translates into a current yield of 5.75%. If you start to tax both the same way, which one of the two would you buy assuming the purchase would be in a taxable account? If the Bush tax cuts expire, then I would expect the current spread to widen by close to the amount of the lost tax benefit, but maybe not all at once." (the trading data was from 9/9/2010)

Personally, if I wanted to buy another GS security, I would view the current spread between the fixed coupon preferred and the senior bond to be insufficient irrespective of a change in the tax law. I would also note that it is possible to buy a trust certificate containing the GS 2033 senior bond and receive more yield than the GSPRB. This is not to say that any of these securities are worthy additions to a portfolio but only an analysis of which one to buy once a decision has been made to buy a fixed coupon GS security.

I do not know, nor does anyone else, what will happen with the Bush tax cuts. In another email, I discussed this issue:

" I would estimate that the chances are good that the Bush tax cuts will expire for everyone at the end of this year due to a stalmate. There is not enough votes to overcome a GOP filibuster in the Senate, which requires 60 votes, and some Democrats are opposed to what Obama wants to do. McClatchy The Bush tax cuts were originally passed by virtue of a reconciliation process that only required 50 votes. PolitiFact | Bush tax cuts were passed with reconciliation's 50 votes The health reform bill was passed the same way. I do not yet see how the reconciliation process can be used to accomplish Obama's objectives."

I do not see now how Obama can achieve his objective without using the reconciliation process, and I do not have sufficient information now to know whether that process can be used to extend the tax cuts for everyone but the top 2%. (see also
: Dividend Tax Rate in 2011? 2011 Dividend Tax Still In Limbo)

2. Bought 50 Hewlett-Packard (HPQ) at $38.20 on Friday (see Disclaimer): Basically, I thought that the decline in HP shares from $54.5 in mid-April to $38.2, a 30% plunge in 5 months, was overdone and indefensible by any rational individual capable of thinking beyond the moment. Of course, the price of HP shares are being determined now by individuals who need a guardian appointed to manage their own money.

While HP estimates may be too high now, the current consensus estimate is for an E.P.S. of $4.5 for the F/Y ending in October of 2010 and $4.99 for the 2011 FY. This translates into a P/E of 7.65 on the forward 2011 estimate. Price to sales is .73. The forward 5 year P.E.G. is .88 according to YF. Wow! LB is now convinced that it is the only rational investor in the universe now, so much for the Rational Man created by economists, a being so rare that LB suspects Diogenes will find the Honest Man before an economist finds an example of the Rational Stock Investor. HK wanted every one to know that the LB is only pure cynic here at HQ and disavows the sentiments expressed in this paragraph, other than the comment about the absurd premise of modern economic theories.

Maybe the knuckleheads selling Hewlett at less than $40 will win the hand so to speak, but this would not mean they are right, anymore than that blackjack player who split a pair of face cards and ultimately won both hands. I thought that I would repeat that story as related by the LB in an earlier post:

"A young man was seated at a blackjack table at a Lake Tahoe casino. He was just glad that it was not winter and his meeting was in about an hour which was not way past the young man's bedtime. For this young man was in reality an old man in training. The last time that he was in Tahoe on business the snow just kept falling until there had to be 10 feet on the ground. He thought to himself that he had not seen that much snow in his entire life even if you piled all of the snowfalls into one giant heap. He did not actually go outside and measure the snow, but just eyeballed it from the safety of his window, wondering whether he would be there for the remainder of the winter and he had to be back in Nashville by early the following week. The young man was a gambler, but not a card gambler. He knew however what many players of blackjack would call the basic strategy. He thought that he would play for an hour until the 10 P.M. meeting, hopefully play the house even, walk away without a tax event occurring, and then go about his business. (possibly the young man, now much older, is the only Tennessean that reports small winnings from the Tennessee Lottery on his tax return).

Shortly after seating down, a much older man, overweight as judged by the thinner and much better looking old young man seated to his left, sat down at the table with a lot of chips, not $25 chips, but $500 chips. Part of the young man's business was to size people up quickly, and his first reaction was that this was a fool with money. This was a judgment reached by the serious younger man based on the totality of circumstances. The demeanor was a dead give away as well as the banter that he engaged in with the young woman standing next to him with a low cut dress and platinum blonde hair whose shared intimacy at the table was how shall I say more cuddly than a husband and wife. The man did have a wedding ring. And, he was playing for $500 in an inebriated state with the waitresses anxious to ply him with more free drinks. After watching him play a few hands, the young man knew that those chips would soon find another owner and just wondered if the young lady was wondering if he had more cash back in the room. The man was playing high stakes blackjack in an inebriated state distracted by a working girl with at best a limited knowledge of the basic blackjack strategy and what he did know was frequently wrong. Then, without warning, he would split a pair of face cards, place another $500 on the table, say some gibberish like I know that I am not supposed to do that, and then win the hand as the dealer managed to bust. This caused the younger man to just exchange a knowing glance with the dealer. Before the time for the meeting, within sixty minutes, the young old man had lost about $10,000. I wonder if the young woman was impressed. Versions of that event had been witnessed many times, somewhat similar to the novices who sank money into internet stocks back in 2000."

I decided to buy HP after replacing two HP cartridges in one of the printers here at HQ. I thought to myself that maybe I could pay for a year of cartridges by making $400 on the stock. While analysts have focused recently on the slowdown in computer sales, HP is much more than a PC company. The $38.2 price was a 62 cent decline from Thursday's close and near HP's 52 week low.

Since HP pays a minuscule dividend, the LB was concerned about being reamed by Headknocker if it bought 100 shares. I believe that this was my first purchase of HP shares.

HPQ closed on Friday at $38.28, down 54 cents or 1.39%.

Joe Nocera claims in his NYT column that the HP Board has laid claim to the most inept board in the U.S. Maybe that is a bit of hyperbole. Or, possibly Joe has not owned as many stocks as HK and has consequently not felt the impact of the vast array of bozos and knuckleheads who inhabit the Board rooms throughout corporate America.

3. Added 50 Renasant at $13.7 (RNST) on Friday (Category 2-Regional Bank Stocks' basket strategy)(see Disclaimer): This was an average down from my last purchase at 14.14. The last earnings report was slightly disappointing. (see item # 3 RNST). I mentioned in that post that I would consider adding to RNST when and if the price sunk to the $10-$11 range. I changed my mind based on just three considerations.

First, the dividend yield at a total cost of $13.7 is close to 5%, and it is very difficult now to pick up that kind of yield in a common stock.

Secondly, after writing the post discussing the disappointing second quarter earnings, RNST announced that it was acquiring the assets of Crescent Bank & Trust Company based in Georgia in a FDIC assisted acquisition. Form 8-K Crescent had 11 banking locations in north Georgia. Renasant's CEO made the following statements in a press release:

"This opportunity represents Renasant’s fourth expansion since 2004 outside of Mississippi, which is our legacy market. We have a successful track record with our past expansions into Memphis and Nashville, Tennessee as well as Huntsville, Decatur and Birmingham, Alabama and believe this new partnership represents a logical expansion as a financial services leader in the Mid-south,” said McGraw. “In looking at and researching FDIC-assisted transactions, we saw Crescent Bank as a tremendous opportunity to enhance our franchise while at the same time giving us access to new markets that would have otherwise been more difficult to enter. . . . The Company also announced today the completion of a $54.95 million capital raise through a private placement of 3,925,000 shares of its $5.00 par value common stock to a select group of investors. The purchase price in the private placement was $14.00 per share. . . .We expect the impact of the acquisition of Crescent Bank, including the accompanying capital raise, to be immediately accretive to the Company’s earnings per share and tangible book value per share. Furthermore, the additional capital provided through the common stock issuance will enhance our already strong capital ratios and provide support for future growth,” commented McGraw. “Going forward, we’re excited to enter the North Georgia banking market and believe Crescent’s 11 locations will give us a platform for future success and market growth." Press Release

And the third reason is that my last purchase was below the recent $14 stock offering. RNST did not participate in TARP (Press Release) and consequently has not used the proceeds from this stock offering to pay back the government.

As of 6/30/2010, RNST had a tangible book value of $10.51 per share; a Tier 1 capital ratio of 11.42%; no preferred stock outstanding; NPLs to total loans at 2.86%; and an allowance for loan losses to NPLs at 63.63%. Form 10-Q Of those numbers, I am more concerned about the low allowance for loan losses to NPLs. The 63.63% number is down from 78.25% as of 12/31/2009.

Given the way that I will now manage the regional bank stock basket, I may at some point sell the higher cost RNST shares for a profit, assuming one comes around, and keep the lower cost shares.

RNST closed at $13.58 on Friday, down 7 cents.

4. Bought 200 BTZ at $13.23 in the ROTH IRA and Sold 100 BTZ at 13.25 in a Taxable Account (see Disclaimer): The LB was stung by Headknocker's statement made in the previous post that the Young Stock Stud had no plan for the recent cash raised in the ROTH. After all, the LB has billions of plans and strategies based on a zillion alternative scenarios and multiple contingencies. (This strategy could not have been implemented if the shares in the taxable account had been sold at a loss without triggering the wash sale rule Wash Sales and Your IRA).

No plainer statement could be made by the LB to explain its perpetual state of confusion, the RB helpfully added, for ultimately chaos and confusion is created out of those rules, plans and strategies coming out of the mind equivalent of the wazoo. RB added the Wikipedia reference for the word "wazoo", since some of our foreign readers, while speaking English better than the Old Geezer, who speaks barely understandable Southern, are unfamiliar with American slang. Time for a Man of Action, the RB added, unencumbered by a bubonic plague of stinking rules.

The BTZ shares sold were in a taxable account and were recently bought at bought at 12.05. This CEF has been bought and sold previously, as described in prior posts. BTZ is a closed end bond fund whose distributions will not qualify for the lower tax rate applicable to qualified dividends. Thus, as the reasoning goes, it makes more sense to hold this fund in an IRA rather than in a taxable account. Also, I sold on Thursday a similar fund, HPF, on its ex dividend date as its discount to net asset value narrowed to nil. Sold HPF at 20.35 in Roth BTZ is similar to HPF and still sells at a discount to its net asset value. And, it goes ex dividend this upcoming Monday, 9/13/2010. I will sometimes buy a dividend in a retirement account since there are no tax consequences in doing so, provided I can buy the stock on a small decline roughly equal to the value of the upcoming dividend. So, the LB had a plan and an abundance of reasons for the plan, contrary to the ruminations of Headknocker. Maybe it is time for a change of leadership here at HQ, some say that the Headknocker is ready for the rocking chair at the Old Folk's home.

This is a link to the last SEC filed shareholder report: Semi-Annual Report file with the SEC

BTZ recently changed its focus to investment grade corporate bonds and is now listed among the CEFs that invest in those bonds. It used to be listed with preferred stock funds. The fund is leveraged which will work against it during a period of rising rates, where the value of the bonds decline as borrowing costs rise. That is the main reason that I am in a hyper trading mode on all of these leveraged CEF bond funds.

NAV information can be found at the Closed-End Fund Association, the, and at the BlackRock site.

The current distribution rate is $.079 paid monthly. Assuming that rate remains unchanged, this equates to a annualized yield of 7.16%. Needless to say, with the LB at the trading desk, these bond funds are at best in a a temporary foster home. BTZ closed at $13.29 on Friday, up 2 cents. At the close on 9/10, the NAV was $14.16 and the discount to NAV was -6.14. HPF closed on Friday at $20.06 which translated into a -1.47% discount.

I will discuss the remaining 3 trades from Friday in the next post.

1 comment:

  1. Very entertaining story about the old gambler. It illustrates a point. For the old gambler, as for the Masters of Disaster, there is a huge disconnect between the true value of money and gambling chips (a.k.a. stocks). I predict we will look back on this period in history as the solidification of this disconnect at all levels of society, from stocks to politics. Technology, especially the Internet, is at the heart of the disconnect. I am reminded of the recent spate of problems with Toyota accelerator pedals and the "Flash Crash" last May, both examples of a disconnect between human and machine values, resulting in disaster.