Wednesday, December 22, 2010

One of LB's PAIRED Trades: Bought 50 AEF at 22.29 in Taxable Account-Sold 50 AEF at 22.35 in Roth IRA/Sold 50 of 100 FJA at 24.75/Bought 50 PJA at 24.65

Peter Morici, one of those economist who likes to hear himself talk on TV, argues that U.S. debt needs to be downgraded to junk.  Seeking Alpha  That may be a harsh assessment.  My personal grade is BBB with a negative credit watch.  Both political Tribes have proven, without any doubt, that they are simply unable to address the looming fiscal crisis in the United States.  Instead, they find ways to make it far worse.   

The regional bank basket kicked into another gear yesterday, passing easily the 7 thousand in unrealized gains mark.

I received this morning the redemption proceeds for both KRH and XFB, two trust certificates called by their respective call warrant owners, not by the issuer.    KRH-Exercise of Call Warrant  

1. Bought 50 of the Aegon Hybrid AEF in a Taxable Account at 22.29 and Sold 50 of AEF in the ROTH IRA at  22.35 (see Disclaimer):  This paired trade of the same security only made sense to the LB, who, when questioned about it by other staff members here at HQ, launched into a three hour dissertation, accompanied by powerpoint presentations and slide shows.  

I am playing with the house's money on the Aegon hybrids.  This is a link to a post that discusses them in detail:  Aegon Hybrids: Gateway Post  During the Near Depression period, the Aegon hybrids were smashed to smithereens and it was possible to buy them with current yields of over 30%.  While that sounds ridiculous, and it was, I still own one of the hybrids, AEH, that was purchased in the regular IRA at $4.63.  All of the Aegon hybrids traded in the U.S. have $25 par values.  The yield at my cost for AEH is around 35%, and it has never missed a dividend payment.  I also still own shares of AEB, the floater, that were purchased in the $4 to $8 range.  

The shares of AEF sold in the Roth IRA were purchased at $16.82 in September 2009.   LB's reasoning for selling those shares and then buying them back in the taxable account has many layers, and only a few will be summarized in this post.

First, with the extension of the qualified dividend tax rate, it makes more sense for me to own the Aegon hybrids in a taxable account since they pay qualified dividends.   So I will replace AEF in the Roth IRA with a bond that pays interest that would be taxable at my highest marginal tax rate if held in a taxable account.  

Second, costs associated with these two transactions are immaterial.  The brokerage commission is so low that it is a non-issue.   And, since I do not pay taxes on gains realized in the retirement account, I do not have consider the impact of taxes on the profitable AEF transaction in the Roth IRA.  

Third, I believe that the Aegon hybrids involve more risks than standard bonds and that risk is better suited to one of my taxable accounts than an IRA.    After all, AEF could have been bought at $3.9 on March 6, 2009.  AEF Historical Prices  As I said, the prices were just smashed.   

There are a number of reasons for the volatility.  These securities are in fact bonds, but they are the most junior bonds in the capital structure.  They have no maturity dates, which makes them vulnerable to interest rate risk in a similar fashion as the long bond.  They are also very vulnerable to a multitude of fears.  During the Dark Period, one fear was that the European Commission would force a deferral, and this never did happen.  But these types of junior bonds, which are treated as part of equity capital for regulatory purposes, are without question susceptible to a deferral if Aegon ever has to apply for state aid again.   If that happens, deferral of the hybrid dividends will most likely be a condition attached to the EC approval of that appeal under its "burden sharing" policy.   And another fear is the credit risk on the balance sheet of European financials in particular and all financials in general. 

The most cogent explanation, however, for the extreme volatility in the hybrid prices during the Near Depression, was the dependable and predictable irrationality of human beings.   The pricing of the European hybrids during the Dark Period is just one example of the laughable absurdity of the efficient market hypothesis.  Efficient Market Hypothesis as Hokum 

Recently, the Aegon hybrids have declined some in value.  I attribute that small decline to three factors.  One is the omnipresent concerns about sovereign debt issues in Europe, which ebbs and flows, and has recently been back in the headlines with negative connotations for the European hybrids.  The other is the decline in bond prices in general due to fears about interest rate risk.  Lastly, these securities just went ex dividend for their quarterly distributions and this seems to cause some investors to sell. 

I would add that Aegon is not paying a common stock dividend. My view was that the transaction associated with repaying the Dutch state in December 2009 triggered at most 4 mandatory payment events for the hybrids.  Aegon and the European Commission  This does not mean that Aegon will defer a hybrid dividends. I doubt that it will.  It only means that there is currently no legal impediment in my opinion that would stop it from doing so.  

I did buy and sell AEF previously.    Added 50 AEF at $18.38  Sold 50 of 100 AEF at 23.43 

AEF PROSPECTUS:  AEF has a 7.25% coupon. 

At a total cost of $22.29, the yield is around 8.14%.  There are not many securities that pay qualified dividends yielding over 8%. 

I still own 100 shares of AEB in the ROTH IRA with an average cost basis of $6.06 per share with commissions. That security, which pays qualified dividends, is being kept in both taxable and non-taxable accounts due to its deflation and inflation protection components.   Managing Interest Rate Risk

All of the fixed coupon Aegon hybrids are functionally equivalent.  There is no reason to prefer one over the other, assuming the investor does not have a fetish for a particular symbol,  except for the yield at the investor's purchase price at the time a decision is reached to buy one of them. Based on yesterday's closing prices, the yields for the other fixed coupon Aegon hybrids traded in the U.S. were:

AED 7.97%
AEH 7.86% /
AEV 7.98%

Link to Aegon web site on its hybrids: Capital securities - AEGON Group

2. Bought 50 of the TC PJA at $24.65 in the Roth IRA (see Disclaimer):  I bought 50 of this TC in a taxable account  at 19.45 last December and still own those shares.  Most likely, I will sell them for a long term capital gain.   I will simply copy that part of my earlier discussion from December 2009 which describes this security: 

"This one had a tight spread for a lightly traded TC. At the time the order was placed, the bid was $19.41 and the ask was at $19.45 so OG entered a market order which was filled at $19.45. (Added to original: the spread was tight on 12/21/2010 too, when I placed the order yesterday, with a bid at 24.64 and a ask at 24.65)  LB said "don't buy any" and RB said "buy a 1000" . OG said in response that the underlying bond is an issue from Qwest Capital Funding (formerly known as U.S. West Capital Funding), a wholly owned subsidiary of Qwest Corporation, a large regional phone company with a lot of hard assets. Qwest provides telecommunications services in 14 midwestern and western states, including the metropolitan areas in Denver, Portland and Seattle. Qwest had some positive news a few days ago about its cash flow projection for 2010.Reuters Cramer said recently that he had even started to warm up on Qwest stock. While the bond is rated junk, the yield at HK's cost is over 10% (10.28% at a total cost of $19.45), which looks good in the current zero short rate environment. Besides, the LB has already picked over virtually every exchange traded bond worth buying, leaving scraps for the OG, and there was little left to buy at reasonable prices, especially given the projections being made by the LB, as Chief of All Things Important Requiring Thought, about the probable course of interest rates over the next decade.

The coupon on the TC is 8% with a maturity in 2031. PJA had the best yield yesterday compared to PKH, another TC with the same bond which was yielding around 10.21%. PKH Stock Quote That one has a 7.75% coupon like the underlying security. Another one, KCW, was priced at around $20.4 yesterday to yield, at 9.20%, about one percent less than PKH or PJA: KCW Stock Quote - Corts Tr Us West Communicatn CORTS 7.5% OG almost bought that one, since it was issued by U.S. West Communications, acquired by Qwest in 2000, and would be viewed as some as a better credit. (prospectus That set off a howl by the RB, calling the Old Geezer a stick in the mud, way too cautious by a factor of at least a zillion to one, at the minimum, and RB said to go for extra 1% if the OG had to buy this boring security. So after a series of compromises, it was decided to risk less than a 1 thousand on the higher yielding, and possibly less secure, PJA. The HK just said that the OG should never try to compromise with the RB, just listen to it.

(Qwest Corporation is a subsidiary of Qwest Services Corporation, and its consolidated subsidiaries, which is in turn a subsidiary of Qwest International Services Inc, the ultimate parent company of Qwest Corporation. The history of Qwest can be found in Wikipedia. It is my current understanding thatQwest Corporation is the entity formerly known as U S West Communications, / )

This is a link to the TC prospectus: Interest is paid in February and August. Par value is $25. The maturity date is 2/15/2031. The underlying security has a lower coupon than the TC at 7.75%. The purchase yesterday was made at a 22% discount to par value.

This is a link to the prospectus for the underlying security: Qwest guarantees the debt of Qwest Capital Funding.(so this is more indirect than a bond issued by U.S. West)

The links to the Finra data on the trades for the underlying bonds in Trust Certificates is accessible at this Gateway Post: LINKS TO FINRA INFORMATION ON UNDERLYING BONDS IN TRUST CERTIFICATESThis is a link to the Finra data on the underlying bond in this TC: FINRA - Investor Information - Market Data - Bonds - Bond Detail The underlying bond is lightly traded. For anyone interested, and are new to using the quantumonline site, there is a general description of the bond which can be assessed by clicking the symbol, PJA, on this page: Third Party Trust Preferred Securities Table - which takes you to this page: PJA Search Results -

The LB added that there are many reasons why it did not buy one of these TCs when it was the Head Trader. Qwest does not own a cellular network, and is instead merely reseller of wireless services from Verizon. It is also a reseller of TV services from Direct TV, which places it behind the competitive curve in that sector too. Qwest is therefore far more dependent than AT & T and Verizon on the land line business. For good measure, the LB emphasized that Qwest has lost lost a third of its residential customers over the past five years. OG replied that Qwest is profitable with net property, plant and equipment of 10.804 billion, about 3 billion higher than long term borrowings of 7.845 billion : LB said that the OG, possibly being in early stages of senility, forgot to add the long term pension expenses and other post-retirement benefits. And for the coup de grâce, the LB pointed out that this security was a long term bond, and better results for 2010 is not the relevant consideration. Instead, the land line business over the long term is analogous to the newspaper business, a perpetual state of decline, thus undermining the security of a long term bond maturing in over 20 years. Do you expect the land line business to be improving in the years to come, OG? And, the OG said there is always hope, LB is being too pessimistic, as usual, and LB said it was a realist who saw the world as it is, in a totally logical and rational manner devoid of ideological prisms."  
ITEM # 2   Bought 50 PJA at 19.45 

So this bond generates a lot of controversy among staff here at HQ. 

At my purchase price yesterday, the current yield is slightly more 8%. Interest payments are made semi-annually with the last ex date in August.  

I would just add that Qwest has since agreed to be acquired by CenturyTel. Possibly, if this acquisition is completed, it will improve the rating of the Qwest bond in this TC. Qwest and CTL Bonds  Another alternative would be a downgrade of CTL bonds, or both. 

3.  Sold 50 of the 100 FJA at 24.75 (see Disclaimer):  The TC FJA contains a senior Embarq bond, and CenturyTel acquired Embarq.   So, I added 50 of Qwest bond in the Roth and sold 50 of an Embarq bond in the taxable account, thereby maintaining my weighting in CenturyTel bonds, assuming the Qwest acquisition is ultimately completed by CTL.   I also have a higher yield on PJA than on FJA at current prices. 

FJA proved to be a good investment.  I realized a long term capital gain on those 50 shares, which were part of a 100 share lot purchased at 15.35   The remaining 50 shares were purchased at below $15.  Bought another 50 FJA at 14.2

FJA Prospectus:
Finra Information on Underlying Bond: FINRA 

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