Tuesday, January 18, 2011

More on Call Warrants and TCs/More on Rationale for Junk Bond Ladder Strategy/Added 40 AA @ 15.75, 200 JQC at 8.74, 1 Edison Mission Energy at 88.75/Intel WBS

The Chinese President views the USD's status as a reserve currency "to be the product of the past".   He also blames the U.S. Federal Reserve's monetary policy for fueling inflation in emerging markets, by causing hot money to flow  into those markets. Both Moody's and S & P have issued recent warnings to the U.S. regarding their AAA ratings. USATODAY.com

My regional bank basket had a good day last Friday, rising 2.02% in value or $975.53.

Over the past several trading days, a Canadian dollar has been more valuable than 1 USD.   CAD/USD Currency Conversion Chart The Canadian dollar traded briefly over par against the USD between September 2007 to May 2008 before plummeting to around USD 78 cents in early March 2009 ( 5 year chart: CAD/USD) If and when the 1 CAD buys more than $1.25, I will consider selling some of my CAD to buy USDs. The CAD was a victim of the fear trade in October 2008, falling quickly from 97 cents USD to 77 cents.

There were a couple of cautionary articles about Apple's stock over the weekend.  James Stewart, a long time bull on Apple's stock, wrote a column for the  WSJ titled  "Why Apple's Best Days May Be Over". The surge in IPhone sales resulting from the recently announced Verizon deal has been expected and most likely baked into the current share price. And, what products are going to be introduced in 2011 as the next "cool" gadget?

The other article was written by Joe Nocera, and titled "With Verizon, iPhone’s Flaws May Become More Apparent". Personally, I own a dumb phone, being a totally unhip Old Geezer. I have seen IPhone users experience problems that I rarely experience on my dumb phone. As Nocera points out, there are smart phones available, which may not be regarded as "cool", that do a better job of handling the nut and bolt functions of a phone.

It was reported yesterday that Steve Jobs was taking another medical leave, but would remain CEO.

I have a small position in JNJ stock and have been just amazed about this firm's failure to follow good manufacturing practices. Those problems received a thorough summary in a long NYT article on Sunday. While vehemently denied by JNJ, the root cause of such a systemic and widespread failure has to involve the profit motive.

To continue to achieve profits acceptable to upper management,  costs are not incurred which would improve safety, thereby improving profits. In addition,  rot, complacency and incompetency had to become the norm at the managerial level. More consumers will question whether the "brand" name JNJ product is better and safer than the cheaper "store" brand.    

For those of use Apple computers, and wondering how to type "accent codes" like the symbol for the EURO or the division symbol, this is a useful site: Macintosh Accent Codes I am typing this blog using a large screen IMAC.   

1. Added 40 Alcoa at 15.75 last Thursday (see Disclaimer): This brings me up to 163 shares with an average cost of $11.47 cents per share. The average total cost for the shares held over one year is $9.44. This purchase of the 40 shares last Thursday raised my average cost for shares held less than a year to $13.52.  My last two purchases were  at $10.95 last July and at $5.6 in March 2009.  I had a favorable view of Alcoa's report for the 4th quarter and its outlook for 2011 and beyond.  Item # 4 Alcoa  

After that earnings release,  J P Morgan maintained its overweight and raised its price target from $20 to $22.  The firm also raised its forecast for 2011 earnings to $1.55 from $1.3. I read the Credit Suisse report on AA's earnings, and that firm maintained its outperform rating with a $21 price target. CS expects demand and pricing to improve in 2011. The $21 price target represents a 6.6 times the CS 2012 EBITDA estimate. Argus maintained its buy rating and increased its price target to $20 from $18 after AA reported earnings. Morningstar is lukewarm, with a three star rating, and a fair value estimate of only $17. 

My general goal is to realize enough profit on the common shares to buy 2 Alcoa bonds.  To reach that goal, I needed to add more shares and somehow acquire the patience to hold all of the shares for a few more years. Hopefully, I will be able to buy those two long term bond with a yield of over 8%, up from the current 6%. To arrive at an 8% yield, those bonds will have to fall a lot in price. There are several long term Alcoa bonds.

Needless to say, the future is unknowable and will have many unanticipated twists and turns. The premise of this plan is that Alcoa shares will rise gradually in a worldwide economic recovery, while its bonds will fall in value as inflation heats up and the demand for money increases. 

My existing unrealized gain in AA shares is around $700. To realized a $2000 long term capital gain on my Alcoa shares, the price would have to rise to around $24, which appears to me to be a rational target price capable of being achieved within five years.  As RB has said many times, it is good to have goals.

Alcoa stock is rated a 10 by the StockScouter at MSN Money.  

2. Webster Financial (WBS)(own):  Webster reported earnings of 30 cents per share for its 4th quarter, beating the consensus estimate by 10 cents.  As of 12/31/2010, the net interest margin was 3.4%; the NPLs to total loans was at 2.48% and at 2.73% including OREO; the allowance for loan losses to NPLs stood at 117.58; the total risk based capital ratio was 13.91%;   the Tier 1 risk based capital ratio was 12.05%; and the tangible common equity ratio was 6.82%. In the 4th quarter, Webster repurchased the government's 300 million in preferred stock.  I bought my shares at  $4.58 (March 2009): 

WBS shares rose $1.7 to close at $21.5 last Friday, up 8.63% for the day.

3.  Intel (INTC)(own):  Intel reported 4th quarter E.P.S. of 59 cents per share, beating estimates by 6 cents, on a 24% rise in revenue year-over-year.  Gross margin increased 10% year-over-year.   The better than expected results were due to a 15% sequential increase in Intel's Data Center Group.   The worldwide increase in PCs and the new emerging computing devices are causing an increase in server demand.  As noted by Paul Otellini, Intel's CEO, the total 2010 traffic crossing the internet was 245 exabytes, more than all of the previous years combined.   Intel also expects revenue to increase 10% in 2011, with the street anticipating 4% growth.  Part of that prediction is a somewhat surprising forecast of mid-teens growth in PC unit growth.   Transcript - Seeking Alpha

Notwithstanding the good earnings report and the upbeat guidance,  Intel stock declined 21 cents in trading last Friday to close at $21.05, though shares were up 2% last week. One analyst,  Adam Benjamin,  opined that desktops were in a secular decline, adding that Intel's handset strategy is unlikely to "drive material revenue growth".  The JP Morgan analyst, Christopher Danely, ventured a guess, masquerading as an opinion, that Intel was being too optimistic about sales in 2011.  Then, there was the general angst that Intel does not have yet a competitive chip for tablets and smart phones.  

Maybe Benjamin will be proven right about Intel. Maybe the OG will wake up tomorrow morning with a full head of hair, and that trim muscular body capable of running a marathon without drawing a deep breath. Somehow, with the resources and talent working at Intel, it would make more sense to bet that this company will succeed in developing a superior chip for use in handsets.  As I understand the issue, it is mostly a question of power conservation. A more balanced view of Intel can be found in this article. 

Possibly, AMD and Intel need to focus on a new growth area, developing a new processor for implantation in the brains of Old Geezers that is capable of retrieving information like "where are my keys."  After all, there are close to 70 million baby boomers who are well past their peak in retrieving and processing information. 

4. Bought 1 Edison Mission Energy Senior Note Maturing in 2016 at 88.75 on Friday (89.55 with concession) (Junk Bond Ladder Strategy)(see Disclaimer) This is a description of EME taken from its 2009 Annual Report: 

          "EME is a holding company whose subsidiaries and affiliates are engaged in the business of developing, acquiring, owning or leasing, operating and selling energy and capacity from independent power production facilities. . . .  EME was formed in 1986 and is an indirect subsidiary of Edison International. Edison International also owns SCE, one of the largest electric utilities in the United States.
       EME's subsidiaries or affiliates have typically been formed to own full or partial interests in one or more power plants and ancillary facilities . . .   EME's operating projects primarily consist of coal-fired generating facilities, natural gas-fired generating facilities and renewable energy facilities (primarily wind projects and one biomass project). As of December 31, 2009, EME's subsidiaries and affiliates owned or leased interests in 39 operating projects with an aggregate net physical capacity of 11,269 MW of which EME's pro rata share was 10,072 MW. At December 31, 2009, EME's subsidiaries and affiliates also owned two wind projects under construction totaling 390 MW of net generating capacity."  (Page 5:  www.sec.gov

While the highlighted portion of that quote refers to EME being a subsidiary of Edison International (EIX), Edison does not guarantee the notes.   If it did, the Edison Mission Energy note would be rated investment grade rather than junk. Bonds issued by Southern California Edison, another EIX subsidiary, are rated A1 by Moody's (Finra)

This is a link to a description of Edison Mission Energy found at the Edison International web site:  Edison International: Our Company: Edison Mission Group

I could have bought an EME note maturing in either 2017 or 2019.  While the note maturing in 2016 gives me a lower yield, I am sufficiently concerned about the credit risk for this issuer to limit my exposure to just 1 bond and to choose the shorter maturity. The 2009 annual report for EME shows that a 500 million dollar note is due in 2013, and no other senior note is due at the parent company level until the 2016 note (see page 143 www.sec.gov). Thereafter EME has to refinance 1.2 billion when the 2017 comes due, and another 800 million for the 2019 note. 

Prospectus:  www.sec.gov  Interest payments are made semi-annually in December and June. The note matures on 6/15/2016.  The coupon is 7.75%.  This bond is currently rated B3 by Moody's and B- by S & P.

My confirmation states that the current yield is 8.654% and the YTM is 10.317%

The following is a summary of some recent news. Edison Mission Group began operation of a 150 MW wind energy project in southern Texas in December 2010. The U.S. government filed suit against EMG and others alleging violations of the Clean Air Act by the Homer City coal plant. Reuters According to that Reuters story, EMG claims that most of the allegations occurred before it bought the plant in 1999 and EMG had spent 300 million since that time to reduce emissions.  

While this note is certainly risky, and a default is a possibility, the company does have real assets which would make some recovery likely even in a worse case scenario.

Added 6/7/12: As noted in subsequent posts, I have turned negative on EME bonds, see Item # 1  Risk Rating Raised on Edison Mission Bond to 10- from 9- (6/6/12 Post) and Item # 4 Sold 2 Edison Mission 7.75% Senior Bonds Maturing in 2016 at 73.25 (3/1/12 Post)

5. More on the Rationale for the Junk Bond Ladder StrategyWith another junk bond purchase last Friday, a borderline speculative purchase to be discussed in the next post, I suspect that there is at least a 50% chance of experiencing one default given the sheer number and risk characteristics of the junk bonds bought over the past several weeks.  A list can be found at the following link to the Junk Bond Ladder Strategy. I will probably add two more bonds before the end of this month,  and then cease buying.  

The odds of having two defaults are not inconsequential in my view, possibly around 20%. The  Junk Bond Ladder Strategy will be a modest success, if 95% of the interest payments are made and I suffer no more than a $1500 capital loss on one or more of them. That result would still leave me ahead compared to buying investment grade bonds with similar maturities. I would be giving up about 4% to 4 1/2% in current yield by buying  short and intermediate term investment grade corporate bonds rated BBB, and many of the better quality bonds are selling at premiums to par value which would guarantee a loss of capital at maturity. I will net a small profit on the junk bonds as a group even if one collapses to zero. And, there is no guarantee that an investment grade company will survive either, the odds are just better than for the collection of companies included in my junk bond strategy.

As shown in this chart at YF, a 5 year AA rated corporate bond has a composite yield of 2.63%, about 7% below my current yield in the junk bond, mostly short term,  strategy. Of the 25-27 bonds which will be my limit, I  currently have just 2 long term bonds (1 Albertsons and 1 Macy's)

The primary rationale for the junk bond ladder to to pick up an additional 4 to 4 1/2%, compared to a similar maturity "BBB" investment grade bond ladder, and to at least have the potential for a small capital gain of around $1,500.  The capital gains would be realized simply by holding the junk bonds until maturity, assuming no defaults. Before I am finished I expect to have the capital gain potential closer to $2000, and to increase my current yield a tad without extending the average duration.

I would add that the two year treasury note closed last Friday (1/14/2011) at a .579% yield. Java Chart  The five year treasury note was then yielding just 1.922%.  Java Chart  The composite five year "BBB" yield is currently 5.82%: Composite Bond Rates The 10 "BBB" composite rate is just 6.24%. My average maturity is 6.16 years with two long term bonds maturing in 2029 and 2030 respectively.

Another rationale, which would be applicable to any short term bond ladder, involves interest rate risk. The bonds in this strategy now mostly mature in the 2012 to 2016 time frame. The short duration reduces substantially interest rate risk. If the bond market is moving into a long term secular bear market, as I suspect, then one strategy to deal with that potential problem for a bond investor is simply to own individual bonds with short maturities. When they mature, the proceeds would then be rolled into higher yielding short term bonds which would then be held to maturity. Hopefully, in two years or so, I can start rolling the proceeds into intermediate term investment grade bonds yielding over 7%. And, in five years, I hope to have a bevy of longer term investment grade bonds yielding over 8% or even 9%. This process of rolling short to intermediate maturities, and working my way up the credit quality ladder, would continue for the duration of a long term bear market in bonds, or at least until I am paid considerably more than now for assuming the interest rate and credit risk of a long term bond.

Another rationale for focusing on junk rated credits is that an economic recovery will likely improve their credit risk profile, which is easily my most important concern about them given their relatively short maturities.     

6. Bought 200 of the CEF JQC at 8.74 on Friday (see Disclaimer): This purchase brings me to 916.525 shares, and I am reinvesting the quarterly dividend. The current quarterly distribution rate is 17.5 cents per share, which translates into a  8% yield at a total cost of $8.74.  Recently, the net asset value of JQC has been increasing, while the market price has stagnated, thereby increasing the discount to net asset value.

JQC is a leveraged fund, currently at around 22.37% as of 12/31/2010: JQC - Nuveen Multi-Strategy Income and Growth Fund 2  It is a balanced global fund, weighted more in bonds: JQC - Holdings and Detail

This is a link to the last SEC file Form N-Q that has a list of holdings as of 9/30/2010. I do not see much appreciation potential in the $25 par value bonds, many of which have been discussed in this blog, but those holdings will generate income.  There may be some appreciation potential in the mostly junk rated senior variable rate loans and corporate bonds, provided the economy continues on upward trajectory. 

The net asset value for JQC as of 1/13/2011 was $10.21 per share, and the discount to net asset value was then at minus 14.5.  The daily NAV information can be found at the WSJ web page for CEFs, Nuveen's web site, or at the Closed-End Fund Association.  Last Friday, JQC closed at $8.71 with a NAV per share of $10.23. The discount to NAV expanded to  -14.86.

It is my intent to sell 200 shares of JQC later in 2011, which would be my highest cost shares using FIFO accounting, in a manner that would avoid the wash sale rule.  Those shares were bought in 2007 as part of my failed CEF strategy, part of a plan adopted as I moved out of stocks. {see discussions at CLOSED END INVESTMENT COMPANIES: Hopefully Lessons Learned and To be Applied (May 2009; Buy High & Sell Low /Retrospective on the Good & Bad (Oct 2008)}

I have discussed this CEF in several posts and have nothing to further to add to those discussions: Added 50 JQC @ 8.8 (NOV 2010), Added CEF JQC at $6.97 (Nov 2009) Added 100 JQC at $6.31 (July 2009) Bought 50  JQC at $4.3 (Oct 2008)

7. Call Warrant Exercise When the TC Has a Significantly Larger Coupon Than the Underlying Bond: Why Was XFJ Called: After the the owner of the call warrant exercised its option to redeem XFJ, I was curious why, since the underlying bond, a 2028 senior Motorola bond, was selling near par value.  In fact, I noticed that someone, most likely the owner of the call warrant, sold over 18 million of those bonds on the day of the redemption, with several entries at FINRA grouped together in time. All of those transactions were near par value.

In answering this question, I am handicapped, in that I would prefer that someone else do all of my math chores. I have had an aversion to math for my entire life, similar to my disdain for most vegetables.  And, it would add that I decided to go to Tulane in 1969 since that college allowed me to substitute philosophy for calculus. But, I thought that a better understanding of this issue may be a relevant issue for the future, so I tackled it over the long weekend.

First, as previously discussed, it is common for a TC to have a different coupon than the underlying bond owned by the trust. Where the TC has a higher rate, then the brokerage firm would have to deposit more bonds with the lower coupon in order to support the coupon payment.

For XFJ, there was a wide discrepancy in coupons. The Motorola bond has a 6.5% coupon whereas the TC XFJ had a 8.375%.

The Trustee's Distribution Statement shows $32,875,000 million in principal amount of the 6.5% MOT bonds. Those bonds produced $1,068,437.50 of interest for six months, and those funds were distributed to the TC owners. The original Prospectus states that there are 1,020,597 trust certificates with a $25 par value. Thus,  it took 32.875 million in principal amount of a 6.5% bond to support a 8.375% coupon for a 25.514925 million in principal amount of TCs. But for a $25,514,925 payment to the owners of the XFJ, plus accrued interest, the call warrant owner could acquire title to $32,875,000. So it would be become profitable for the call warrant owner to exercise the call even when the underlying bond is selling near par value. The problem would be finding buyers for most of those bonds before the exercise to avoid holding such a large inventory.

Possibly, there were more TCs actually sold than noted in the prospectus. To check whether or not this happened, I performed the following calculation. For a year, the bonds that were in the trust would generate $2,136,875 in interest. The principal value of 1,020,597 TCs at $25 is $25,514,925 which would generate $2,136,874.97 in annual interest income at 8.375%.  

Voila, the call warrant owner acquired $32,875,000 in principal amount for $25,514.925. When the bonds are sold, the buyer would have to pay the accrued interest, so the call warrant owner does not lose anything by having to pay the accrued interest to the TC owners. And, it would be profitable to exercise the call even if the call warrant owner could sell the bonds at or even below par value. 


  1. Hi. Did you really buy JQC @7.84? Perhaps 8.74?

  2. The correct price is $8.74. I transposed the 7 and 8.