Wednesday, March 30, 2011

Bought Back Synthetic Floater GJP at 22.25-ROTH IRA/Tax Accounting For Bonds Purchased in the Secondary Market-Too Complicated/

In an article in the WSJ, I noted several interesting facts that I wanted to jot down.   Profit margins for companies in the S & P 500 were 8.2% in the 4th quarter of 2010, the third consecutive quarter over 8%.  While that sounds good, the author of the article, Ben Levisohn, noted that this is about as good as it gets based on history.  Another measure of corporate profitability is the percentage of corporate profits as a percentage of national income.  The FED reported this number at 12.7%, which is also near the top of the historical range.  In other words, the question is whether it is rationale to predict over the near term a continuation of a historically high trend?  Possibly, while profit margins may not shrink much, profits could continue to increase by expanding revenue rather than profit margins.

S & P cut Portugal's debt rating to BBB- from BBB.  Of interest to European financial institutions, there was a statement from last week's EC summit confirming press reports that sovereign debt restructuring may be required before a government can access the European Stability Mechanism when it replaces the EC's existing emergency funding in 2013. ESM  A government's senior debt will be subordinated to any loans secured through the ESM.

The Case Shiller index of home prices in 20 metropolitan areas continues to confirm a double dip in housing prices.  As shown by the data on page 3 of that report, the only area experiencing an increase in home prices was the Washington, D.C. metropolitan area, leading the pack with a .1% increase in January over the December number. D.C. and San Diego were the only metropolitan areas showing an increase over the prior 12 months, though S.D. barely eked out a gain of .1%. The index is accessible by clicking the appropriate link at standardandpoors.com. The latest data released yesterday is from January 2011.

Today is the final day in MKN's second annual coupon period. It will have another good payday for this period, the only question being how much. The DJ-UBS commodity index closed yesterday at 166.55,  MKN will make its annual interest payment on April 6, 2011 (see page PS-2: Pricing Supplement).  I received an 18% interest payment on my 100 shares for the 1st coupon period. Par value is $10 and the note matures in 2014. Bought 100 MKN at 9.85 (see also Item # 1  MKZ and MKN Now) The starting value for the second coupon period was 132.67. I will be able to compute the interest rate for the current period this afternoon.  A close at 166.55 today in the commodity index would mean a 25.5% coupon payment.   MKN has been a real hoss so far.  Its cousin, MKZ, has been a dud so far.  Things change.



1. Tax Accounting for Bond Purchases in the Secondary Market:  I had never purchased a bond in the secondary bond market prior to 2010. I did purchase a number of bonds in 2007 at par value directly from the issuer, as I shifted out of stocks into bonds.  I did not have to pay accrued interest for those purchases.  I knew that bond purchases made in the secondary market would require the payment of accrued interest to the seller.  A broker furnished me with a list of those payments made in 2010 at page 55 of my 1099:


Since I prepare my own tax return, and would not even consider paying anyone to do it,  I have to figure out how to account for the interest paid to the seller.  Was the interest paid added to my cost basis in the bond?  I quickly find out that my broker was not including those amounts in my cost basis.  Yet, when I receive the first semi-annual interest payment after purchasing the bond, I will receive the total amount, including what I had paid the seller of the bond, and the total amount will likely be included in interest income by my brokerage firm.  

Of the bonds listing in the above snapshot, all purchased late in 2010, I did not receive a semi-annual interest payment in 2010, but have started to receive payments in 2011.  

This was my first experience in trying to figure out the tax accounting interest associated with accrued interest paid to a bond seller.  I am handicapped in resolving that kind of issue by a number of factors, including a lack of any training or education in accounting matters.  In an earlier post, I mentioned that my law school, George Washington, required me to take a course in Federal Income Taxation back in 1974.  I attended one day of classes, decided that I could not stand it, and next appeared in the classroom for the final exam.  I also did not read any materials other than a perusal of the J.K. Lasser 1974 tax guide.  Somehow, I manage to pass the exam, though the margin over failure was not very large. 

Based on reading a number of articles found with a Google search, the consensus among those who appeared to be experts made sense to my simpleton mind.  I needed to include a line item in Schedule B deducting the amount of interest paid to a seller in the year that the issuer pays me provided the broker includes the amount that I paid to the seller when reporting my interest income in my Form 1099 for the 2011 tax year.


This adjustment to interest income is not yet being made by the broker.  For example, United Refining recently paid me $52.5 for 6 months interest on the one bond that I own, which reflects an entire 6 months interest on one 10.5% $1000 par value bond.   That entire amount is currently shown as interest income paid to me by my broker.  I paid the seller $33.25 of that $52.5.   If my broker does not adjust that $52.5 down by $33.25, then I need to have a line item in my 2011 Schedule B making that adjustment for that interest payment and all others similarly situated which will be all of the ones shown in the snapshot above and all others where I bought the bond in 2011, paid the seller accrued interest and later received an interest payment that year from the issuer.  

As I understand it, and this makes sense to me, I could not deduct the interest paid to the seller in Schedule B until I actually receive an interest payment from the bond's issuer and that entire payment is included in my broker's 1099 without any adjustment.  

I am just relying on what I read, which included the following: Accrued Interest on Bonds  I subsequently found some material on the subject from the IRS: 

This is a quote from an IRA publication 550 on this subject: "Accrued interest on bonds.   If you received a Form 1099-INT that reflects accrued interest paid on a bond you bought between interest payment dates, include the full amount shown as interest on the Form 1099-INT on Schedule B (Form 1040A or 1040), Part I, line 1. Then, below a subtotal of all interest income listed, enter “Accrued Interest” and the amount of accrued interest you paid to the seller. That amount is taxable to the seller, not you. Subtract that amount from the interest income subtotal. Enter the result on line 2 and also on Form 1040, line 8a." Publication 550 (2010), Investment Income and Expenses

Fortunately, my main broker does keep tract of a really complex issue arising when I sell a bond bought at a discount to par value which I have started to do in 2011.   While the first issue discussed above makes sense to me, the following issue appears to me to be needlessly complex. 

Yesterday, I mentioned that the profit shown by the broker for the 1 U S G bond sale was $32.44:


The proceeds from this transaction do not include the accrued interest, which will be reported as part of the interest income section in Schedule B. The proceeds includes just the amount received from the 1 bond adjusted for the commission paid. The amount paid to me by the purchaser in accrued interest is already reflected as interest income received in 2011. 

However, the cost basis shown is not the amount paid for that bond, which was $898. Instead, my broker has increased the cost basis to $902.06, and placed a "d" symbol next to the adjusted tax basis.

The reason for that adjustment is explained in note "d" and it is not the kind of adjustment that I would want to make on my own: "d - Adjusted cost basis reflects any cumulative original issue discount, premium, or acquisition premium (including any year-to-date amount). It assumes such amounts were amortized or accrued for tax purposes from the acquisition date through the disposition date (or, for securities still held, through the maturity date). Premium amortization was calculated using the yield-to-maturity method. Acquisition premium was calculated using the ratable accrual method. Any market discount accretion for this position was calculated using the straight-line method and, if applicable, recognized upon disposition. Gain/loss displayed for this position is calculated using the cost basis adjustments as described above."

This issue is discussed in this article: Cost Basis - Bonds bought at a discount

A separate schedule reflects details for realized market discounts and shows that the U S G transaction resulted in a $4.06 upward adjustment in my cost basis with the symbol "r" next to that number:  " r - Market discount income was calculated using the straight-line method from acquisition date through disposition date. This market discount income is included in the adjusted cost basis provided. Our calculation assumed the taxpayer elected to defer recognizing market discount until sale (or other disposition)."  This $4.06 accounts for the tax cost difference shown in my confirmation of $898 and the $902.06 shown as my adjusted cost basis by the broker. 

Since I did not sell a bond purchased in the bond market until 2011, I can work more on addressing the tax accounting issues next year.  My question now is where else that $4.06 has to show up if I add it to my cost basis as my broker has already done. I suspect, though do not yet know, that it would have to appear as OID interest income.  If that proves correct, then I would be adding $4.06 in Schedule B and in effect subtracting $4.06 from the Schedule D total creating a wash.  Since the U S G bond sale was a short term capital gain, there would be no impact on a federal tax liability by those adjustments.   It could have a negligible impact only if I had a long term capital gain on the bond sale, which I did not, and my highest marginal rate was greater than 15%.  

The Nerd Machine is proud of the fact that the HK's 1099s and associated tax information are approaching 100 pages.  One of its goal in life is cause the Heaknocker's return to exceed the width of the Nashville phone book and to require the resolution of tax issues that would perplex the Almighty.   


2. Bought 100 GJP, A Synthetic Floater, at $22.25 on Monday (see Disclaimer): I am gradually moving toward playing with the house's money on this security, though I have not yet realized a large percentage gain trading it.  I have been in a trading mode for GJP since 2009:    Bought 100 GJP at $18.97 (Oct 2009)  Sold 100 GJP at 22.42 (Feb 2010)  Bought 50 GJP at 20.55 (July 2010) Sold: 50 GJP at 23.31 (Oct 2010)  Bought 100 GJP at 21.95 (Jan 2011) Sold 100 GJP @ 23.52 (February 2011).  I also bought some shares back in April 2009 at  $17,75


GJP is a trust certificate (TC).  It is also a Synthetic Floater. The trust owns a senior bond 5.95% coupon issued by Dominion Resources (D), a large electric utility based in Virginia. Both the TC and the underlying bond mature on 6/15/2035.  The TC has a $25 par value.  The owners of GJP are entitled to receive, by virtue of a swap agreement, the greater of 3% or 1.15% over the 3 month treasury bill rate.  GJP has a maximum interest rate of 8%.  So, for as long as the swap agreement creating a floater remains in effect, I know the minimum and maximum interest rates for this security at a total cost of $22.25.  The minimum coupon will be 3.37%, which is being paid now, and the maximum yield at that total cost number would be about 8.99%. The maximum rate would be hit with a treasury bill rate in excess of 6.85%.


While the owners of GJP do not receive the fixed coupon of the underlying bond, unless the swap agreement terminates for some reason (e.g. JBK), they are nonetheless vulnerable to the credit risk of the issuer of that bond.  If Dominion fails to pay the GJP trustee the interest owed on the 2035 bond, then the owners of GJP will not be paid.


I am comfortable with the credit risk. S & P rates the underlying bond at A-. This is one reason that I continue to come back to this security.


GJP also makes monthly interest payments, another plus.


I am not that much worse off than a buyer the underlying note, which is trading slightly above its par value.  FINRA The owner of that bond does receive the fixed coupon of 5.95%, but their current yield is closer to 5.83%, whereas the TC owner would receive 3.37% at a total cost of $22.25.  So, I am giving up a little less than 2.5% in current yield.  In exchange I receive three benefits compared to the owner of the fixed coupon bond.


First, I am paid monthly rather than semi-annually.


Second, I will make an additional yield by holding the TC to maturity representing the difference between my purchase price of $22.25 and $25, while the buyer of the underlying bond would have a slight loss on the security by holding until maturity.


Lastly, and more important, I have some inflation protection with GJP's float which is good at 1.15% over the 3 month treasury bill.  That provision will kick in when the three month treasury bill exceeds 1.85%, a low number by historical standards.  When the 3 month T Bill hits 4.8%, a buyer of GJP would have the same coupon as the owner of the underlying fixed coupon bond at 5.95%.  A buyer of GJP at a total cost of $22.25 would hit that 5.95% current yield, assuming a total cost purchase of the underlying bond at par value, at slightly less than a 4.25% 3 month treasury bill rate during the applicable computation period for GJP and would thereafter exceed it.  The break even point would be lower if the underlying bond was purchased above its par value  (Calculation: .0425% 3 month treasury bill + .0115% spread= .054% coupon multiplied by $25 par value= $1.35 annually per TC divided by a total cost of $22.25= .0607%)


GJP Prospectus: www.sec.gov
Underlying Bond Prospectus: FORM 424B5


YF does not show any shares traded on Monday when I bought my 100 shares.  Only 400 shares are shown as traded yesterday, with a price range from $22.24 to $22.7.  This is a very thinly traded security. I used a limit order.  

8 comments:

  1. I see monthly distribution on GJB dropped this month, is that a trend?
    .063> .057 after years at .06

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  2. sorry- GJP- dividend reduced, as I said.
    re: WSF- CALLED, told ya insiders got the news when I saw 500K shares trade a few days ago at 9:45am est, from 25.32 down to 25.21, it traded 1mil shares that day.

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  3. I have noticed on a number of occasions, usually with trust certificates, that there is a spike in the volume, a significant change in price indicating the call warrant owner might have exercised its option to redeem, and yet there is no news anywhere.

    Today I received notice from Vanguard that the exchange traded bond TDA will be called on 5/2. Yet there is no news at the financial web sites notifying potential new purchasers. There is news under TDS, the issuer, that it just floated a new bond at a 7% rate. If I went to the SEC site, I would find a prospectus for that bond, and would expect to see a statement that the proceeds were going to be used to pay off TDA which has a 7.6% coupon.

    So, there is a problem about disseminating information to individual investors about bond calls. It should be required that the entity calling the security disseminate notice using one of the wire services like Business Wire. Then it would be picked up at Marketwatch, YF, and other financial websites.

    I suspect that there may have been notice on WSF provided you had a Bloomberg terminal at your desk.

    As to GJP, your facts are just wrong as I will explain in a moment. There will of course be fluctuations in the monthly rate once the float provision exceeds the 3% guarantee.

    Now, there is a 3% guarantee that has to be paid monthly based on the par value. It would not be reasonable to expect a lower rate than the 3%.

    There is fluctuation in the penny rate depending on the number of days in the payment period. The last monthly period has the short month of February in it.

    The March 2011 distribution was $.0575345.

    The February 2011 distribution was $.06369864 (this period had more days)

    The October 2010 distribution was $.06164383.
    This period, which included September, had one less day.

    The March 2010 distribution was $.05753425, the same as the recent March 2011 distribution.

    So you are incorrect in your assumption that the .063 rate has been paid for years. The rate based on the guarantee obviously depends on whether the payment period has 30 or 31 days, or is a short month like the one between 2/15 and 3/15.

    The same kind of calculations are applicable for such securities like OSM and PFK that pay monthly interest.

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  4. quantumonline says reuters had some news re: WSF I guess it's good to go every morning to their "called" securities list.

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  5. I am not familiar with the Reuter's called securities list.

    I did find a Form 8-K filing made by Wells yesterday (3/29) that lists WSF along with several other TPs in a redemption notice. WSF is not scheduled to be redeemed until 4/25.

    It also looks like the underlying TP in the trust certificate KTV is also being called by Wells, even though it will require a premium payment to par value plus accrued interest. That TP has a 8.04% coupon, which tells me Wells is really motivated to get rid of its TPs after the recently enacted legislation that requires the phase out of their use as Tier 1 equity capital. I will hate to lose that one. The TC has a higher coupon at 8.2%. According to the prospectus, a redemption in 2011 requires a $26.11 principal payment per certificate plus accrued interest. KTV is on a semi-annual payment schedule with the next payment scheduled on 6/1. The redemption date is 4/27 for the First Union 8.04% TP.

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  6. Thanks for that, I'll check it. I meant the called list @ quantumonline. My WSF was halted today on TDAmeritrade.

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  7. Since I believe KTV will also be redeemed as a result of Wells redeeming the underlying security, I looked again at the prospectus since I already own KTV.

    I am not sure now whether the owners of that TC will receive $26.11 per certificate if Wells claims that there is a Regulatory Capital Event, such as the recently passed financial reform law. A different schedule applies in such a case based on an obtuse calculation. At the minimum, the payment has to be par value plus accrued interest even under that formula. I also do not know whether Wells is claiming that there is a Regulatory Capital Event or whether notice was given within 90 days after the occurrence of such an event which would be required to take advantage of the alternative redemption calculation method. I consequently would not buy any KTV now based on the possibility that the 26.11 will be made.

    ReplyDelete