Monday, July 11, 2011

Sold 100 of 550 ERC at 15.49/Bought 50 SHOPRD at 24.15 in Roth IRA/Bought Back 300 WIW at 12.47

China's CPI surged 6.4% in June, compared to a year ago.

According to Morningstar's models, stocks are fairly valued now.  I would agree with that assessment for the broad market and for most stocks in the S & P 500. There are still values among several of the large cap names. Michael Santoli notes that 30 mega  cap companies in the S & P 500 are both inexpensive and scorned, whereas the other 470 are selling near their long time average P/E ratios. Barrons.com

This is a link to a transcript of a discussion among Vanguard employees about the bond market: Webcast Without knowing the identity of the participants in that interview or their employer, I could have told you that they all worked for a mutual fund company that wanted to sell investors bond funds and to discourage investment in individual bonds. They viewed an individual bond ladder to be simply a less efficient mutual fund. Apparently, none of those individuals have lived through a long term bear market in bonds, marked by a prolonged rise in interest rats and declines in yields, similar to what happened between 1965 to 1982.

At least for an intelligent individual investor willing to do research, a bond ladder would clearly be superior in my opinion to a bond fund during such a period.  Perhaps, if the next few decades are a carbon copy of the period from 1982 to present, there would be merit in their arguments, but I see no reason to make such an unrealistic, simplistic, and overly optimistic forecast for bonds after a 40 year secular bull market. Item # 2 Interest Rate Risks- Bonds (January 2010 Post);  For BND: Is it Safe is not the Right Question. Instead Ask What are the Risks & Rewards/Assume Lost of Principal Possible (June 2009 Post); Rising Rates and Your Investments (article from SIFMA); Managing Interest Rate Risk/Continued Discussion on 1982 or 1974 (June 2010 Post); Bonds on the Cusp of a Long Term Bear Market? (February 2011 Post); What is the More Rational Prediction for the Future-Inflation or Deflation (July 2010 Post); Bond and Bond Funds (SIFMA article).

I did agree with them that bonds have a place in an asset allocation and will frequently have a negative correlation to stocks in times of stress. That was not the case for investment grade corporate bonds for several weeks after Lehman's failure in September 2008, but that proved to be a buying opportunity for me.  However, the Vanguard employees might want to examine the history of bonds and stocks during 1965 to 1982, where there would be a positive correlation in those major asset classes to the downside. It is important for the intelligent investor to remember that correlations between asset classes are not static over time, and macro issues will signal likely correlations at different times. Instability & Volatility in Asset Correlations (May 2009 Post);  Hyman Minsky & the Economic Profession/Correlation of Asset Classes (December 2009); Static v. Dynamic Asset Allocation;

A chart in this article shows the fluctuating correlations between stocks and the 5 year treasury note from 1938 to December 2008, when the article was written.  Asset Class Rolling Correlation  I discuss that chart in a post from May 2009: Total Bond Market Index (BND) and IEF as Non-Correlated Assets to Stocks Please note the positive correlation from the late 1960s to 1982.  Was that good or bad?

From about 1/1/1966 to 1/1/1981, an investment in the S & P 500 would have had an annualized negative real return, after reinvestment of dividends, of  -1.04. CAGR of the Stock Market: Annualized Returns of the S&P 500  Buy and Hold or Dynamic Asset Allocation/Trading: Long Term Secular Bull and Bear Markets/ Australian currency and the Carry Trade (February 2010 Post). If you were living in the 1970s, looking for an asset class with a negative correlation to stocks, bonds would not be your option. Inflation was causing bond investors a lot of pain in those years.

{See generally two T Rowe Price publications on how a rise in interest rates negatively impact bond prices:  T Rrowe Price publication at page 8 and T. Rowe Price Investor - March 2010 - Page 12-13.} When the coupon of an existing 10 year bond is 3%, a two percent rise in rates can be devastating.

The lackluster and disappointing jobs report for June casts serious doubt on both the strength and durability of the economic recovery. This was report was surprising given the ADP report released last Thursday. The Labor Department reported that only 18,000 jobs were created in June. Employment Situation Summary Government employment continued to trend down, with 39,000 jobs lost. I would anticipate government job losses to continue.  The broader measure of unemployment, the U-6 number, rose to 16.2% in June from 15.8% in May 2011. That number includes the unemployed and those marginally attached to the workforce or working involuntarily part time.

And, to make matters worse, the government revised the job numbers for April and May to show 44,000 fewer jobs. There was a small decline in wages and hours worked.

The market reacted negatively to this report but experienced a late day rally to close down only .7% in the S & P 500 average. I have been surprised about the recent strength in the stock market given the crappy employment and housing numbers. There seems to be a pervasive Pollyanna belief in a robust second half recovery, borderline phantasmagoria, even though it is clear that the governments in developed countries are withdrawing fiscal stimulus and cutting their payrolls. And, for some reason that is unclear to me, the market believes that the GOP House members will behave in a responsible manner. Boehner made it clear after yesterday's meeting with Obama that the GOP will not agree to any tax hikes.

The House GOP members are joining Michele Bachmann's crusade to preserve our freedom to choose energy inefficient light bulbs. WSJ.com Michele's signature piece of legislation is the "Light Bulb Freedom of Choice Act", Michelle Bachmann, though she is confused about the law that she is trying to repeal as noted in an article by the non-partisan fact checker PolitiFact. Michele claims to be a truth teller, but a recent article by FactCheck.org highlights some of her recent statements that are devoid of truth.

Michele told a crowd to roaring approval that she opposed any raise in the debt ceiling.  NYT It is unfortunate that Know Nothing Zealots have so much power in the U.S. today.     

Tim Pawlenty is in full agreement with Michele's sentiments. Of course, he did manage to leave as Minnesota's governor before the state shut down due to a large budget shortfall left after his 8 years as governor. POLITICO.com 

It is really easy to be irresponsible. Being irresponsible, ignorant, and just plain stupid can be a dangerous mix.  

1. SOLD 100 of the 550 shares of the bond CEF ERC at $15.49 Last Thursday (see Disclaimer): This pare is mostly profit taking.  Using FIFO accounting, I had a gain on this 100 shares of $244.9:

100 ERC Long Term Capital Gain=$244.8
Those shares were purchased in July 2009. The shares close at $15.52 last Thursday, and the fund had a net asset value per share then of $16.58.

In addition to profit taking, I am reducing somewhat my over allocation to junk bonds by selling shares in some funds that have a high percentage of their assets in that risky bond class. As of 3/31/11, ERC had 42.8% of its assets in bonds rated at BB/Ba and B/B, and another 5.2% at CCC/Caa and below. wellsfargo/pdf FactSheet My over allocation to junk bonds is not caused by my long standing allocation to a few funds that are heavy into them. Instead, it is due to the expansion of the Junk Bond Ladder Strategy, where I am taking even more risk in return for a higher yield.

Someone wanted to know the answer to a question, phrased in the following manner: "Can Junk Bonds be trusted for retirement income"?  What can I say, other than No, of course junk bonds are not safe in that sense. How can any security with an enhanced risk of default be trusted to pay a retiree income? Asking whether junk bonds are safe is not the appropriate question, and it baffling to me to hear individuals asking that kind of question as I noted in a recent post. Is this Bond Safe? Instead, there needs to be a thorough analysis of the risks and benefits. For many retirees, one risk is trying to live off their savings earning nothing due to the prolonged Jihad conducted by the Federal Reserve against the saver class, particularly retirees trying to live off their income generated by savings accounts and bank certificates of deposit.  And, as I will explore in a post later this week, that risk is aggravated by cash inflation starting to pop.

Wells Fargo Advantage Multi-Sector Income Fund closed last Friday at $15.48, with a net asset value per share of $16.59. Based on its current monthly dividend of 10 cents per share, the yield at that price according to Marketwatch is 7.5%. The average yield in my ladder strategy is close to 10%. 

2. Bought 50 of the REIT Cumulative Preferred Stock SHOPRD at 24.15 in ROTH IRA Last Thursday (see Disclaimer): This security is almost functionally equivalent to another preferred stock issued by Sunstone Hotel Investors that I previously purchased in a taxable account. Functional Equivalence in Bond Trading (January 2009 Post) There is one important difference in favor of SHOPRD compared with SHOPRA which involves conversion rights into common shares in the event of a change in control.  Bought 50 SHOPRA @ 24.35 (May 2011 Post)

The main issue for me is which one provides the most yield at an available purchase price. SHO.PD had a slightly higher yield last Thursday than SHO.PA. And, as explained below, SHOPRD has a unique feature that is absent from SHOPRD and other REIT preferred stocks.  SHOPRD is a recent issue which may explain its conversion clause. If anyone is familiar with another REIT preferred stock with a conversion feature, please let me know.

SHOPRD pays cumulative dividends at the rate of 8% on a $25 par value. As with other equity preferred stocks, the security has no maturity date, but Sunstone has the option to redeem it after 4/16/2016. PROSPECTUS SUPPLEMENT Some REITs have actually started to redeem their preferred stocks. I would not count on that happening. 

This is a link to Sunstone's  Profile page at Reuters, and to Key Developments' page which I always read before buying a security.   

The intent is to sell the SHOPRA held in the taxable account at a small profit and to keep SHOPRD shares bought in the ROTH, the account viewed as a more appropriate spot for this security. 

In the ROTH, the dividends are not taxed, thereby in effect providing me with a tax free yield of about 8.3%.  Even though SHOPRD is an equity preferred stock, I doubt that any significant part of its dividend will be classified as a qualified dividend.  This exception is due to the lack of taxation at the corporate level when the REIT pays out 90% or more of its net income to its equity stakeholders.  Thus, most, if not all of the dividend, would be taxed at my highest marginal tax rate when held in a taxable account.  

The main drawbacks for this type of security are the risks associated with REIT preferred stocks. REIT CUMULATIVE PREFERRED LINKS IN ONE POST/Advantages & Disadvantages. The risks discussed in summary fashion in that post make any significant exposure to them inappropriate for a retirement account in my opinion. As a result of their many unfavorable characteristics, I will underweight them in my portfolio and will trade them.  Equity Preferred Stocks as a Disfavored Sub-Asset Class (May 2009 Post);  Embracing Volatility as A Risk Management Tool In the Sub-Asset Class of Equity Preferred Stock (May 2009 Post) 

It would be fair to say that their prices were just crushed during the Near Depression period, when 20%+ yields were available for anyone with the nerve to buy.  I still own one that pays me 75% a year based on my cost, and the REIT has never missed a payment. 

For purposes of my allocation, I treat the equity preferred stocks as bonds, since their bond characteristics are more important and dominant. They are more like bonds than common stocks.  All of their equity attributes are negative ones. Those equity  attributes include the perpetual character of the security, and its inferiority in the capital structure to all bonds. 

Basically, an owner of an equity preferred stock has the dividend and a preference right to the earnings of the company to pay that dividend over the common shareholders.  So, the dividend payable to the owner of the preferred stock has to be paid for as long as the company pays a dividend to its common shareholders.  If the common dividend is eliminated, then the cumulative preferred dividend can legally be deferred, but no interest is earned on the deferred amount for REIT preferred shares, unlike the Trust Preferreds which are in reality bonds.  Many equity preferred stocks pay non-cumulative dividends, but the REIT preferred stocks pay cumulative dividends.  I am not familiar with one that is not cumulative.    

For anyone unfamiliar with the terms cumulative and non-cumulative, a common stock dividend is non-cumulative, which means that it can be eliminated and the owner of the stock has no legal right ever to receive a payment. The same is true for non-cumulative equity preferred stocks. Once the dividend is legally eliminated, it is just gone. Once the firm starts to pay a common dividend again, however, the company would have to restart paying the non-cumulative preferred stock dividend. The company would have no obligation to pay for those quarters when the common or non-cumulative dividend was eliminated by it.

A  Cumulative Dividend is not eliminated short of bankruptcy, and there is still an obligation to pay it under the circumstances outlined in the prospectus.  Generally, I would expect to be paid deferred dividends when and if the company starts paying a common dividend again. A cumulative dividend can be deferred provided there is no activation of the stopper provision such as a dividend payment on common stock. The stopper provision in SHOPRD can be found at page S-18. However, the deferral of a preferred dividend would indicate significant financial distress, and it is certainly possible that it will never be paid since the firm will simply not survive.   

While equity preferred stocks are part of a firm's equity, the owners of those securities will generally have no equity interest in the business. In the event of a leveraged buyout or merger, the common shareholders would receive the benefit, while the preferred shareholders would be left hanging. (This is not the case with SHOPD as explained below.) This scenario has happened in the past, as a private equity firm took a REIT private in a leveraged buyout, the owners of the common received a nice premium, and the owners of the preferred stock were left with a security that later become worthless when the REIT declared bankruptcy, burdened by the debt imposed on it by the private equity firm.  Those firms specialize in loading up viable businesses with excessive debt in a going private transaction, thereby rendering dicey the survival of the firm, and serve no useful function in society.

The prospectus for SHOPRD contains an unusual provision allowing the owners of the preferred stock to convert into common shares upon a "change in control". (see pages S-9/S-10). I would like to see that provision in all REIT preferred stock prospectuses. I do not recall seeing a similar provision in another REIT preferred stock prospectus.  Please note that SHOPRA does not have that conversion right which would make it less desirable than SHOPRD when both securities have the same current yield. (see page 8 of SHOPRA Prospectus

Sunstone has a ton lot of secured debt, as shown at page 13 of its Form 10-Q for the Q/E 3/2011.  www.sec.gov  That debt consists of mortgages on its hotels.  There is also some unsecured senior debt.  All of that debt has priority over the equity preferred stock.  In the event of a bankruptcy, I would expect the preferred stock to be worthless, or very close to it.

Sunstone Hotel Investors Inc. 8.00% Cum. Redeem. Pfd. Series D closed at $24.24 last Friday.

3. Bought Back 300 of the bond CEF WIW at 12.47 (see Disclaimer):  This purchase was a knee-jerk reaction by the Old Geezer to the dismal jobs report.  I have bought and sold this bond CEF several times along with the similar CEF IMF, realizing small gains. I treat them as functionally equivalent investments. Both invest mostly in U.S. government inflation protected bonds:


                                      
                                                   WIW 2010 +266.07


                                      
                                                   WIW 2011 +117.43


IMF 2010 +215.77
IMF 2011 +146.82

Total=$746.09. That number encourages me to dip my toe back into the well. Sooner or later, I will try this trade one too many times.

As previously mentioned, there is nothing attractive to me about the yields on treasury bonds.  The coupon yield on TIPs is of course worse than the non-inflation protected treasuries with similar maturities.  The TIPs do have the advantage of the inflation protection component, as the principal amount is adjusted for increases (and decreases) in the CPI.

WIW does have a few advantages over a TIP mutual fund, such as the one from Vanguard that I recently sold.   As of last Thursday, the fund closed with a net asset value of $13.74 per share. Based on a market price then of $12.45 per share, this created a discount to net asset value of -9.39%.  The daily net asset values can be found at a number of places, including the sponsor's web page for WIW and at the Closed-End Fund Association. The mutual fund will sell shares at net asset value. By buying at a discount, particularly at one approaching 10%, I will receive a higher yield compared to buying at net asset value. The principal is involved when buying a bond at a discount to par value.

The current monthly distribution rate is .03350 per share which has been reduced a couple of times since 11/15/2010 when it was 4 cents. WIW - Historical Distributions Neither amount is much, but it is still a better current yield than I could receive by buying TIPs in the bond market today. (see the current yield data at WSJ.com)

I am not a long term holder of any bond fund purchased now. I am content to move in and out of them, make a few bucks, and collect the distributions.  The bond market has been in a secular bull move since 1982.  I do not want to be caught owning many bond funds when that worm turns, and it will.

As shown at the sponsor's Portfolio page, 90.31% of the assets are rated AAA.  Assuming the U.S. does not default soon, I suspect the credit rating agencies will keep that AAA rating for U.S. government debt for at least a few more years.

This is a link to the last shareholder report filed with the SEC: www.sec.gov

The last filed Form N-Q shows the fund's holdings as of 3/31/2011.

WIW closed Friday at $12.48. The net asset value as of 7/8/2011 was $13.81 per share creating a discount of -9.63. IMF closed last Friday with a discount to its net asset value of -7.18.

Advantages and Disadvantages of Treasury Inflation Protected Securities
Treasury Inflation Protected Securities as a Non-Correlated Asset

I will discuss the remaining trade from last Friday in the next post. 

No comments:

Post a Comment