Wednesday, May 30, 2012

Exchange Traded Bonds: New Gateway Post

This post is an update of a 2009 Post on the same subject:  Exchange Traded Bonds

Exchange traded bonds are simply bonds traded on a stock exchange and consequently may be purchased or sold in the same manner as a stock. 

Most exchange traded bonds have $25 par values. The relatively low par value, coupled with the ability to trade them like stocks, make them more desirable to many individual investors, compared to $1,000 par value bonds traded in the frequently inhospitable bond market, where I am also an active participant primarily in the junk bond category. 

Exchange traded bonds will trade "flat", which simply means that the buyer does not have to pay accrued interest to the seller. The investor who owns the exchange traded bond on the ex interest date will receive the entire interest payment. As with common stocks, the price on the ex distribution date will be adjusted by the amount of the distribution. 

Exchange traded bonds come in a variety of legal forms. The most easily understood is the "baby bond". Bonds traded in the bond market will have $1,000 par values, whereas most baby bonds have $25 par values. 

The other categories of exchange traded bonds are Trust Certificates, Trust Preferred securities, synthetic floaters, European hybrids, and "principal protected" unsecured senior notes. Detailed discussions on those types of exchange traded bonds can be found in the following posts:

For European hybrids, I have focused solely on those issued by ING and Aegon.

Any investor desiring to purchase one of these securities needs to review the prospectus. 

Due to the long term secular bull market in bonds, attenuated and given longevity by the current Federal Reserve Board's zero percent federal funds policy, I no longer find most exchange traded bonds attractive.

For customers of Fidelity, there are entire categories of exchange traded bonds that are off limits to you. Currently, and for no legitimate reason, Fidelity customers are not allowed to buy exchange traded "principal protected" notes, synthetic floaters, and some other securities like the Aegon hybrid AEB and the fixed coupon TC JBK which started out as a synthetic floater but become a fixed coupon TC after the swap agreement with Lehman was terminated due to that firm's bankruptcy Fidelity Prohibits New Purchases of SIPsFidelity Brokerage Interference with Customer Trading Opportunities;  Fidelity Brokerage Extends Denial of Trading Opportunities to Synthetic Floaters and Even an Exchange Traded Junior Bond DFP. I am not aware of any other brokerage firm that interferes with its customers in a similar way.

Most exchange traded bonds are lightly traded, frequently with large bid-ask spreads, so limit orders need to be used.  If I am willing to accept the ask price, I will still enter a limit  order at that price, rather than a market order. 

1. Trust Certificates (TC): A Trust Certificate represents an undivided beneficial interest in a bond owned by a Grantor Trust. The Trust is administered by an independent trustee, charged with the responsibility of collecting interest payments paid by the bonds owned by the trust and then distributing those funds to the owners of the Trust Certificates. 

The TC will have the same maturity as the underlying bonds. The TC's par value will generally be $25, though there are exceptions. 

The Grantor Trust is formed by a brokerage company who buys the bonds in the secondary market. The trust buys the bonds from the brokerage company with the IPO proceeds from the sale of TCs. Since the bonds are purchased in the secondary market, their price may be at a premium or discount to their par values when originally purchased. That fact may result in the TC having a higher or lower coupon than the underlying bonds owned by the trust. 

Most of the underlying bonds in Trust Certificates have Make Whole Provisions that render a redemption by the issuer less likely. 

However, when the trust is formed, the brokerage company will attach a call warrant to the TC which gives the call warrant owner the right to redeem the TC at par value plus accrued interest in most cases. The existence of that right will restrain the appreciation of the TC. There is no duty to ever exercise that warrant. Call Warrants and Trust CertificatesMore on the Call Warrant in TCsCall Warrant Exercised on JZE and JZJCall Warrant Exercise for XFJCall Warrant Exercised on MJT and MJVKVW Called by Owner of Call WarrantDKK-Called by Owner of Call WarrantKRH-Exercise of Call WarrantVerizon TC XFL: Called by Owner of Call Warrant; Notice Filed for Redemption of Trust Certificate DKF.

I have lost a significant number of TCs to redemptions, not by the bond issuer, but by the owner of this call warrant.   

For example, I own a TC JZJ which has as its underlying security a 2031 senior bond issued by AT & T.  That bond is currently trading in the bond market at over a 40% premium to its par value. FINRA That bond contains a make whole provision which renders it less likely to be called by AT & T. The TC JZJ, on the other hand, trades at less than a 4% premium to its $25 par value. The presence of the call warrant attached to JZJ will restrain its upward price movement. In fact, JZJ has already been subject to a partial call at $25 plus accrued interest. Proceeds Received from Full Call of JZE and Partial Call of JZJ The owner of that warrant could take possession of the AT & T bonds owned by the trust after issuing a notice and delivering to the trustee the $25 par value, plus accrued interest, for each TC redeemed, and then sell the bonds for a no risk profit.

In short, the existence of a call warrant is a major disadvantage to this particular type of exchange traded bond, particularly in a period where long term interest rates are in a secular decline and the bonds have make whole provisions. 

Some TCs do not have a call warrant attached to them. I own one of them, KTN, which contains a junior bond issued by AON. TRUST CERTIFICATE AON BOND KTN ORDER FILLED 100 shares at $13.1 October 2008KTN add at less than $14 November 2008. KTN has a 8.205% coupon on a $25 par value,, and is currently selling at over $28 per TC. Structured Products Corp. 8.205% Credit-Enhanced CorTS  (KTN)

I have owned other TCs containing the same AON bond as the underlying security and most of them have been called by their respective call warrant owners. The exception is MS Structured Asset Corp. SATURN Aon Capital Security Backed Series 2005-2 6.875% Deb. Cl A Call Un (HJO), which I own in the Roth IRA.

Snapshots of my realized gains and losses from trading Trust Certificates can be found at the end of Trust Certificates: New Gateway Post (September 2011 Post)

In my original gateway post on TRUST Certificates, published in 2009, I noted then the favorable pricing of these securities in 2008, particularly after Lehman's collapse, when it was possible to buy these securities at a 3% to 5% yield advantage compared to the underlying security. Those days are long gone. Some TCs now trade at less of a yield than the underlying bond, so it would be more advantageous to buy the underlying bond in the bond market rather than the TC. I may have played some role in popularizing this type of security.

Virtually all TCs were created before 2005.


2. Synthetic Floaters: This type of exchange traded bond is attractively priced in many cases due to what I call the Federal Reserve's Jihad Against the Saving Class, likely to last well into 2014 and possibly longer. As a result of that monetary policy, short term rates are abnormally low at the present time. The float provisions of synthetic floaters will generally be a spread over the 3 month LIBOR or treasury bill rate, though some use other rates. The three month treasury bill rate is now hugging zero so offering a .75% or .85% spread over zero is not particularly attractive. Consequently, the prices of many synthetic floaters can be bought now at significant discounts to their par values.

Synthetic Floater is in the Trust Certificate legal form of ownership. So, before the investor can understood this complicated security, it is first imperative to understand the TC.

The synthetic floater adds levels of complexity to the TC. A brokerage company will buy fixed coupon bonds in the secondary market and transfer ownership to the Grantor Trust. When that trust is formed, the trust and the brokerage company also execute a swap agreement, where the trustee will "swap" the interest paid by the bonds for the amount due the owners of the TC.

As an example, I recently bought the synthetic floater GYB. Added 50 of the Synthetic Floater GYB at $16.5-Roth IRA That TC contains a 6.345% fixed coupon Goldman Sachs trust preferred security maturing in 2034. The trustee receives the interest paid by GS and then transfers those funds to UBS who in turn pays the trustee the amount owed by the owners of GYB.

Those owners are entitled to receive the greater of 3.25% or .85% above the 3 month LIBOR rate on a $25 par value, up to a maximum interest rate of 8.25%. Since I bought this security at a discount to par value, this will juice my overall current yield and yield to maturity. The minimum current yield at a total cost of $16.5 would be about 4.92% and the maximum yield would be approximately 12.5%. Assuming GS survives to pay off the underlying bond in 2034, the purchaser of GYB at a total cost of $16.5 would receive the additional yield representing the difference between that cost and $25.

The owner of GYB bears the credit risk associated with the underlying GS TP. If GS went bankrupt, that TP would likely become worthless, or close to it. I would lose most or all of my investment in that eventuality, but UBS would lose only the right to earn that spread between what GS pays the trustee and the amount paid by UBS in the swap transaction.

Another type of synthetic floater has no minimum coupon but simply pays a spread over another rate. For example, I own GJR in my Roth IRA, a trust certificate containing a senior Proctor & Gamble bond maturing in 2034. That TC pays a .7% spread over the 3 month T Bill on a $25 par value, with a cap of 7.5%.

The price of many synthetic floaters are depressed for several reasons. One reason is that the float coupon provision is not likely to become the applicable rate anytime soon, where the security offers a minimum coupon, so the owners of these securities are stuck with the minimum amount payable by the synthetic floaters. And for those synthetic floaters without a minimum coupon, the current coupon rate will be even lower due to the absence of a minimum level.

Their attractiveness would obviously improve with short rates near or above normal or average rates, assuming no adverse change in the credit risk.

The basic terms of the exchange traded synthetic floaters can be bound at two of my posts:  Synthetic Floaters and Floaters: Links in One Post.

3. Trust Preferred: Like trust certificates, the Trust Preferred (TP) security represents an undivided beneficial interest in a bond owned by a trust. Invariably, that bond will be a junior bond and the lowest in priority debt security issued by a company, usually a bank holding company. There are some TPs originating from utilities and other non-bank companies.

Generally speaking, a company will form a Delaware Trust. That trust will then sell trust preferred securities to the public and will use the proceeds to buy a junior bond issued by the company. The TP will represent a beneficial interest in that bond. The terms of the TP and the junior bond will be the same. Both will mature on the same day and will have the same coupon and material provisions. Sometimes, the TP will become the underlying security in a TC and then there can be major changes in material provisions between the TP and the TC. (see, e.g. GYB discussed above which is a TC containing a GS TP).

The issuer of the underlying junior bond will generally have the right to defer interest payments, typically for up to 5 years, provided there is no activation of the "stopper" clause.  A stopper clause can be activated in a variety of ways. The main protection for the TP owner is the payment of a distribution on a junior security, which would include all equity securities such as common stock and traditional or equity preferred stock.

If there is a lawful deferral of the interest payment, interest will generally accrue on the deferred amount at the coupon rate. Interest payments are cumulative and remain obligations unless discharged in bankruptcy.  

It is important to keep in mind, when addressing priority and other issues, that the TP is in effect a junior bond, senior in priority to all equity securities. For bank holding companies that have their bank operating company seized by the FDIC, however, I would anticipate that owners of either the equity securities or the TP would receive nothing in most cases, though it is conceivable that the bank operating company would have other assets sufficient to pay the TP owners something, Regular Preferred and Trust Preferred. I certainly would not count on anything as a TP owner after such a failure. Anyone who owns a TP originating from a failed financial company can visit their money in money heaven.

The low priority can explain why many TPs issued by large financial institutions sank into the single digits during the Near Depression period. For example, I bought a Wells Fargo TP, JWK, at $9.15 (March 2009), later sold at 25.06. I had another large percentage gain in a BAC TP that was the underlying security in the TC MJH: Buy of 50 MJH at $7.51 March 2009-Sold 50 MJH at 23.6 June 2010.

For banks that survived the Near Depression, most of them never deferred interest payments including the hapless Citigroup and Bank of America. I doubt that the owners of junior securities will be so fortunate again, in the event banks need to grovel to Uncle Sam for taxpayer funds to bail them out from the wreckage caused by their Masters of Disaster.

The priority issue is also relevant to those financial companies that issued equity preferred stock to the U.S. government under the TARP program, see generally discussion at Item # 7  Bought 50 ZBPRB in Roth at $19.9.

Before a recent important change in the law, banks issued TPs since those securities could be treated as equity capital provided certain conditions were met. Item # 8 Stocks, Bonds & Politics/ Added 50 of ABWPRA

A bank can not deduct dividend distributions made by its equity securities, including its traditional equity preferred stock. The interest paid by the underlying bond in a TP would be deductible however. Thus, in essence, the bank could receive the tax benefit of a bond while treating the bond as equity which could be included to meet its Tier 1 capital regulatory requirements. A recent law change will phase out the use of these bonds as TIER 1 equity capital for financial institutions with more than 15 billion in assets as of 12/31/2009  {Trust Preferred Securities & Financial Reform; and see citations in Item # 2  Bought 50 SUSPRA at $25.25 ROTH IRA} Some large banks have started to redeem their TPs due to that law change.

For banks with less than $15 billion in assets as of 12/31/2009, and SUSQ may be the closest to that limit without going over among banks with TPs outstanding, TPs issued before 5/19/2010 can still be counted as TIER 1 capital, but no new issues.

Unless there is a change in the law, the TPs issued by bank holding companies will gradually become extinct as older issues are redeemed or mature.

As of 5/30/2012, I own four TPs in the Roth IRA, where interest payments are sheltered from taxation. Except for SUSPRA, all of these positions are subject to being called now. SUSPRA may be called on or after 12/12/12, which is certainly a possibility given its high coupon rate. All of my TP positions are small, reflecting their disfavored status, and include the following:

50 Shares of KRBPRE: (added 8/3/12: This security has been called, see subsequent post- Redemption Proceeds Received BAC Trust Preferred Securities)
Quote: MBNA Capital E 8.10% TOPrS Series E
Prospectus (now a BAC obligation)
Coupon: 8.1% on a $25 Par Value
Maturity: 2/15/33

80 Shares of SUSPRA
Quote: Susquehanna Capital I 9.375% Cap Secs. Series I, SUS.PA
Coupon: 9.375% on a $25 Par Value until 12/12/37, then 3 month LIBOR +5.455%
Maturity: Initially 12/12/57, but may be  extended under certain circumstances to 12/12/67, 12/12/77 or 12/12/87
This security has been called for 9/18/12: SUSQ Redemption of TPs 

200 Shares of STLPRA
Quote: Sterling Bancorp Trust I 8.375% Cum. Trust Pfd. Secs., STL.PA
Coupon: 8.375% on a $10 par value
Maturity: 3/31/2032
Sold 200 STLPRA at $10.5-ROTH IRA (8/17/2012 Post)
This security has been called by the issuer. 

50 Shares of FPCPRA (currently a PGN obligation)
Quote: FPC Capital I 7.10% Cum. QUIPS Series A, FPC.PA
Coupon: 7.1% on a $25 Par Value
Maturity: 5/15/2039
This security was been called in February 2013. 

4. European Hybrids: I have limited myself to buying hybrids issued by Aegon and ING, since I am familiar with both of those European companies. Other than Santander, I have very limited knowledge about other European financial institutions. I own an equity preferred floater, STDPRB, which is my exposure to Santander.

I give a detailed explanation of European hybrids when discussing those issued by Aegon. Aegon Hybrids: Gateway Post These hybrid securities are volatile. During the Near Depression period, I was able to buy them in the low single digits.

A hybrid is simply a security that has characteristics of both a bond and an equity security. The Aegon and ING hybrids are junior bonds, ranked lower in priority than any other debt security. They are senior to common stock and traditional equity preferred stock. For regulatory purposes, those securities are treated as equity capital, similar in that respect to the U.S. Trust Preferred stocks. Unlike distributions from TPs, which are classified as interest, the AEG and ING hybrids pay qualified dividends. Those European hybrids have no maturity date, which makes them more like common stock, than the U.S. TPs.

While AEG and ING hybrids did not defer dividends during the Near Depression, and both companies received state aid, the EU has made it clear that the hybrid owners will have to suffer in the event a financial institution receives state aid in the future. {page 8 at (26)  ec.europa.pdf} In the event that happens again,  a deferral of hybrid dividends will likely be a precondition to the receipt of state aid. The only way to avoid it, and this would be only temporary, would be the prior activation of a Mandatory Payment clause which in many cases would require 4 quarterly payments after the Mandatory Payment Event.

5. Principal Protected Senior Unsecured Notes: Many investors are confused by the meaning of "principal protected" in this context. For those who unfortunately owned these notes issued by Lehman, they soon found out the hard way that principal protected is limited in scope. Once the firm declares bankruptcy, the owners of a principal protected note are in the same position as any unsecured debt owner of the bankrupt firm. In short, you would be screwed which is hopefully not too difficult to understand.

I am not familiar with most exchange traded principal protected notes. A list can be found at QuantumOnline (free site, registration required). Generally, these notes have $10 par values, represent unsecured senior obligations, and have relatively short maturities. Their importance is due to their potential return, based on the performance of an index or the price of commodity like gold.

Many of them do not pay a minimum coupon or any distribution at all until the note matures. While I have owned some of those, I have focused on notes that pay the greater of a minimum coupon or some percentage based on the performance of a stock index or the price of gold. All of those notes were issued by Citigroup Funding and are guaranteed by Citigroup as provided in the prospectus. Those Citigroup Funding unsecured notes mature in 2014 at a $10 par value and have minimum annual coupons. I have received substantially more than the minimum coupon on several occasions which is why I own some of them. For example, MKN paid me a 18% in the first year of my ownership and over 25% the year after. However, the last payment was the 3% minimum coupon.  MKN Ends Its Annual Period With Minimum Coupon Payment Another one, MOU, paid out a 27.93% coupon. MOU Ends Second Annual Coupon Period With a 27.93% Gain Since I am satisfied barely with the minimum coupon, given the maturity date and the low interest rate environment, I view anything above that rate as a bonus.

Links to some of the discussions of Citigroup Funding Exchange Traded Senior Unsecured  Notes: Bought 100 MKN at 9.85Bought 100 MKZ at 9.91 in the Roth IRA100 MKZ bought at 9.96Bought 100 MYP at $10.12Bought 100 MHC at 9.8Bought 100 MOU at $10.12Bought 100 MBC at 9.84Bought 100 MBC at 9.78Bought 100 MKN at 9.85 January 2010Bought 200 MOL at 9.95Sold 100 MOL @ 10.3Bought 100 MTY at $10.03Bought 100 MTY at 10.49. MTY and MOL are linked to gold prices while the others are linked to indexes including both commodity and stock indexes.

For non-Citigroup Funding "principal protected" notes, I currently own 100 shares of a senior unsecured note issued by Bank of America that matures in 2015. This note will make only an interest payment when it matures which will be tied to the performance of the DJIA. Bought 100 SDA at $9.8-ROTH IRA. Attention needs to be paid to tax issues, explained in the prospectus, which may determine whether the security needs to be purchased in a retirement account.

My most recent sell was 100 shares of IFO, which matures later this year. Sold 100 IFO at $11.22-Bought 100 IFO at $9.35.

Any investor wishing to buy one of these notes needs to spend time reading the prospectus until it is understood. A major provision is what I call the Maximum Level Violation and the resulting reversion to the minimum coupon.

6. Baby Bonds: While most of the opportunities in 2008-2009 were in the categories mentioned above, baby bonds will likely become the dominant category for the future, particularly as TCs and TPs mature or are redeemed.  There will most likely not be any new TPs. The supply of TCs are not being replenished and many of them have already been redeemed by the call warrant owners as discussed above. There are also limited issuances of new principal protected notes and many of those outstanding will soon mature. The synthetic floaters are mostly still around, and present buying opportunities from time to time. If you were the swap counterparty, would you give up that risk free interest spread, even if you owned the call warrant too?

The new supply of exchange traded bonds is coming from baby bonds. Over the past year or so, however, many of them have been redeemed, as shown in notes made in my old Gateway Post on this subject: Exchange Traded Bonds

My only recent purchase of a baby bond was a recent issue by the Business Development Corporation Hercules Technology Growth Capital. Bought 100 HTGZ at $24.63Bought 100 HTGZ at $24.6-ROTH IRA. I am not thrilled with this bond's yield. However, since it matures in 2019, I do not face a lot of interest risk associated with the long bonds, and I was able to purchase this bond at below its $25 par value. The coupon is barely acceptable to me at 7%. Still, in the ROTH IRA, that yield in effect becomes tax free.

I have either sold most of my baby bonds or the bonds have been redeemed by the issuer. I did not want to lose several First Mortgage baby bonds, with $25 par values, issued by electric utility companies. Several of those type of bonds are still around but are selling way over par value and at unattractive current yields. (e.g. Entergy Texas Inc. 7.875% Series Mortgage Bonds 2039, EDT;  Entergy Louisiana LLC First Mortgage Bonds 6.00% Series 2040, ELBEntergy Mississippi Inc. 6.00% Series First Mortgage Bonds 2032, EMQ). These bonds will have call provisions.

Many of the baby bonds mature after 2040, which exposes the investor to a ton of interest rate risk. And, at least for the OG, holding such a long bond to maturity is not an option.

I noted in a recent post a number of newly issued baby bonds. New Exchange Traded Bonds Many of these bonds have maturity dates within ten years which is desirable for me. However, I am not interested in paying more than par value for them given their relatively low coupons compared to rates more normal for their risk profiles.

QuantumOnline has a good list of these baby bonds under the heading "exchange-traded debt securities". That list includes the European hybrids. By simply scrolling down that list, the investor can see that most of them have $25 par values which makes them more palatable to individual investors than $1,000 par value bonds. And, exchange traded bonds are easier to buy and sell in small lots than those $1,000 par value bonds in a mostly unfriendly bond market. Bond Market: Operated for the Benefit of Dealers and Not Really a Market 

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