The stock market continues to believe that the politicians will soon work out their differences sufficiently to reopen the government and to avoid a debt default. The market odds of a deal early this week are at 100%. The default risk is currently being given a zero percent chance and would be a black swan type event based on expectations currently built into stock prices.
The potential agreement is taking shape in the Senate and appears to be another can kick.
Whatever agreement emerges from the Senate, there is no guarantee that it will pass the House. I would assume that the Speaker would at least permit a vote on a plan that passes with bipartisan support in the Senate.
The debt limit will probably be increased longer than a CR for the budget. Hopefully, nothing will expire during the Christmas shopping season.
Big Picture Synopsis
The potential agreement is taking shape in the Senate and appears to be another can kick.
Whatever agreement emerges from the Senate, there is no guarantee that it will pass the House. I would assume that the Speaker would at least permit a vote on a plan that passes with bipartisan support in the Senate.
The debt limit will probably be increased longer than a CR for the budget. Hopefully, nothing will expire during the Christmas shopping season.
Stocks:
Stable Vix Pattern
Stocks, Bonds & Politics: Vix Asset Allocation Model Explained Simply
Stocks, Bonds & Politics: Mark Hulbert and the Use of the VIX as a Timing Model
Short Term: Expecting a 10%+ Correction
Intermediate and Long Term: Bullish
Since 9/30/13, I have reduced my stock allocation by slightly over $20,000 (3/4th of that number since 10/1/13). That stock money will be on vacation for awhile.
My main taxable account is slightly over 20% in cash. I would have boosted my cash allocation higher but the .01% yield on MM funds, part of the Fed's Jihad Against the Saving Class, acts as a restraint. I went over 30% in 2007 when the MM rates were over 4%.
I was concerned about stocks even before the latest manifestation of politician infestation.
Some of the recent sluggish data, compiled before the shutdown started, is summarized by Bob Johnson of Morningstar.
Bonds:
Short Term Bullish: Based on Sluggish Economic Reports/Economic Drag Caused by Politicians
Intermediate and Long Term: Slightly Bearish Based on Interest Rate Normalization: The Difficult Path to Interest Rate Normalization
The slightly bearish intermediate and long term outlook is based solely on interest rate normalization and assumes a 2%-2.25% average annual inflation rate over the next 10 years.
*********
Recent Developments:
China's exports unexpectedly dropped in September. Bloomberg The consensus estimate was for a 5.5% gain.
An editorial in China's state run news agency stated that it is perhaps time to build a de-Americanized world given the high level of U.S. political dysfunction.
**************
Note: After paring my stock allocation by selling some low yielding stock ETFs, and the stock CEF discussed in #1 below, I replaced all or most of the lost dividend income from those securities with the purchases described below.
In this kind of allocation shift, I decreased my stock allocation, increased my cash allocation and kept my income generation about the same.
1 Sold 201+ MSF at $15.62 (see Disclaimer): The Morgan Stanley Emerging Markets Fund (MSF) is a stock ETF that invests in emerging market stocks:
As of 10/11/13, the date of my trade, the net asset value per share was $17.32, with a discount to net asset value of -10.16 based on a closing price per share of $15.56.
CEFConnect Page
Snapshot of Trade:
Snapshot of Profit: This snapshot does not include a fractional share that will be liquidated on the settlement date:
Snapshot of Prior Trade: I had two 100 share flips in 2010 that netted $403.14 in realized gains:
Total Realized Gain Subject to Minor Adjustment for Fractional Share: $512.78
Rationale: MSF was the last stock fund that I sold to reduce risk. As with the others, the position is relatively small and produces negligible income. For the past two to three years, it has been difficult making any return in emerging market funds.
Future Buys: I will come back to this one at a lower price, when and if I become more comfortable with risk assets than I am now.
2. Added 100 BANCL at $25.1 (see Disclaimer):
Snapshot of Trade:
Security Description: The Banc of California Inc. Senior Notes (BANCL) is a senior note that makes quarterly interest payments at a 7.5% fixed coupon rate on a $25 par value.
The bond will mature on 4/15/2020. The relatively short time to maturity reduces interest rate risk.
BANC may redeem the bond at par plus accrued interest on or after 5/15/2015. That optional call date will restrain the price rise over par value when and if interest rates start to fall again, thereby making it more likely that the security will be redeemed; provided it was in the interest of BANC to do so after taking into account the refinancing costs.
This bond is an Exchange Traded baby bond.
Prospectus
The issuer is the Banc of California, a holding company, that owns Pacific Trust Bank and The Private Bank of California. The bank has over $3B in assets and more than 60 banking locations including loan origination offices. BANC recently sold 8 branches to another bank. Pacific Trust Bank Completes Sale of Branches
The bank changed its name from First Pactruct Bancorp to Banc of California last July. SEC Filing July 2013
This note went ex interest shortly before this last purchase: Banc of California, Inc. Announces Quarterly Senior Debt Interest Payment
Form 10-K-2012 Annual Report
SEC Filed Investor Presentation July 2013
Banc of California (BANC) Profile Page at Reuters
Banc of California Key Developments Page at Reuters
BANC Key Statistics Page at YF
Branch Map
The current consensus E.P.S. estimate is $1.58 for 2013 and $1.49 for 2014. BANC Analyst Estimates
Prior Trade: Item # 6 Bought Roth IRA: 50 BANCL at $25.20 (December 2012)
Related Trades:
Item # 2 Bought 50 BANCP at $25.19 (equity preferred stock)
Bought 50 BANC at $11.3 February 2013 (common stock-regional bank basket)
Recent Earnings Report: QE 6/30/13
SEC Filed Press Release
Form 10-Q
Net Income: $4.363M
E.P.S. $.36
Net Interest Margin: 3.93%
Efficiency Ratio: 83.01% (needs to come down)
ROA: .76% (prefer over 1%)
ROE: 8.58% (prefer over 10%)
Texas Ratio: 12%
The capital ratios remain good:
Rationale: (1) This add is solely about replacing the income lost due to my stock allocation reduction. I do not have to spend much capital to replace the income generated by those low yielding stock funds.
Interest payments are made quarterly.
My current yield will be slightly less than the 7.5% coupon.
Risks: (1) At the moment, I view interest rate risk to be slightly more important than credit risk. I am not currently concerned about interest rate risk given the 2020 maturity date and the anticipated longevity of the FED's current monetary policies. ZIRP could continue to last well into 2015 and that abnormal monetary policy acts as a yield restraint on shorter term bonds.
(2) Credit Risk: With another recession, credit and market risk become more important.
(3) Market Risk-The Risk of Lost Opportunity: By market risk, I am referring to the pricing of assets that can reach extremes during a downturn. Market risk also encompasses what I call the risk of lost opportunity.
The risk of lost opportunity is easy to understand. Say the world enters into another severe downturn next year, or soon thereafter, and BANCL falls quickly to $15 based on credit risk concerns. If I own 150 shares bought at near par and continue to own it, I lose the opportunity to use those funds tied up in BANC ($3,750+) to buy 250 shares at $15 that will provide me with more income:
Same Amount of Money
250 Shares Bought at $15 Annual Income: $468.75 per year
+ Profit a Maturity: $2,500
150 Shares Bought at $25 Par Value Annual Income: $281.25 per year
No Profit at Maturity
Fear takes over pricing decisions during bear markets. During the catastrophic bears cycles, where the market declines more than 45% over a relatively short period, the worst possible outcome is given a higher probability rating than warranted by the facts.
In those catastrophic kind of downturns, such as the recent Near Depression or 1974, fear becomes the dominant component of pricing decisions, with the general thrust being "it is bad, will soon get worse, and will never get any better". Stocks, Bonds & Politics: Common Valuation in Bear Markets: It is Bad and Will Never Get Better/Tribe on Impairment of Contracts/Alexander & Baldwin/Stock Rallies and Quantitative Easing (3/22/09)
In those kind of scenarios, the devastation will go beyond common stocks and will spill over into the pricing of securities higher up in the capital structure, including senior bonds. If the bond issuer survives the economic downturn, then eventually the price of the bond will start to recover.
Stocks, Bonds & Politics: Vix Asset Allocation Model Explained Simply
Stocks, Bonds & Politics: Mark Hulbert and the Use of the VIX as a Timing Model
Short Term: Expecting a 10%+ Correction
Intermediate and Long Term: Bullish
Since 9/30/13, I have reduced my stock allocation by slightly over $20,000 (3/4th of that number since 10/1/13). That stock money will be on vacation for awhile.
My main taxable account is slightly over 20% in cash. I would have boosted my cash allocation higher but the .01% yield on MM funds, part of the Fed's Jihad Against the Saving Class, acts as a restraint. I went over 30% in 2007 when the MM rates were over 4%.
I was concerned about stocks even before the latest manifestation of politician infestation.
Some of the recent sluggish data, compiled before the shutdown started, is summarized by Bob Johnson of Morningstar.
Bonds:
Short Term Bullish: Based on Sluggish Economic Reports/Economic Drag Caused by Politicians
Intermediate and Long Term: Slightly Bearish Based on Interest Rate Normalization: The Difficult Path to Interest Rate Normalization
The slightly bearish intermediate and long term outlook is based solely on interest rate normalization and assumes a 2%-2.25% average annual inflation rate over the next 10 years.
*********
Recent Developments:
China's exports unexpectedly dropped in September. Bloomberg The consensus estimate was for a 5.5% gain.
An editorial in China's state run news agency stated that it is perhaps time to build a de-Americanized world given the high level of U.S. political dysfunction.
**************
Note: After paring my stock allocation by selling some low yielding stock ETFs, and the stock CEF discussed in #1 below, I replaced all or most of the lost dividend income from those securities with the purchases described below.
In this kind of allocation shift, I decreased my stock allocation, increased my cash allocation and kept my income generation about the same.
1 Sold 201+ MSF at $15.62 (see Disclaimer): The Morgan Stanley Emerging Markets Fund (MSF) is a stock ETF that invests in emerging market stocks:
As of 10/11/13, the date of my trade, the net asset value per share was $17.32, with a discount to net asset value of -10.16 based on a closing price per share of $15.56.
CEFConnect Page
Snapshot of Trade:
Snapshot of Profit: This snapshot does not include a fractional share that will be liquidated on the settlement date:
 |
| 2013 MSF 201 Shares +$109.64 |
Snapshot of Prior Trade: I had two 100 share flips in 2010 that netted $403.14 in realized gains:
 |
| 2010 MSF +$403.14 |
Rationale: MSF was the last stock fund that I sold to reduce risk. As with the others, the position is relatively small and produces negligible income. For the past two to three years, it has been difficult making any return in emerging market funds.
Future Buys: I will come back to this one at a lower price, when and if I become more comfortable with risk assets than I am now.
2. Added 100 BANCL at $25.1 (see Disclaimer):
Snapshot of Trade:
Security Description: The Banc of California Inc. Senior Notes (BANCL) is a senior note that makes quarterly interest payments at a 7.5% fixed coupon rate on a $25 par value.
The bond will mature on 4/15/2020. The relatively short time to maturity reduces interest rate risk.
BANC may redeem the bond at par plus accrued interest on or after 5/15/2015. That optional call date will restrain the price rise over par value when and if interest rates start to fall again, thereby making it more likely that the security will be redeemed; provided it was in the interest of BANC to do so after taking into account the refinancing costs.
This bond is an Exchange Traded baby bond.
Prospectus
The issuer is the Banc of California, a holding company, that owns Pacific Trust Bank and The Private Bank of California. The bank has over $3B in assets and more than 60 banking locations including loan origination offices. BANC recently sold 8 branches to another bank. Pacific Trust Bank Completes Sale of Branches
The bank changed its name from First Pactruct Bancorp to Banc of California last July. SEC Filing July 2013
This note went ex interest shortly before this last purchase: Banc of California, Inc. Announces Quarterly Senior Debt Interest Payment
Form 10-K-2012 Annual Report
SEC Filed Investor Presentation July 2013
Banc of California (BANC) Profile Page at Reuters
Banc of California Key Developments Page at Reuters
BANC Key Statistics Page at YF
Branch Map
The current consensus E.P.S. estimate is $1.58 for 2013 and $1.49 for 2014. BANC Analyst Estimates
Prior Trade: Item # 6 Bought Roth IRA: 50 BANCL at $25.20 (December 2012)
Related Trades:
Item # 2 Bought 50 BANCP at $25.19 (equity preferred stock)
Bought 50 BANC at $11.3 February 2013 (common stock-regional bank basket)
Recent Earnings Report: QE 6/30/13
SEC Filed Press Release
Form 10-Q
Net Income: $4.363M
E.P.S. $.36
Net Interest Margin: 3.93%
Efficiency Ratio: 83.01% (needs to come down)
ROA: .76% (prefer over 1%)
ROE: 8.58% (prefer over 10%)
Texas Ratio: 12%
The capital ratios remain good:
Rationale: (1) This add is solely about replacing the income lost due to my stock allocation reduction. I do not have to spend much capital to replace the income generated by those low yielding stock funds.
Interest payments are made quarterly.
My current yield will be slightly less than the 7.5% coupon.
Risks: (1) At the moment, I view interest rate risk to be slightly more important than credit risk. I am not currently concerned about interest rate risk given the 2020 maturity date and the anticipated longevity of the FED's current monetary policies. ZIRP could continue to last well into 2015 and that abnormal monetary policy acts as a yield restraint on shorter term bonds.
(2) Credit Risk: With another recession, credit and market risk become more important.
(3) Market Risk-The Risk of Lost Opportunity: By market risk, I am referring to the pricing of assets that can reach extremes during a downturn. Market risk also encompasses what I call the risk of lost opportunity.
The risk of lost opportunity is easy to understand. Say the world enters into another severe downturn next year, or soon thereafter, and BANCL falls quickly to $15 based on credit risk concerns. If I own 150 shares bought at near par and continue to own it, I lose the opportunity to use those funds tied up in BANC ($3,750+) to buy 250 shares at $15 that will provide me with more income:
Same Amount of Money
250 Shares Bought at $15 Annual Income: $468.75 per year
+ Profit a Maturity: $2,500
150 Shares Bought at $25 Par Value Annual Income: $281.25 per year
No Profit at Maturity
Fear takes over pricing decisions during bear markets. During the catastrophic bears cycles, where the market declines more than 45% over a relatively short period, the worst possible outcome is given a higher probability rating than warranted by the facts.
In those catastrophic kind of downturns, such as the recent Near Depression or 1974, fear becomes the dominant component of pricing decisions, with the general thrust being "it is bad, will soon get worse, and will never get any better". Stocks, Bonds & Politics: Common Valuation in Bear Markets: It is Bad and Will Never Get Better/Tribe on Impairment of Contracts/Alexander & Baldwin/Stock Rallies and Quantitative Easing (3/22/09)
In those kind of scenarios, the devastation will go beyond common stocks and will spill over into the pricing of securities higher up in the capital structure, including senior bonds. If the bond issuer survives the economic downturn, then eventually the price of the bond will start to recover.
3. Bought 100 IGI at $19.28 (see Disclaimer): The Western Asset Investment Grade Defined Opportunity Trust (IGI)
Snapshot of Trade:
Security Description: The Western Asset Investment Grade Defined Opportunity Trust (IGI) is an unleveraged bond CEF that is weighted in investment grade bonds.
Dividends are paid monthly at the current rate of $.10 per share: Western Asset Investment Grade Defined Opportunity Trust Inc. (“IGI”) Announces Distributions for the Months of September, October and November 2013
Assuming a continuation of that dividend, the yield at a total cost of $19.28 would be about 6.22%.
The fund is scheduled to liquidate on or about 12/2/2024.
IGI Page at CEFConnect
Morningstar Page
SEC Filed Shareholder Report for the period ending 5/31/13
Data as of Date of Purchase 10/11/13
Closing Net Asset Value Per Share: $21.39
Market Price: $19.51
Discount: -8.79%
Discount at Purchase Price: -9.86%
Prior Trades/Rationale/Risks: I recently discussed these items: Bought Roth IRA: 100 IGI at $19.43 (9/7/13).
Total Realized Gains (snapshots in prior linked post): $462.07
I have nothing to add to that discussion.
4. Bought 200 JTP at $7.5258 (see Disclaimer):
Snapshot of Trade:
Security Description: Nuveen Quality Preferred Income Fund (JTP)
SEC Filed Shareholder Report for the Period Ending 7/31/13 (list of JTP holdings starts at page 17)
Current Monthly Dividend: $.052 per share: Nuveen Closed-End Funds Monthly Distributions
Dividend Yield: 8.29% (assuming continuation at that rate and total cost per share of $7.53)
Data as of Day of Purchase Friday 10/11/13:
Net Asset Value Per Share: $8.55
Market Price= $7.52
Discount= -12.05%
JTP Page at CEFConnect
Sponsor's Webpage: JTP - Nuveen Quality Preferred Income Fund (as of 9/30/12: holdings 203 effective leverage at 29.66%; annualized leverage cost 1.11%)
Credit Quality: The fund is weighted in investment grade rated bonds:
Prior Trades: None
Rationale: I am just trying to generate income in a retirement account. I decided to buy JTP in the regular IRA which gives me the option of realizing some benefit if the market price continues to sink. That benefit is realized by transferring a security to the Roth IRA when and if the price declines significantly and consequently paying less income tax for the conversion.
I started to transfer some assets out of the Regular IRA into the ROTH IRA in October 2008. In all cases, I was fortunate that the price more than recovered the lost market value after the conversion. A market meltdown, such as what happened after Lehman's failure, is an ideal time for a Roth conversion.
"Roth IRA Conversion: Look Before You Leap" Charles Schwab
"5 Roth IRA Rules You Need to Know" Motley Fool
Snapshot of Trade:
Security Description: The Western Asset Investment Grade Defined Opportunity Trust (IGI) is an unleveraged bond CEF that is weighted in investment grade bonds.
Dividends are paid monthly at the current rate of $.10 per share: Western Asset Investment Grade Defined Opportunity Trust Inc. (“IGI”) Announces Distributions for the Months of September, October and November 2013
Assuming a continuation of that dividend, the yield at a total cost of $19.28 would be about 6.22%.
The fund is scheduled to liquidate on or about 12/2/2024.
IGI Page at CEFConnect
Morningstar Page
SEC Filed Shareholder Report for the period ending 5/31/13
Data as of Date of Purchase 10/11/13
Closing Net Asset Value Per Share: $21.39
Market Price: $19.51
Discount: -8.79%
Discount at Purchase Price: -9.86%
Prior Trades/Rationale/Risks: I recently discussed these items: Bought Roth IRA: 100 IGI at $19.43 (9/7/13).
Total Realized Gains (snapshots in prior linked post): $462.07
I have nothing to add to that discussion.
4. Bought 200 JTP at $7.5258 (see Disclaimer):
Snapshot of Trade:
Security Description: Nuveen Quality Preferred Income Fund (JTP)
SEC Filed Shareholder Report for the Period Ending 7/31/13 (list of JTP holdings starts at page 17)
Current Monthly Dividend: $.052 per share: Nuveen Closed-End Funds Monthly Distributions
Dividend Yield: 8.29% (assuming continuation at that rate and total cost per share of $7.53)
Data as of Day of Purchase Friday 10/11/13:
Net Asset Value Per Share: $8.55
Market Price= $7.52
Discount= -12.05%
JTP Page at CEFConnect
Sponsor's Webpage: JTP - Nuveen Quality Preferred Income Fund (as of 9/30/12: holdings 203 effective leverage at 29.66%; annualized leverage cost 1.11%)
Credit Quality: The fund is weighted in investment grade rated bonds:
Prior Trades: None
Rationale: I am just trying to generate income in a retirement account. I decided to buy JTP in the regular IRA which gives me the option of realizing some benefit if the market price continues to sink. That benefit is realized by transferring a security to the Roth IRA when and if the price declines significantly and consequently paying less income tax for the conversion.
I started to transfer some assets out of the Regular IRA into the ROTH IRA in October 2008. In all cases, I was fortunate that the price more than recovered the lost market value after the conversion. A market meltdown, such as what happened after Lehman's failure, is an ideal time for a Roth conversion.
"Roth IRA Conversion: Look Before You Leap" Charles Schwab
"5 Roth IRA Rules You Need to Know" Motley Fool
IRS Form 8606.pdf
I do not pay the conversion tax out of IRA funds. I will only convert securities that have fallen significantly in value. I have a long term time horizon for the ROTH IRA and will probably never need any of those funds.
Risks: (1) Interest Rate and Credit Risk: One only need to look at the maturity range to see the interest rate risk:
Credit risk is less important due to the quality of bonds and the fund's diversification with over 200 holdings.
(2) CEF Risk: There are many risks unique to the CEF form of ownership. The most important risk is that the market price is not the same as the net asset value per share.
The market price for a CEF is determined by buyers and sellers, mostly individual investors, who will frequently make irrational pricing decisions. The market price of a CEF may be driven to large premiums to net asset value per share or large discounts.
The market price and net asset value per share information for leveraged bond CEFs over the past few months highlight this CEF risk. The percentage decline in market price has fallen by significantly more than the percentage decline in net asset value, adjusting for the payment of dividends. The result is that the discount to net asset value has expanded since early May. The widening of that discount adds to an investor's unrealized losses.
(3) Leverage Risk: Leverage works both ways. Buying more assets with borrowed money works when the values of those assets go up. The net interest spread adds to the total return, particularly when the cost of short term borrowings is so low.
Fortunately investors in leverage CEF bond funds, short term borrowing costs have remained abnormally low since the FED adopted ZIRP late in 2008. That abnormal monetary policy will end. When the FED starts its tightening cycle by raising the Federal Funds rate, the net interest rate spread between short term borrowing cost and bond yields will shrink and could even disappear over time for treasuries and high investment grade corporates. It would not take much of a rise in the federal funds rate to wipe out the spread altogether for a ten year treasury bought with a 2.6% yield, for example.
I also anticipate that the pricing of leverage bond CEFs may take that spread narrowing into account even before it starts. That would be done by increasing the discount to net asset value in anticipation of lower dividend income, due to net spread shrinkage, and the then anticipated decline in bond prices caused by interest rate normalization and possibly an increase in inflation expectations. The expected decline in bond prices would depend on a number of factors, including interest rate normalization, future inflation expectations, and the market's response to the pace of tightening.
Future Buy and Sells: For the 200 shares, I would transfer them to the Roth IRA after a 10%+ decline. I would consider selling them to harvest a 10%+ total return.
I do not pay the conversion tax out of IRA funds. I will only convert securities that have fallen significantly in value. I have a long term time horizon for the ROTH IRA and will probably never need any of those funds.
Risks: (1) Interest Rate and Credit Risk: One only need to look at the maturity range to see the interest rate risk:
Credit risk is less important due to the quality of bonds and the fund's diversification with over 200 holdings.
(2) CEF Risk: There are many risks unique to the CEF form of ownership. The most important risk is that the market price is not the same as the net asset value per share.
The market price for a CEF is determined by buyers and sellers, mostly individual investors, who will frequently make irrational pricing decisions. The market price of a CEF may be driven to large premiums to net asset value per share or large discounts.
The market price and net asset value per share information for leveraged bond CEFs over the past few months highlight this CEF risk. The percentage decline in market price has fallen by significantly more than the percentage decline in net asset value, adjusting for the payment of dividends. The result is that the discount to net asset value has expanded since early May. The widening of that discount adds to an investor's unrealized losses.
(3) Leverage Risk: Leverage works both ways. Buying more assets with borrowed money works when the values of those assets go up. The net interest spread adds to the total return, particularly when the cost of short term borrowings is so low.
Fortunately investors in leverage CEF bond funds, short term borrowing costs have remained abnormally low since the FED adopted ZIRP late in 2008. That abnormal monetary policy will end. When the FED starts its tightening cycle by raising the Federal Funds rate, the net interest rate spread between short term borrowing cost and bond yields will shrink and could even disappear over time for treasuries and high investment grade corporates. It would not take much of a rise in the federal funds rate to wipe out the spread altogether for a ten year treasury bought with a 2.6% yield, for example.
I also anticipate that the pricing of leverage bond CEFs may take that spread narrowing into account even before it starts. That would be done by increasing the discount to net asset value in anticipation of lower dividend income, due to net spread shrinkage, and the then anticipated decline in bond prices caused by interest rate normalization and possibly an increase in inflation expectations. The expected decline in bond prices would depend on a number of factors, including interest rate normalization, future inflation expectations, and the market's response to the pace of tightening.
Future Buy and Sells: For the 200 shares, I would transfer them to the Roth IRA after a 10%+ decline. I would consider selling them to harvest a 10%+ total return.
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