Tuesday, December 9, 2014

Added 100 of the Bond CEF BTZ at $13.25-Roth IRA/Dumpster Diving: Added 50 PSEC at $8.32-Lowers Average Cost Per Share to $9.07

Big Picture: No Change

Stable Vix Pattern (Bullish):

Recent Developments:

The NFIB reported that small  business optimism increased in December to  98.1, just a "tick" below its long term average before the Near Depression.  


1. Added 100 BTZ in Roth IRA at $13.25 (see Disclaimer): 

Snapshot of Trade: 

Security Description: The BlackRock Credit Allocation Income Trust (BTZ) is a closed end leveraged bond fund that is weighted in investment grade bonds.

Data on Date of Trade: Monday (12/8/14):

Closing Net Asset Value Per Share: $15.21
Closing Market Price: $13.27
Discount: -12.75%
Average Discounts:
1 Year:  -12.48%
3 Year:  -10.62%
5 Years: -11.14%

The net asset value per share rose 1 cent while the market price declined 8 cents per share from the prior close. 

CEFConnect Page for BTZ

Sponsor's Website: Credit Allocation Income Trust-BTZ  

According to the sponsor, the effective duration was 5.99 years as of 11/28/14. 

A duration of 6 years provides the investor with a rule of thumb about the potential impact of interest rate changes on the bond fund's portfolio. A 1% rise in rates would likely cause a 6% decline in value, while a 2% rise in rates would generate close to a 12% decline in value. Conversely, a 1% decline in rates would result in about a a 6% increase in value, as more fully explained in the previous two links.  

When interest rates were rising last year, one of the worst bond ETFs to own, if not the worst, was the PIMCO 25 Year Zero Coupon U.S. Treasury ETF (ZROZ) The share price closed 2013 at $83, down from $113.31, as of 5/1/13, or a 26.75% decline. Long term zero coupon treasuries will have extremely long durations, and ZROZ has a 27.26 year duration as of 12/5/14.

BTZ is currently rated 5 stars by Morningstar.

BTZ was mentioned favorably in this recent Forbes article.

BTZ Interactive Stock Chart

BLACKROCK CREDIT ALLOCATION INCOME TRUST (SEC N-Q Filing: holdings as of 7/31/14/Cost Before Options Written: $2.15+B/Value 7/31/14=$2.364+B before options)

SEC Filings for BTZ

Credit Quality: The credit quality is weighted in investment grade bonds, primarily in the BBB category, but there is significant junk bond exposure:

Dividends: The fund is currently paying a monthly dividend of $.0805 per share. Distribution Dates and Amounts Announced for Certain BlackRock Closed-End Funds

Ex dividend date for the last distribution: Wednesday 12/10/14.

BTZ Dividend History

At a total cost of $13.25 per share, and assuming a continuation of the current monthly dividend per share which is in no way assured, the dividend yield would be about 7.29% with those assumptions.

Money will double in 9.85 years at 7.29%. Estimate Compound Interest

If I compounded interest monthly at 7.29%, starting with $1325 in principal, the future value after 10 years would be $2,740.68. Compound Interest Calculator | Investor.gov

Prior Trades: I have transitioned ownership of this bond CEF to the Roth IRA from a taxable account after selling my remaining shares held in a taxable account. This last add brings me up to 515+ shares owned in two Roth IRAs. This last purchase was made in another Roth IRA where I will not be reinvesting the dividends. The other 415+ are held in a Roth IRA where I am reinvesting the dividends. 

I was just using this fund to generate cash flow in a taxable account, and I successfully exited the position profitably. Item # 4 Sold 361+BTZ at $13.45-Taxable Account (10/21/14 Post)(profit snapshot=+116.91). Snapshots of earlier profits, totaling $413.8, can be found in Item # 3 Added 50 BTZ at $12.35 (8/31/13 Post)(discount then at -14.87%)

I also sold some higher cost shares held in the regular IRA earlier this year: Item # 8 Sold IRA: 210+BTZ at $13.62 (3/17/14 Post)

Rationale: Since this fund collects interest payments from its bond positions, the dividends paid to its shareholders take on that same non-favored tax status and would be taxed at my highest marginal rate when paid into a taxable account.

Dividends paid into my ROTH IRA are not taxable when paid or withdrawn under current law with a very limited exception that is not applicable to my situation. I in effect turn the BTZ taxable "interest" payments into tax free distributions in the Roth.

A tax free yield of 7.29% is hard to find these days. Just for comparison purposes, I looked at the current yield of a high yield municipal tax free bond ETF. SPDR Nuveen S&P High Yield Municipal Bond ETF (HYMB). As of 12/8/14, the sponsor lists the current yield as 4.52% (credit quality: 35.18% below BBB; 22.01% not rated; 23.06% BBB; 19.38% at A)

Risks: (1) CEF Prices are Determined by Frequently Irrational Investors: This risk is applicable to all CEFs. Irrationality can result in a CEF selling at a significant premium to net asset value or at an increasing discount even when the net asset value per share is going up.

Another common occurrence is that the percentage decline in the market price will be significantly greater than the percentage decline in net asset value per share. For some investors with strong stomachs, that kind of scenario can present a buying opportunity, while others would throw up their hands and sell their CEFs.

BTZ-Unadjusted for Dividend Payments
NAV Per Share 5/1/13: $15.75
Market Price: $14.39

NAV Per Share 12/31/13: $14.84
Market Price: $13.06

Decline Based on NAV Unadjusted: -5.778%
Declined Based on Market Price Unadjusted: -8.96%

The differential flows into an increase in the 12/31/13 discount to net asset value per share.

That differential was better than most.  For that May through December 2013 period, a general rule of thumb would be for the market price decline to be at least twice the percentage decline in NAV per share. It goes with the territory.  

(2) Rise in Interest Rates- Negative Impacts on Bond Prices and Borrowing Costs: When interest rates start to rise across the maturity spectrum, the leveraged bond CEF would be one of the worst investments to own. The fund's borrowing cost would be going up at a time when the bonds are going down in value. Most likely, the discount to net asset value would be widening in that scenario-The Infamous Triple Whammy!

The interest rate risk issue was highlighted with emphasis when the ten year treasury rose from a 1.66% to a 3.04% yield between 5/2/13 to 12/31/13. Daily Treasury Yield Curve Rates The decline in bond CEF markets prices was sufficient to offset well over one year of dividend payments.

A rise in short term rates, which may easily start to happen next year, will increase the borrowing costs for leveraged bond CEFs including BTZ.

Frequently, I hear arguments from bond fund sponsors that investors need not fret about interest rates going up. The bond managers can hold the bonds to maturity and then invest the proceeds into higher yielding instruments.

There are several major flaws in that argument in my opinion.

First, current bond fund net asset values include a very large number of bonds selling at premiums. Today, those bonds could be sold for a profit and many are being sold. Those profits have already started to diminish for junk bonds. Now, if the bond manager sells or waits to sell during a period of rising rates, the proceeds will be lower and the net asset value would be negatively impacted and continue to be negatively impacted as the premium price melts to par at maturity. That is not even the major problem.

The major problem, applicable to bond mutual funds and bond ETFs, flows from the risks associated with investor redemptions. When prices start to decline in a non-temporary fashion, the funds will transition from net inflows to net outflows, causing the fund managers to sell something that locks in a lower price while the funds fly out the door and consequently can not be reinvested in a higher yielding bond. That process perpetually locks in lower net asset values per share due to selling bonds at ever lower prices, possibly at a loss rather than at a diminishing gain. At some point, the herd will change direction and start to pull money out of those funds.

Closed end funds do not have that type of redemption risk. With incompetent managers, the decline in bond prices may be met nonetheless with a lot of inopportune selling that has the same negative impact on net asset value per share as selling by mutual funds to meet redemptions when prices are declining.

(3) Situational Risk: I have highlighted throughout this blog another important risk.

The investment chosen by the investor will simply not produce the income needed to fund retirement making it likely, even probable, that the individual will outlive their retirement savings.

Over $7.5 trillion dollars is gathering rays in savings accounts earning close to nothing. Total Savings Deposits at all Depository Institutions- St. Louis FedFRB: H.6 Releases

What exactly would a 2.3% ten year treasury generate in income before inflation and taxes? On a hefty one million dollars, the income would be about $23,000.

About 90+% of retirees do not have that million and $23,000 does not go very far nowadays anywhere. Maybe some people, who do not actually pay attention to the bills, may think otherwise.

In some jurisdictions, that amount after tax might be enough to pay property taxes on a middle class home with enough left off to pay the home and auto insurance premiums and to fill up a car a few times. Forget about the premiums for medicare and supplemental health insurance, necessary repairs to the home, food, gas, nursing homes, new appliances, cable TV, etc. and so on.

An article in the NYT discussed the risk to retirees and those nearing retirement caused by the abnormally low interest rates now, aptly titled "Why Many Retirees Could Outlive a $1 Million Nest Egg"-NYTimes.com

It is a horrendous situation caused by the Federal  Reserves Jihad Against the Saving Class that has first substantially reduced their incomes to practically nothing for risk free savings, but has now placed many of those retired seniors in a potentially precarious position of having to sell bonds to pay expenses as those bonds lose value due to interest rate normalization or a prolonged rise in rates caused by currently unanticipated inflationary pressures. The Difficult Path to Interest Rate Normalization

A return to normal rates, assuming that occurs within a few years, will cause significant losses in principal to those who own bond funds and have to sell shares to pay expenses, at least until the rate normalization period comes to an end. Last year's spike in interest rates was in my opinion the first salvo in the interest rate normalization process. Inflation expectations, as expressed in the break-even spread of the ten year TIPs, were trending down last year as interest rates spiked for intermediate and long term maturities.

The more substantial risk for bond CEFs, assuming competent management, is that the discount to net asset value will increase substantially during periods of market turmoil, at a far greater rate than the percentage decline in net asset value per share. That phenomenon may cause individuals, who are the primary owners of those funds, to see at the worst possible times, either due to panic or to margin calls. Eventually, the expansion of the discount at a faster rate then the decline in net asset value will stop as more sophisticated investors see an opportunity to acquire a $1 worth of bonds for $.85 or $.8 or even in one of my buys in October 2008 at $.58 on the dollar. As the discount increases, the yield increases too.

(4) Default and Credit Risk:  Junk bonds have a significant default rate and can go down significantly in price even without a default as shown by what happened in the last recession. The average yield for junk bonds spiked to over 22.5%. US High Yield Index BTZ does have a significant weighting in junk bonds.

Closing Prices 12/9/14:
BTZ: 13.26 -0.01 (-0.08%)
Closing Net Asset Value: $15.17 (slightly disappointing)
Closing Discount:  -12.59%
TLT: $123.20 +0.63 (+0.51%) : iShares 20+ Year Treasury Bond ETF
LQD: $119.02 +0.10 (+0.08%) : iShares Investment Grade Corp Bond ETF
JNK: $38.78 -0.11 (-0.28%) : SPDR Barclays High Yield Bond ETF
Relative Strength: JNK:TLT-StockCharts.com

2. Dumpster Diving: Added 50 PSEC at $8.32-Lowers Average Cost Per Share to $9.07 (see Disclaimer): There are a number of individuals who view any criticism of PSEC to be sacrilegious. I might as well set fire to a bible in a room full of evangelicals or wear a sign on my back criticizing the Prophet as I tour Pakistan's Northwest Territory. So, I am not going to publish this section at SA, where many of those True Believers reside and hold court. Their approach to many BDCs is analogous to the tale of those three wise monkeys.

Snapshot of Trade: 

Snapshot of Position Before Trade:

74.308 Shares Average Cost Per Share $9.46
Of those 74+ shares, only 50 were bought in the open market with the purchase made in July 2010. The remaining shares were lower cost shares purchased with dividends that survived my last slash in this position.

Snapshot of Position After Trade: 

124.308 Shares Average Cost Per Share $9.07
I changed my distribution option to reinvestment and will continue to reinvest as long as the price stays below my average cost per share.

Prior Trades: In my IRA, I have successfully traded PSEC for profits. I included snapshots in an earlier post. Item # 3 Paired Trade: Sold 50 PRY @ $25.51 & Bought 100 PSEC at $10.2-Roth IRA (12/16/12 Post)

Item # 2 Sold 100 PSEC at $10.83-Roth IRA (6/1/2012 Post)(profit $60.47)-Item # 3 Added 100 PSEC at 10.1-Roth IRA (7/5/11 Post)

Item # 1 Sold 100 PSEC at $11.36 (6/19/2012 Post)(profit snapshot=$39.6/one 50 share lot held for about 13 months and the other for less than 5 months)

Item # 2 Sold  50 PSEC at $11.5 (1/14/11 Post)(profit: $63.52)-Bought  50 PSEC at $9.97 in IRA (11/19/2010 Post)

Item # 2 Sold 50 PSEC at $12.16 (3/10/2010 Post)(profit=$79.23)-Item # 2 Bought 50 PSEC at $10.48 (9/16/2009 Post)

My last liquidation was a few months ago when the price was last above net asset value per share. Item # 7 Sold Roth IRA: 100 PSEC at $10.65 (9/6/14 Post)(profit=$30.99; total return calculation=$291.66)- Bought 100 PSEC at $10.2-Roth IRA (12/16/12 Post)

Total Trading Profit IRAs: +$270.81

I then elected to follow my trading rules and bought back 50 of those 100 shares: Bought 50 PSEC at $9.65-Roth IRA (10/24/14 Post) The last reported net asset value prior to that purchase was $10.47 as of 9/30/14. PSEC 10-Q Q1 2015 The discount to net asset value at a $9.65 price was 7.83%. At some point, and I do not recall when, I established a 10% discount to net asset value as the minimum marker for any future purchases of TICC and PSEC.

Security Description: Prospect Capital Corp. (PSEC) is an externally managed business development corporation (BDC). The external managers are paid 2% of gross assets and an extremely generous incentive fee to accomplish what is hereafter described in this post.

AUM Skyrockets While Net Asset Value Per Share Stagnates:  
Q/E 9/30/14: Net Asset Value Per Share $10.47 Assets Under Management $6.253+B
Q/E 9/30/11: Net Asset Value Per Share $10.41 Assets Under Management $1.652+B

What will happen to NAV per share when the next recession rolls into town?

Who has benefited from the AUM increase? It is not a hard question to answer.

Net Asset Asset Value Destruction 
Sourced from PSEC's 10-Q Filings
Net Asset Values Per Share Q/E
9/30/14: $10.47
9/30/09  $11.11
6/30/09 $12.4
3/31/08: $14.15 10q
6/30/07: $15.04
6/31/06 $15.31

The market price of an externally managed BDC will generally hug its net asset value per share within a few percent. Over the past few weeks, discounts haven widen for many externally managed BDCs to historically high levels.

As that net asset value declines over time, the market price will follow. PSEC's net asset value per share has stabilized in the $10 to $11 range, at the moment, but is down from $15.31 per share as of 6/30/06. 10-Q at page 3 The market price topped out near $18 in 2007 and is now having difficulty hovering over $8 per share. PSEC Interactive Chart

Recognizing the foregoing, I have an exit strategy and will not become a long term investor in an externally managed BDC. I view them with extreme disfavor, but can not ignore entirely their income generation, particularly in a Roth IRA where the dividends become tax free.

Given my disdain for them and my extremely negative opinions about the compensation paid to the external managers, I will keep my exposure low, break the potential exposure into several 50 or 100 share trades, trade the position for any profit whatsoever after collecting a number of dividends, possibly average down with a small lot and then selling the highest cost lot when and if I can do so profitably after a pop, and will generally try to buy when the shares are selling at below net asset value per share.

Company Website: Prospect Capital

Annualized Total Return 7/27/2004 through 12/8/14: +4.73% Calculator

That return is with dividend reinvestment.

PSEC has a bad history of selling stock at below net asset value per share. Seeking Alpha

An author of an article published at Motley Fool summarized the investments made in a 2011 period when stock was sold at less than net asset value per share.

PSEC has some amorphous plan to "unlock value by spinning off" pure play "business strategies" shareholders. PressRelease One investor referred to this plan as mind-numbing and suggested that the plan was for the benefit of the external managers. That plan could be used as a cloak for a dividend cut, which by the way just happened.  It remains to be seen whether this plan, once implemented, will have benefit for existing shareholders.

Chart: The price has been trending down since 2007: PSEC Interactive Stock Chart

Recent Earnings Report: For the Q/E 9/30/14, net investment income was reported at $.28 per share, down from $.32 per share in the 2013 quarter. The net asset value per share was reported at $10.47, down from $10.56 as of 6/30/14. The annualized current yield on income producing investments was 11.9%. PressRelease

PSEC 10-Q Q1 2015

Rationale: I am not a long term holder of this stock. Instead, I will trade this stock attempting to lower my average cost per share over time, to realize some share profits before they turn into losses, and to hopefully generate a total return in excess of my dividend yield. With PSEC, I view the accomplishment of those objectives to be difficult.

Even after the most recent dividend slash, the yield is about 12% at a total cost of $8.32 per share. Maybe PSEC can support that dividend rate with net investment income, at least until the next recession occurs.


1. PSEC Has a Long History of Being A Serial Issuer of Common Stock-A Major Negative: It is certain that these share offerings benefit management since their fees will increase. The common share offerings are part of a significant expansion in PSEC's capital for reinvestment. Other capital raises include senior unsecured note offerings and a unsecured convertible senior note issuances. Prospect Capital Convertible Notes List It is not certain that those capital raises will benefit shareholders in the future. There does not appear to be any past benefit given the net asset per share history noted above.

One positive is that the company has recently quit selling stock at below net asset value under its ATM program. It should have never started that practice, so I am not giving management kudos for stopping what they should have never done in the first place.

2. Dividend Stream is Unreliable: While rewarding its managers handsomely over the years, PSEC has now slashed its dividend to shareholders twice.

The first slash occurred in 2010 when the company went from a $.41 per share quarterly rate to a $.10 monthly rate. Prospect Capital Dividend History-NASDAQ.com When making that announcement, PSEC did not refer to that change as a dividend cut. Prospect Capital Announces Change From Quarterly to Monthly Cash Distributions to Shareholders

The second slash occurred last Monday, when the company reduced its dividend from $.11+ per share to $.0833 or close to a 25% reduction.

3. Depletion of Capital Through Dividend Payments: One reason for capital raises is the requirement that a BDC must distribute at least 90+% of its income to its shareholders. That requirement is the same for REITs and avoids double taxation for the amounts distributed as dividends.

While this requirement will generate greater dividends compared to a regular "C" corporation, the downside is that insufficient capital is being retained to grow the business with investments. The issuance of common shares is therefore understandable, at least to a degree.

4. Risky Portfolio: This risk is common to BDCs. These companies are basically lending money to mostly private firms that would find it difficult to obtain needed capital from banks. Some of the borrowers may be relatively new with little or no track record, heavily indebted companies that have gone private after a leveraged buyout, or older companies that have fallen on hard times. The loans will generally carry high interest rates and will sometimes have an equity kicker such as a stock warrant. One does not need to be a professional loan officer to recognize the risks.

5. Company Discussion of Risks: The risk section in PSEC's last SEC filed Annual Report is 25 single spaced pages long. The "conflict of interest" discussion can be found starting at page 28. PSEC 2014 10-K

6. Other Discussions of Risks:  I have discussed risks in prior PSEC posts linked above and in comments made at SA (South Gent's Comments on PSEC: Prospect Capital Corporation | Seeking Alpha)

I also discuss risks relating to externally managed BDC's in three recent SA Instablogs:

New Mountain Finance Share Offering Today Illustrates Multiple Risks Inherent In BDC Stocks - South Gent | Seeking Alpha

Added 50 AINV At $7.94 - South Gent | Seeking Alpha

Bought 50 ARCC At $15.41-A Typical Small Lot Purchase Of An Externally Managed BDC Stock - South Gent | Seeking Alpha

Future Buys/Sells: I am targeting a potential 100 share add, using two potential 50 share lot purchases. The first would be at less than $8 to average down in the IRA, and the second would be to average down again in the taxable account, possibly a little lower than the IRA average down. If and when the market price comes within a few percent of net asset value per share, I will consider selling the highest cost lot bought in 2010.  

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