Monday, December 22, 2014

Averaged Down-Bought 50 GSPRC at $19.63/High Risk Junk Bond Strategy: Bought 2 Northern Oil & Gas 8% Senior Unsecured Bonds Maturing 2020 at 73.9

Big Picture: No Change

Stable Vix Pattern (Bullish):

Recent Developments:

Yikes. I am receiving way too many large year end dividend distributions. I just received a $6.2318 per share dividend in cash from the mutual fund SSgA Emerging Markets Fund; (SSEMX). I only own 100 shares and consequently received a cash distribution of $623.18 on that small position. I had an unrealized profit on the shares and now I have an unrealized loss and a tax obligation. I am worse off. I have a tax obligation that decreases my net worth and this mutual fund's price is adjusted down by the amount of the dividend per share.

I have been taking cash distributions from SSEMX. I had sold my position down to 100 shares in May 2007 and have not added to that fund since that time. (snapshot in Stocks, Bonds & Politics: Updated Stock Fund Table as of 6/6/2013)

These large distributions are pushing up my tax 2014 obligation beyond my previous estimates. Consequently, I decided to harvest some tax losses to offset in part those gains. I sold out of the closed end foreign bond funds FAM and SGL, but only in my taxable accounts. My total share loss on those two positions was $1,181 but I would guess that the total loss adjusted for dividends paid and received would be close to $600.

Those two funds are performed poorly this year due to the parabolic rise in the USD against foreign currencies and exposure to less than desirable sovereign bonds that have been hit hard by the crude oil plunge (e.g. Venezuela). I will consider buying back some FAM shares at lower prices next year, after waiting the required period to avoid a wash sale.

I am going to start adding some junior E & P names in my LT basket. Someone mentioned that a better option would be to take a whip and give myself a few lashes on the back. That sector does qualify for the deep value contrarian, falling knife and smashed stock prices that are the sine qua non of the Lottery Ticket basket strategy. I will summarize the purchases when and if I also buy a bond or when I update the LT basket which will be several weeks from now.


1. Averaged Down: Bought 50 GSPRC at $19.63 (see Disclaimer): My prior purchase was at $19.95, so this is an insignificant price change for an average down.

Snapshot of Trade:

Security Description: The Goldman Sachs Group Preferred Series C (GS.PC) is an equity preferred stock issued by the Goldman Sachs Group Inc. (GS) that pays non-cumulative and qualified dividends at the greater of 4% or .75% above the 3 month Libor rate on a $25 par value. This security will be senior only to common stock.

The minimum coupon provides a measure of deflation/low inflation protection while the spread to the 3 month Libor rate addresses the problematic inflation scenario.


This security falls under my classification of floating rate equity preferred stocks. I discuss their advantages and many disadvantages in this Gateway Post: Stocks, Bonds & Politics: Advantages and Disadvantages of Equity Preferred Floating Rate Securities That post also contains snapshots of my profits and losses greater than $30. The current total net profit stands at $11,752.05. My largest unrealized gain is in SANPRB, an equity preferred floating rate stock issued by Santander Finance that pays the greater of 4% or .52 above the 3 month Libor rate.

Historical 3 month Libor Rates:

3-Month London Interbank Offered Rate (LIBOR)

An increase in the GSPRC coupon above the 4% minimum will not occur until the 3 month Libor rate exceeds 3.25% during the relevant computation period.

It would not be reasonable at this time to predict a coupon increase for several years. That probability is one disadvantage for this security compared to a fixed rate coupon from the same issuer.

Comparison to a Fixed Coupon GS Preferred Stock: For example, Goldman Sachs does have a 6.2% fixed coupon preferred that is functionally equivalent with GSPRC except for the coupon. GSPRB Prospectus Both are non-cumulative, potentially perpetual equity preferred stocks with $25 par values, and are in pari passu with one another in the capital structure.

The Goldman Sachs Group Inc. Series B preferred stock closed at $25.1 on 12/19/14, which gave that security about a 6.17% current yield, slightly below the coupon amount due to the premium price above the $25 par value.

GSPRC closed at $19.53 on 12/19/14, which is equivalent to about a 5.12%. In both calculations, I am not factoring in the impact of a brokerage commission.

The investor has to accept a slightly lower yield now in exchange for the interest rate and inflation protection contained in the float provision. That differential in current yields, which was about 1.05%, is similar to an insurance policy. The investor is in effect paying a current price for a type of insurance against an unexpected rise in short term rates caused by a FED response to problematic increases in both current and anticipated inflation. Unlike the fixed rate coupon, the floater will increase the coupon rate after the float provision is activated by a sufficient increase in the 3 month Libor rate.

Just for illustration purposes, I am assuming that the 3 month Libor rate was 6% during the relevant computation period. With the .75% spread, the coupon would become 6.75%, higher than the 6.25% of the fixed rate preferred GSPRB. More importantly, the yield at a constant total cost per share of $19.53 would increase to 8.64%. At a 4% 3 month Libor rate, the yield would increase from 5.12% to 6.08%.

List of Goldman Sachs Preferred Stocks

There is one other pure fixed coupon preferred, GSPRL, which has a 5.95% fixed rate coupon.

There are currently 3 fixed-to-floating rate GS preferred stocks. I view that type of security as a gimmick. I discuss my reasoning in Item # 1 Bought 100 VRP at $24.89.

I have bought and sold one of them. (see discussion in Item # 4 Bought: 50 GSPRJ AT $22.78)

Crossover Point in Yield-4.07% 3 Month Libor Rate: So the crossover point, where the current yields for GSPRB and GSPRC become similar, based on the differential in their constant cost per share numbers, is around a 4.07% 3 month Libor rate (4.07% + .75%=4.82% coupon x. $25 par value=$1.205 per share annual dividend divided by $19.53 total cost per share=6.17%)

As the Libor increases over 4.07%, the differential in favor of GSPRC will increase.

Stopper Clause: The stopper clause is the legal mechanism that assures the preferred stock owner that their dividend will be paid in full for as long as a cash dividend is paid on the common shares. As soon as that common share cash dividend is eliminated, however, there is no remaining legal impediment to prevent the elimination of the non-cumulative preferred dividend.

The prospectus does contain a standard "stopper" provision that would prevent Goldman Sachs from paying a cash dividend to the common shareholders and eliminating its non-cumulative preferred stock dividends.  (see pages S-12 to S-13). Once the common dividend is eliminated, there would be nothing legally that could stop GS from eliminating the GSPRC dividend.

However, as a practical matter, it would be unwise for Goldman Sachs to eliminate the preferred stock dividends to preserve capital. If you were an institutional client, what kind of message would such an elimination send to you?

For an investment bank, dependent on customer confidence in its financial viability, the only practical course would be to pay the preferred stock dividend until the company does a Lehman Brothers. A failure to pay prior to a bankruptcy filing could easily cause that result.

Prior Trades: Bought: 50 GSPRC at $19.95 (11/6/13 Post)

Related Preferred Stock Trades: I currently own 150 GSPRD, a functionally equivalent floating rate preferred stock. Snapshots of gains from trading GS floating rate preferred stocks can be found in the Gateway post for this topic. The largest realized gain to date was just $257.24 from a 100 share lot of GSPRD. The other gains have been in the $40 to $100 range. Until I have a better feel as to the timing of a coupon increase, I am in a trading mode for the equity preferred floaters except for my SANPRB shares due to their low cost basis.

Recent Earnings Report: For the 2014 third quarter, GS reported net earnings of $2.24B or $4.57 per diluted share, up from $2.88 in the 2013 third quarter. SEC Filed Press Release

Form 10-Q for the Q/E 9/30/14

Rationale: The main advantages of this type of security are as follows: (1) the security pays qualified dividends and (2) provides a measure of deflation/low inflation and problematic inflation in the same security. The deflation/low inflation scenario is addressed by the minimum coupon, while the protection for problematic inflation involves the LIBOR float activation. By buying at a discount to par value, I juice the yield in both scenarios.

At a total cost of $19.63, the minimum yield will be about 5.01%. There is no maximum coupon. If the coupon becomes too high for GS due an increase in the LIBOR rate, then the security can be called at the $25 par value, which will generate a decent percentage profit, plus the accrued dividend at the time of any such redemption. 

The discount to par value has a built in profit potential when and if a scenario arises that would cause GS to redeem at par value. That potential does not exist with the fixed coupon preferred GSPRB which is currently selling at a premium to par value. 

I currently have no concerns about GS paying the preferred stock dividend. It is paying a common stock dividend which would have to be eliminated before GS could eliminate its non-cumulative preferred stock dividends.

Goldman Sachs Group Dividend Date & History


(1) Highly Volatile/Heightened Risk/Non-Cumulative: I started to invest in some of these securities during the Near Depression when they could be purchased at greater than 50% discounts to their $25 par values. The downside risk is zero as shown by what happened to those unfortunate souls who owned LEHPRG, a Lehman equity preferred floater, that is now worthless of course.

An equity preferred stock is only superior to common stock. It will be junior in the capital structure to all bonds. Given that low priority, the non-cumulative dividends paid by many of them, and the highly leveraged balance sheets of financial institutions issuing them, there will be no recovery in a bankruptcy for an owner of an equity preferred stock. Investors realize that would be the likely outcome and will behave irrationally when there is a whiff of a possible financial collapse. (a 75% chance of bankruptcy priced into the preferred stock when a rational number would be less than 10%).

BAC equity preferred stocks, for example, could have been bought for less than $10 even in 2009. I bought ZBPRA, a Zions equity preferred floater for $7.8. None of those equity preferred floaters missed a dividend payment. 

In the October 2008 to March 2009 period, GSPRC pierced at times the $10 price level. GS.PC Stock Chart  A long term chart highlights the risk. Over the past two years, this preferred stock has traded mostly in the $20 to $24 range, with occasional breaks to $18 and crosses over $24. The last rally over $24 peaked at $24.97 in  May 2013.

Periodically, these stocks will hit an air pocket and just fall as if a bankruptcy filing was imminent. I am just use to it.

I discuss an example from August 2011: Item # 1 Fear and Enhanced Volatility in Certain Classes of Income Securities 

The low coupon floating rate preferred stocks declined broadly when interest rates rose starting in May 2013. Short term rates remained anchored near zero and inflation expectations were trending down. Under those circumstances, the was no anticipation of a coupon increase and other credit instruments become more competitive in their yields. 

2. No Coupon Bump Likely for Several Years: The likely continuation of ZIRP into 2015, and the probable slow pace of the subsequent tightening cycle after ZIRP's end, will combine to keep the 4% minimum coupon as the applicable rate for several years. It would take a rise in the 3 month LIBOR rate to over 3.25% during the relevant computation period to trigger any increase in the coupon. I do not currently see that happening before 2017. However, investors may be too sanguine now about future inflation prospects.  

3. Zero Value in a Bankruptcy: If GS goes bankrupt, I will not be asking anyone why my equity preferred stocks are now worthless pieces of paper. 

Future Buys and Sells: Most likely, I am full owning 250 shares of a GS preferred stock. If I get a pop in either GSPRC or GSPRD, I will consider lightening up some.

2. High Risk Junk Bond Strategy-Bought 2 Northern Oil & Gas 8% Senior Unsecured Bonds Maturing on 6/1/2020 at 73.9 (see Disclaimer):

Snapshot of Trade: 

The price shown in the confirmation includes the $8 Fidelity commission.

Security and Company Description: Northern Oil & Gas (NOG) is an independent energy company engaged in the acquisition, exploration and production of oil and natural gas, primarily in the Bakken and Three Forks formations within the Williston Basin in North Dakota and Montana. Average daily production in the 2014 third quarter was 16,448 Boe weighted 89% in oil. The proved reserves was estimated by an independent third party at 84.2MMBoe as of 12/31/13. NOG 10-K at page 2

NOG owns a minority interest in wells in a large number of wells. In 2013, NOG participated in the drilling of 531 gross (40 net) wells in the Williston Basin. The company owned working interests in 1,758 wells (146.2 net), as of 12/31/13. NOG uses a non-operator model which limits the ability to control the timing or allocation of capital spending. I would view that model as a disadvantage in the current operating environment.

The confirmation excerpt, shown above, states that the current yield at my cost is 10.767% and the yield to maturity is 15.07%. The confirmation further notes that the bond was then rated at Caa1 by Moody's and B- by S & P.

FINRA Bond Detail

The common stock chart shows duress and highlights risks: NOG Interactive Stock Chart The stock was smashed in 2008 when the WTI oil price plunged from over $140 to less than $40 over a brief period of time. The NOG shares went from $14 to slightly over $2 by March 2009 and then rallied to over $32 in February 2011, and then declined into a channel trade mostly between $20-$25 between May 2011 and April 2012. A lower channel developed thereafter between $12 and $16. The abrupt decline in crude prices in late summer caused the shares to crater to $5.16 earlier this month before recovering a tad.

As of 9/30/14, NOG had drawn $228M on its secured credit facility. There was $508+M in the 8% senior unsecured notes outstanding. 10-Q Q/E 9/30/14 NOG then had slightly over $8M in cash.

As of 9/30/14, the company "had a total volume on open commodity swaps of 5.8 million barrels at a weighted average price of approximately $89.57":

Under the present circumstances, the hedge book is very important to a senior unsecured bond owner. I took this snapshot which shows the derivative contracts as of 9/30/14:

Net production for the 2014 third quarter was 1.513+ million barrels of oil equivalent. Net production for the nine month period ending 9/30/14 was 4.11+M Boe. The third quarter's dollar value was heavily weighted in oil with $113.6M+M vs. natural gas at $5.5+M. At the quarter end, the company had an interest  in 177.4 "net producing wells"

Prior and Related Trades: None

Recent Earnings Report: The last earnings report was good.

Page 3: NOG 10-Q

Earnings Press Release (for 2015, the company has approximately 4 million barrels of oil hedged at $89.43 per barrel; adjusted EBITDA for the third quarter was $81.4; available liquidity as of 9/30/14 was $330M)

The 2015 hedging looks okay to me at 990,000 barrels per quarter at slightly over a weighted average cost of $89 per barrel. However, there is a lot of production that is unhedged. In the last quarter, the company had 1.348+M barrels of crude oil production.

The problem is not the past but the near and intermediate term future.

To finance spending, NOG has been devouring all of its cash flow and then borrowing funds to pay the balance under its secured senior credit facility.

This aggressiveness may be salutary when WTI is over $90 a barrel, but is potentially dangerous now.

A secured unsecured bond owner does not want to see a company increase draws under its secured credit facility, particularly when that draw comes close to 75% of the maximum. The credit facility can be revised down based on the estimated value of proved reserves that could result in a downward revision of credit capacity and could even require the borrower who was under the limit to pay down the outstanding amount to bring the borrowings back under the revised lower limit.

Rationale and Risks: The rationale and risks are inextricably intertwined. I receive the yield because the risk of loss is high. A 73 price for an 8% bond maturing in 2020 reflects a market judgment that there is a significant default risk prior to maturity. Recognizing that risk, and balancing the return with it, I thought that it was a fair trade to assume the risk only up to a 2 bond purchase.

The company discusses risks factors incident to its operations starting at page 10 of its last SEC filed Annual Report: NOG 10

One of those risks relates to NOG non-operator status:

Summary of Non-Operator Risks
This bond is scary to the Old Geezer,  just not as scary as the Sandridge bond.  

Future Buys and Sells: I have the common stock on my lottery ticket monitor list. I will not buy more NOG bonds. I have no firm plans about selling this 2 bond lot. If I become concerned that the WTI crude oil price will remain low for an extended period of time, I will consider selling this bond even at a loss. I will be inclined to hold it, possibly until maturity, with WTI holding steady above $80 per barrel. A 15.07% annualized total return to 6/1/2020 is highly likely to beat the SPY total return.

The 15.07% total annualized return is locked with the usual caveat that Northern Oil has to survive to pay par value at maturity and to make all interest payments until that time.

Can anyone give me the name of a stock that is likely to produce the same return?

I plugged in a recent Apple stock price of $112 into a compound interest calculator and assumed a 15% annual compounded rate for 5 years. For ease of calculation, I did not factor in the dividend. Apple's share price would be $225.27 with those assumptions.

The SPDR S&P 500 ETF (SPY) price would have to increase from about $207 per share to $416. That would require a similar up move over the next five years as SPY's move from October 2009 to date. SPY Interactive Stock Chart

Money doubles in five years at a 15% annualized and compounded rate. 

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