Wednesday, December 17, 2014

Bought 1 Extremely High Risk Sandridge Energy 8.75% Senior Bond Maturing 1/15/2020 at 65/Added 50 FSC at $7.86/Bought 50 TCRD at $11.38 Regular IRA

I am going to gradually discuss some small junk bond purchases over the next week or so. I have focused on several smashed junk bonds issued by highly leveraged E & P companies. Under the current circumstances, those purchases are HIGH RISK, and I have consequently kept my exposure small. The riskiest one is the one bond purchase discussed below.

Big Picture: No Change

Stable Vix Pattern (Bullish):

Recent Developments:

With three dissents (2 from hawks and 1 from a dove), the Federal Reserve approved a statement indicating that it "can be patient in beginning to normalize the stance of monetary policy". The Fed deleted the statement made in prior releases that it expected to keep rates low for a considerable time. The FED insisted that the patience language effectively meant the same thing. FRB: Press Release--Federal Reserve issues FOMC statement--December 17, 2014

It is my current opinion that economic conditions will improve next year compared to 2014 and that job growth will accelerate some from current levels. Capacity utilization will increase above historic levels. I am therefore anticipating two .25% increases in the federal funds rate next year, with the first being in the summer and the second late in the year. The FED will then assess for several months the impact of those increases and whether further small increases spaced out over time is warranted under the then existing economic conditions.

Jeff Gundlach has a slide presentation that is worth viewing. Chart 24 highlights a major problem. The annualized percent change in real hourly wages between 2007 and 2014 is negative for most wage earners, with only the very 20% showing any growth. Another problem is that the minimum wage for a full time worker has declined substantially since the early 1980s. I highlighted these strong structural problems in an old blog. Introduction "Labor Productivity and Wages" (9/28/13 Post)

The German two year government bond has a negative yield. Inflation expectations are trending down.

The flash HSBC/Markit manufacturing PMI fell into contraction territory, falling to 49.5 in December. The new orders sub-index declined to 49.6.

U.S. industrial production increased 1.3% in November. Capacity utilization for the industrial sector increased .8% to 80.1%, a rate equal to the long term average. It has been a long slog back to that average:

Capacity Utilization: Total Industry-St. Louis Fed

Capacity utilization to the current level is associated with business spending increasing at 8%: Bloomberg


1. Bought 1 Extremely High Risk Sandridge Energy 8.75% Senior Bond Maturing on 1/15/2020 at 65 (see Disclaimer): 

Snapshot of Trade Information: This bond was bought at Fidelity which charges an $8 commission. 

I was not able to buy just 1 bond online at Vanguard, when I decided to make this purchase, where the commission would have been $2 for that 1 bond purchase. 

Fidelity will add its $8 commission to the price paid, so the following snapshot shows a $65.8 price, which includes the $8 commission, bumping the price shown in the confirmation to $65.8. 

For those unfamiliar with the bond market, this is a $1,000 par value bond that I bought for $650, plus an $8 commission. 

I also had to pay the seller accrued interest in the amount of $36.94. That number is not added to my cost basis which will be $658.

FINRA Page for SD 2020 Bond: Bonds Detail

Instead, when I receive the semi-annual interest payment on 1/15/2015, I will receive the entire month's interest payment, even though I did not own the bond for the first five months or so of that six month period.  

I will then deduct that $36.94 interest payment made to the seller when I prepare my tax return for 2015. I will have a deduct accrued interest paid to seller line in my schedule B. That assumes that my 1099 includes the full six month's interest payment which has always been the case for me so far. 

I am gambling with this purchase. 

I am placing a small bet that SD will make all interest payments when due and will survive to pay me $1,000 on 1/15/2020, which will create a large total return somewhat commensurate with the huge risk.

The broker calculates my current yield at 13.297% and the yield to maturity at 19.699% at my cost. That is a locked in 19.7% annualized yield to maturity provided all interest payments are made when due and the principal amount is paid in full on 1/15/2020. That is one important caveat.

The sentiment being expressed in both the Sandridge common and bond prices has been overwhelmingly and relentlessly bearish for several weeks, though the pricing improved for both last Wednesday with the robust stock market rally and a rise in energy prices. 

Bond investor fears were nowhere to be found a few months ago. On 5/2/14, I sold a 7.5% Sandridge senior unsecured bond maturing in 2021 for $106.375:

That 2021 senior unsecured bond closed at $57.25 on 12/15/14, almost cut in half in just 7+ months. FINRA

Another possible favorable result would be for SD to be acquired before a BK filing by a larger company with a rock solid investment grade rating. 

Company Description: SandRidge Energy (SD) is a relatively small E & P company that has recently sold off  assets to focus on the Mississippi Lime area. One problem with production in the Mississippian Lime area generates huge amounts of saltwater and costs have to be incurred to dispose of that waste product properly. The primary operators in this area are Chesapeake, MidStates Petroleum and Sandridge. Midstates Petroleum's stock closed at $1.6 on 12/17/14, and its high yield bond closed with a YTM just south of 27%. FINRA

The company is currently unable to file a third quarter 10-Q with the SEC due to an accounting problem that some investors view as minor. (e.g. Seeking Alpha). The company discussed the reasons for the delay in an early November 2014 press release, which generated the usual number of class action lawsuits filed by the usual assortment of attorneys: SandRidge Energy I would not hazard an opinion on the impact, but will simply note its existence here.

Sandridge did release a press release describing third quarter results. The company made the following statements. It claims to have a substantial majority of production through 2015 hedged over $90 per barrel. No borrowings then existed on its $1.2B credit facility. Total company production was 80MBoe per day which was a 14% quarter-over-quarter increase. Sandridge estimated that over 90% of its liquids production was hedged at over above $93/Bbl.  SEC Filed Press Release

The company has a lot of senior unsecured debt but none of it matures before 2020:

Cash and Long Term Debt as of 9/30/14

I do not trade future's contracts and simply have to accept whatever the company says about its hedge book:

Derivative Contracts
SandRidge Energy has filed a registration statement for an IPO for MidCon Midstream L.P. that was formed by SD to own, operate, acquire and develop assets to gather, process and dispose of saltwater produced alongside oil and gas. There has been no activity after that filing on 10/24/14: SEC Filings for MidCon

Rationale: This is a speculative purchase. I would call it a gamble, sort of like playing a hand of blackjack for $650. If Sandridge survives to pay this bond off at maturity, I have locked in a total annualized return  of 19.699% with the usual highly material caveat. Sandridge has to survive until it pays off that bond at maturity. And that is the rub.

Risks: The bond market has some really serious questions about SD surviving to the 2020 maturity date. A close to 20% annualized yield from a senior bond carries with it a substantial default risk. 

How long will oil prices remain low? How will SD finance production in 2015 to 2020 without having to borrow more money, probably by drawing down its credit facilities. Selling senior unsecured bonds is not an option now.

In a S & P report that I read, which was prepared in July 2014, the analyst opined that SD would outspend its cash flow by $900 million this year and that deficit would be financed with a draw on the credit facility and an asset sale which has already occurred.

Bond investors are probably anticipating that SD will start to heavily lean on its credit facility which will have priority over the senior unsecured bonds.

Expenditures in 2015 need to be brought in line with cash flow generated by production and hedges, and that may not happen.

The bond market is not predicting a default in 2015 at a 65 price in my opinion.

But that price is not consistent with anywhere near a 100% likelihood of survival to the bond's maturity date.

The 65 price is, in my opinion, predicting a significant possibility of a default in the 2017-2020 time period with the recovery in a BK hampered by significant draws on the credit facility to finance production.

The market's opinion, expressed in the price, will change based on subsequent developments.

If crude oil is at $50 next winter, and has stayed below $70 in the interim, then that is an adverse scenario for the bond, whereas a $80 price which is rising that allows for hedges to be secured at favorable prices for 2016 and beyond is another.

Hard to say now what will happen, but it will most likely be very dicey with some drama before there is a clear resolution.

2. Bought 50 TCRD at $11.38-Regular IRA (see Disclaimer): 

Snapshot of Trade: 

I recently discussed this BDC here and have nothing material to add to that discussion. Stocks, Bonds & Politics: Bought 100 TCRD at $12.83/Sold 433+ RMT at $12.76-Average Cost Per Share $7.91

I also have an article at SA that is an excerpt from that blog post and I have made some comments linked to that article. Nibbling At BDCs During The Current Downdraft: Bought 100 TCRD At $12.83 - South Gent | Seeking Alpha

Since my purchase, this stock has gone ex dividend for its $.34 per share quarterly dividend and has fallen significantly after adjusting for that payment. The entire BDC sector has been in a substantial downtrend for weeks, a topic discussed in more detail in the next item.

At a total cost of $11.38 per share, and assuming a continuing of that quarterly dividend rate, the yield is about 11.98%.

3. Added 50 FSC at $7.86 (see Disclaimer): I have small positions in this BDC in two IRAs and in a taxable account. This buy was made in a taxable account to generate cash flow for reinvestment in other securities and to reduce my average cost to $9.04 per share, with just a 150 share position.

Snapshot of Trade: 

Security Description: Fifth Street Finance (FSC) is a business development corporation ( hereinafter BDC) that invests primarily in small and mid-sized private companies, primarily in connection with investments made by private equity sponsors.

Website: Individual Investor | Fifth Street

Fifth Street Finance Profile Page at Reuters

Fifth Street Finance Key Developments Page at Reuters

The portfolio is weighted in secured loans:

Portfolio Composition as of 9/30/14

A description of the FSC's investments can be found starting at page 90 of its recently filed 10-K.

The oil and gas sector exposure appears to be relatively light at 3.71% as of 9/30/14 and is described as "oil & gas equipment services" rather than a loan to a production company. (page 55) That exposure is to three companies and two of them are in the "process of sold for a fairly substantial multiple". Page 4 Earnings Call Transcript | Seeking Alpha

One of the comments to that SA transcript reproduces some comments, both negative and hopeful, about FSC from the BDC Reporter that are worth reading.

This BDC has what is called an ATM program where KeyBank capital markets can sell FSC's stock in the open market. In a Prospectus filed 12/9/14, FSC mentions that it sold through its ATM program 841,456 shares of stock between 8/22/14 and 9/30/14 at an average price per share of $9.86 or $8.3M The $100M authorization under the ATM program is consequently reduced to $91.7+M. There is a statement in the prospectus that the sale's price can not be "less than the net asset value per share of our common stock at the time of such sale" (page S-10).

After the share price finally worked its way back over $10 per share, FSC Interactive Chart, FSC announced after the close on 7/10/14 that it was going to sell stock, one of the well known and perpetually annoying risks associated with BDCs. Fifth Street Finance Corp. Commences Public Offering of Common Stock FSC priced 13.25M shares at $9.95 per share to the public. There was the usual over allotment option granted to the underwriters. Fifth Street Finance Corp. Prices Public Offering of Common Stock

When looking at a stock offering, it is important to keep in mind that the $9.95 per share offering price to the public is not what FSC receives per share. The underwriters bought the stock at $9.81. FSC also incurred about 2 cents per share in expenses relating to the offering. So the net proceeds after the underwriting discount and FSC's expenses was about $9.79 per share. The net asset value per share was $9.71 as of 6/30/14.

Other stock offerings since December 2012 are detailed at page 71:

This BDC has sold two exchange traded baby bonds with a $25 par values: Fifth Street Finance Corp. 6.125% Senior Notes due 2028 (FSCFL);  Fifth Street Finance Corp. 5.875% Senior Notes due 2024 (FSCE)

This is a link to a press release discussing one large recent investment: Metalogix Acquisition by Permira Funds

Dividend History: Fifth Street Finance raised its monthly dividend from .0833 per share to $.0917 effective with the September 2014 distribution.

FSC has cut its monthly rate twice since the 2010 4th quarter. The first cut was a small decline from $.11 to $.1066. The next cut was to $.0958 in January 2012 and then to $.0833. Fifth Street Finance Dividend History

I would not call the increase to $.0917 a dividend raise. When the dividend is increased to over $.11 per month, the rate from November 2010, then that increase will be a raise. The last increase just restored some of the previous cuts.

Assuming a continuation of the current monthly rate and a total cost per share of $7.86, the dividend yield is about 14%.

When the ten year treasury is yielding just over 2%, a 14% yield obviously carries a lot of risk. The problem with BDCs is how to harvest the yield without giving some or all of it back in share losses.

Recent Earnings Report: For the Q/E 9/30/14, FSC reported $.25 of net investment income per share. The weighted average yield on FSC's income producing investments was 11.1% with the cash component of that yield making up 9.9%. At fair value, 79% of FSC's portfolio consisted of senior secured loans.

Fifth Street Finance Corp. Announces Fourth Quarter and Fiscal Year Ended September 30, 2014 Financial Results

An article discussing this report is authored by Scott Kennedy and published earlier this month at Seeking Alpha.

Rationale: There is only one reason to invest in this company. In today's abnormally low interest rate environment, a prudent saver has no real options for generating a satisfactory real rate of return without taking risks. I could buy a 10 year treasury yielding slightly over 2%. Before taxes and inflation, it will take about 35 years for money to double at a 2% rate. Estimate Compound Interest  Investing at a 2% rate of return is in my opinion a huge risk for most investors to take, since it enhances the risk that assets will not grow sufficiently to meet expenses.

So, I have no choice but to take risks. I would prefer to avoid companies like FSC altogether.

I can suffer a loss in the shares that generate a 14% yield and still receive an acceptable real rate of return, particularly with inflation trending down.

The discount to the last reported net asset value per share of $9.64 is historically abnormal at 18.46+% based on the purchase price of $7.86. That historically high discount at least suggests a reasonable possibility of price appreciation to more normal levels, assuming the market price decline is primarily due to temporary factors.

Management has stated that it will not sell stock below net asset value per share, which is a positive.

Risks: The risks are substantial, as one would expect for a 14% yield.

1. Net Asset Value Per Share Destruction: Most of the time, the market price for an externally managed BDC will hug net asset value per share within a few percent either higher or lower. If the external managers are destroying net asset value over time, the market price will be declining too.

What is FSC's long term record? Fortunately, this BDC had an IPO in 2008 rather than in 2006 with the investments made just in time for the Near Depression.

6/30/08: $13.2 per share (page 5 10-Q)
6/30/09: $11.95 per share (page 5 10-Q)
6/30/10: $10.43 per share   (")
6/30/14  $ 9.71 per share (page 3 10-Q
9/30/14: $ 9.64 Fifth Street Finance

Does that history show a trend yet, or is the decline some kind of aberration that will not repeat itself in the future?

2. Unsatisfactory Long Term Total Returns: The Longrundata calculator goes back to 6/12/2008 for FSC and will reinvest the dividends to buy more shares. Starting then and calculating the total return through 12/16/2014, FSC has produced only a 4.56% annualized total return, significantly below its average dividend yield. Calculator That poor annualized total return highlights an issue. An investor should not become mesmerized by the dividend yield when the long term total return performance screams trade.  

3. Serial Stock Issuer: Stock offerings cost money and raise significantly less per share after the underwriting discount and the BDC's expenses relating to the offering than the public price per share. The continuous offering of shares whenever the price creeps above net asset value per share has a tendency to cap price gains to small premiums.

If there is a prolonged period where stock can not be sold above NAV per share, the coffers will not be replenished after loan losses, and net assets producing income will decline. The company would also lose the asset value accretion due to stock offerings where the proceeds to the BDC per share exceed the then existing book value per share.

4. The dividend is not safe or secure. The dividend history proves this point. In case anyone needs to be reminded, the next recession will provide a refresher course about the sustainability of the payouts.

5. Dividends Drain Cash: To maintain its tax status, the BDC must pay 90%+ of its taxable net income to its shareholders. The avoidance of double taxation increases the amount available for distribution, but the dark side to that high dividend is that funds are not being retained to grow the business.

6 The company discusses the abundant risks incident to its operations, including conflict issues inherent in the external management arrangement, starting at page 24 of its recently filed annual report, FSC 10-K F/Y Ending 09/30/2014

7. The significant costs of external management are also a major negative. Net expenses for the year rose to $151.4M from $106.7M for the prior fiscal year.

How did net asset value increase between 9/30/13 and 9/30/14?

Page 47-FSC 10-K
9/30/14: $9.64 Net Asset Value Per Share
9/30/13: $9.85 Net Asset Value Per Share

What can you say about that? In a generally favorable economic environment, net asset value per share decreased by $.21 per share as expenses rose $44.7M. Are FSC's external managers justifying their pay packages? Each investor can answer that question for themselves. I view the answer as both obvious and certain.

8. The chart looks awful: FSC Interactive Stock Chart

I believe that it is important to have a handle on the downside risks.

When I look at the preceding summary, one rational and understandable response is just to say no. Another, which I follow, is to recognize those downside risks and then try to adapt.

Future Buys and Sells: I will consider averaging down at a lower price. I will consider selling shares when the market price exceeds net asset value per share or possibly as soon as I have a net profit in the shares after harvesting dividends. My preference is to harvest 1 to 2 years and then escape with a profit on the shares while I still have one.

Closing Price 12/17/14: FSC: $7.92 +0.10 (+1.28%)

The next ex dividend date is 1/13/15. FSC 

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