Wednesday, January 14, 2015

Sold 200 BHK at $13.86-Taxable Account-Completes BHK Transition to Roth IRA/Sold 2 LINN 2020 Bonds at $88.5-Bought at $81/Sold 2 Northern Oil & Gas 8% Senior Unsecured Bonds Maturing in 2020 at $81.75-Bought at 73.9/Initiated a Position in the ETF PFF at $39.55-Commission Free at Fidelity

Big Picture: While there is no change as of today, the VIX has been spiking some in a somewhat worrisome pattern since October 2014. VIX Interactive Chart So far, as I have explained earlier, those spikes do not yet qualify as a Trigger Event that would change the outlook to "Unstable Vix Pattern (Bearish)". 

Stable Vix Pattern (Bullish):

Recent Developments: 

The government's estimate for December's retail sales was a shocker. Retail sales dropped by .9%. Gasoline sales sales fell by 6.5% which was to be expected given the huge decline in price. The shocker was that retail sales, excluding autos and gasoline, fell by .3%. And to throw more ice cold water on the bulls, sales for November and October were revised to .4% from .7% and to .3% from .5% respectively.

Crude oil prices took another dive last Monday after Goldman Sachs reduced its WTI forecast to $39 per barrel in six months and $65 in a year, down from their previous estimates of $75 and $80. Those later forecasts were already way out of line with markets prices when GS reduced its near term estimates.

Import prices declined by 2.5% in December, the sixth straight monthly decline. Fuel import prices declined by  15.1% in December which followed a 8.7% decrease in November. Excluding fuel, import prices declined by .1% in December and .3% in November. For the 12 month period ending in December, import prices fell by 5.5%, the largest drop since 2009. U.S. Import and Export Price Indexes

The DSR Ratio (debt service payments to disposable income) hit a new lower for the 2014 3rd quarter. Household Debt Service and Financial Obligations Ratios

A lower ratio means that households in the aggregate have more disposable income after debt service payments that can be spent, saved and/or used to reduce higher cost debt. The rapid decline in energy costs adds to disposable income that can be used for more benign economic purposes.

Mortgage Debt Service Payments as a Percent of Disposable Personal Income- St. Louis Fed

The primary reason for the decline in the DSR is massive tsunami of mortgage refinancings at abnormally low rates which reduces the debt service obligation. Foreclosures and bankruptcies have also contributed to the decline.

When looking at this data, it is important to keep in mind that about 1/3rd of primary residences are owned free and clear. U.S. Census BureauZillow Real Estate ResearchLos Angeles Times

If those households were excluded from the data altogether, the ratios would have much higher levels of debt service payments to disposable income. The improvement in the balance sheet of the indebted class is causing the decline in those ratios, as the savings class continues to avoid taking on debt.

Forest City plans to convert to a REIT effective 1/1/2016. The stock reacted positively to that announcement on a down day for stocks.

Closing Price 1/13/15: FCE-A: $22.21 +0.81 (+3.79%)

There was a robust gain in today's down market:

FCE-A: $24.72 +2.51 (+11.30%)

While I have bought and sold Forest City bonds, I currently only own the common shares bought as a Lottery Ticket back in January 2012: Bought: 30 FCE/A at $11.58


1. Sold 200 BHK at $13.86-Taxable Account (see Disclaimer):

Trade Snapshot and 2015 Dividend Payment:

Closing Price Day of Trade1/9/15: BHK: $13.71 +0.19 (+1.41%)

The market price rose $.19 from 1/8/15 while the NAV per share rose $.06.

Snapshot of Profit:

2015 Sold 200 BHK +$75.23
Item # 1 Bought 200 BHK at $13.4 (8/23/14 Post)

Snapshot of 2014 Dividend Payments:

2014 BHK Dividends=$109.5

Total Dividends 2014 & 2015= $124.6

Total Return: $199.83

Security Description: BlackRock Core Bond Trust (BHK) is a leveraged bond CEF that is weighted in investment grade bonds, but has a significant exposure to junk rated securities. As noted by the sponsor, the fund will generally have at least 75% of its assets in investment grade bonds.

Data on Date of Trade 1/9/15
Closing Net Asset Value Per Share: $15.05
Market Price: $13.71
Discount:  -8.9%
Discount at $13.86= 7.9%
Average Discounts
1 Year:  -9.65%
3 Year:  -5.98%
5 Year:  -6.2%

CEFConnect Page for BHK

Sponsor's Website: Core Bond Trust | BHK

Last SEC Filed Shareholder Report (fiscal year ending 8/31/14; holdings start at page 13; net unrealized appreciation $37+M-see page 64; capital loss carryforward $5.935+M-see page 91)

Sponsor's WebsiteCore Bond Trust | BHK (28.89% leverage as of 11/28/14; 97.8% weighted in USD denominated bonds with 595 holdings as of 12/31/14)

The sponsor states that the effective duration was 9.55 years as of 12/31/2104.

Credit quality is weighted in investment grade bonds with a significant allocation to "A" or better rated bonds.

Prior Trades: I have transitioned this position to the Roth IRA. Bought Roth IRA 200 BHK at $13.305 (11/7/14 Post) I noted in that post that I would sell the 200 shares held in the taxable account. The BHK dividends take on the tax characteristics of interest payments made by the bonds owned by the fund and consequently will be taxed at the highest marginal tax rate when owned in a taxable account.

Notwithstanding that tax issue, I will own non-tax favored investments in taxable accounts to generate cash flow. I will frequently transition the position to a retirement account after harvesting a number of dividends, when I can do so profitably. I intend to use the proceeds to buy a common stock that pays qualified dividends without having to dip into my cash allocation.

I have had one prior round trip transaction:

Sold All of the Bond CEF BHK at $14.058 (2/21/12 Post)(snapshot total return=$293.25 or 10.63%)

Given the nature of this investment, I am content with harvesting the dividends and exiting the position at a profit. An annual total return of 8% would be viewed as good. Eventually, I am going to get caught holding one or more leveraged bond CEFs when there is a non-temporary, quick and significant share price decline.  

Rationale: The primary reason for selling these shares was due to a pre-existing plan to shift ownership to the Roth IRA, where I started a 200 share position last November. I waited to see whether there would be a pop in the share price that would allow me to profitably exit the position held in a taxable account which occurred last Friday.

The current monthly distribution is $.0755 per share. At a $13.86 price, the yield is about 6.54%.

It is hard for me to generate much enthusiasm for that yield, given the risks associated with this leverage bond CEF  with close to a 10 year duration. I have a position since the alternatives are really very thin almost six years after the FED launched its Jihad Against the Savings Class.

When interest rates rose in 2013, leveraged bond CEFs saw their net asset values decline some as interest rates rose from an abnormally low level to a less abnormally low level.

While that decline was significant for many of them, the decline in the market price was at a faster rate.

When the market price declines at a faster percentage rate than the fall in net asset value per share, the discount to net asset value expands creating an even larger loss in value. A fairly typical result during periods of rising rates is for the market price to decline at nearly twice the rate of the net asset value per share decline. This phenomenon increases the yield, but that kind of decline can also easily wipe out the benefit of the dividend for a year or more.

At CEFConnect, an investor can explore this recent history for a particular CEF by clicking the "Pricing Information" tab and to change the one month history tab back to 5/1/13 when the 10 year treasury closed at a 1.66% yield. I will generally compare that data with 12/31/13 which was near the peak in that last interest rate spike.

BHK Historical Data:
Market Price: $15.06
Net Asset Value Per Share: $15.67
Discount: -3.89%

Market Price: $12.88
Net Asset Value Per Share: $14.1
Discount: -8.65

I can see right away that part of the market price loss was caused by an expansion of the discount from -3.89% to -8.65, more than a doubling.

Unadjusted for the dividends, the net asset value per share declined 10%, which should be a reminder to all investors that bond investing carries risks. The market price decline was greater at 14.48%. That additional loss is what I call a normal CEF risk. It can work both ways which gives investors both more risks than an ETF or a mutual fund investing in the same securities, and potentially greater benefits, depending on what happens to the discount after purchase. It is not a one way street.

With a current duration of close to 10 years, a slightly more than 1% increase in rates could result in a 10% loss in net asset value per share.

Investor Alert - Duration—What an Interest Rate Hike Could Do to Your Bond Portfolio - FINRA

It would not take much of a rise in rates to wipe out a year's worth of dividends.

Admittedly, investor are more concerned about deflation rather than inflation at the moment. Duration does work both ways. A 1% decrease in rates, which are already abnormally low, could result in close to a 10% NAV per share increase for a fund with a 9.55 year duration.

This fund's leverage increases the risks. A rise in short term rates will cause the borrowing costs to rise. If intermediate and longer term rates are also rising, then the value of securities bought with that borrowed money would be going down in value. Anyone investing in leveraged bond funds needs to understand that risk, which would likely be compounded by an increase in the discount in that scenario of rising short to long term rates.

At the moment, short term rates are near zero and the value of investment grade bonds went up both in 2014 and so far this year.

The ETF for investment grade corporate bonds, LQD, had a 2014 total return of 8.57% based on net asset value per year. The duration of that fund was 8.09 years as of 1/9/15: iShares Investment Grade Corporate Bond ETF.

The decline in intermediate and longer term interest rates, coupled with a steady and abnormally low short term borrowing cost, is an ideal scenario for leveraged bond funds who can generate a higher dividend for their investors due to the spread compared to an unleveraged fund investing in the same securities.

Conditions will change, possibly or even probably for the worse. So I do not view the leveraged closed end bond funds as long term holdings, but simply as trading vehicles that produce some income for funds that would otherwise generate a .01% yield in a brokerage money market fund.

In the Roth IRA, I turn that 6.5+% yield into a tax free one.

2. Sold 2 Linn Energy 8.625% Senior Unsecured Notes at 88.5 (see Disclaimer): 

Snapshot of Trade: 

Snapshot of Profit: 

2015 Linn 2020 Bonds (2) +133.78

Bought 2 LINN Energy LLC 8.625% Senior Unsecured Bonds at $81 (12/13/14 Post)

Before discussing this trade and the next bond transaction, I would note an important trading development at Fidelity. For the first time, I was allowed to enter my price for the bond and to keep that price open for an entire trading day. Other brokers that I use, including Schwab and Vanguard, do not allow for that kind order entry, and Schwab evens requires that its customers call their bond desk in order to sell bonds.  

Rationale: I got cold feet and decided to harvest my profit plus a month or so of interest. While crude oil rallied today (1/14/15), this was probably a short covering rally due to option expirations.

It simply appears to me that it will take a year or more before crude oil prices can sustain a $70+ per barrel price. If there is a worldwide recession, and Europe is probably already in another one, the demand component of the equation may even take longer to soak up the production.

It also looks like most U.S. shale producers are still planning to increase production in 2015 compared to 2014, focusing on more fertile areas with less rigs. It may take a year for their hedges to expire and to actually curb production Y-O-Y.

With this outlook and taking into consideration that both the Linn and Northern Oil bonds have risen in value even as crude oil declined in price, I decided not to gamble further with at least two of my recent purchases.

3. Sold 2 Northern Oil & Gas 8% Senior Unsecured Bonds Maturing in 2020 at $81.75-Bought at 73.9  (see Disclaimer): 

Snapshot of Trade: 

Snapshot of Profit:

2015 Sold 2 NOG 8% Senior Unsecured Bonds +$133.15 

High Risk Junk Bond Strategy: Bought 2 Northern Oil & Gas 8% Senior Unsecured Bonds Maturing 2020 at 73.9 (12/22/14 Post)

Rationale: I got cold feet and decided to harvest my profit for the reasons outlined above.

For both the Linn and Northern Oil bonds, I had to pay the bond sellers accrued interest when I made those purchases and I will receive accrued interest from the buyers who just bought those bonds from me. I netted only $26.75  in interest since I did not own these bonds for long.

Total Return Linn and NOG Bonds: $293.68 

4. Bought 25 of the ETF PFF at $39.55-Commission Free at Fidelity (see Disclaimer): The iShares U.S. Preferred Stock ETF Fund (PFF) can be bought commission free at Fidelity, so I do not mind buying small lots whenever the spirit moves me.

A similar ETF, PowerShares Preferred Portfolio ETF (PGX), can currently be bought commission free at Charles Schwab.

I have bought and sold PGX back in 2010. Item # 5 Sold: 200 PGX at $14.38 (11/12/14)(profit snapshot=$155.96)-Item # 3 Preferred Stock ETFs: Bought 200 PGX at $13.53 (6/25/10 Post) That later linked post has a discussion of "preferred stock" ETFs.

Since I have bought and sold many of the individual securities owned by these two "preferred stock" ETFs, I decided to take a starter position and describe here what I know about these securities including their material risks. The readers of my blog know already that I prefer to buy the individual securities rather than the ETFs.

Most of the securities owned by these funds are not traditional equity preferred stocks. They are junior or senior bonds that are superior in the capital structure to equity preferred stocks. The junior bonds fall into three categories: trust preferred securities, European hybrids, and baby bonds. The senior bonds are mostly unsecured, but there are a few first lien bonds. For the most part, these bonds are "exchange traded" securities with $25 par values.

I discuss these categories of exchange traded bonds in this post.

The preferred stock ETFs do not own the exchange traded bond known as Trust Certificates, since that fertile area for bond investors has almost become extinct due to calls.

I explain in more detail why trust preferred securities are in reality junior bonds in two old posts. Regular Preferred and Trust PreferredTrust Preferred Securities: Links in One Post. Many of those securities have been redeemed by the issuers, but a number are still around.

A trust preferred stock involves the creation of what is called a Delaware Trust, and that trust then buys a junior bond issued by the entity creating that trust. The trust "preferred stock" represents an undivided beneficial interest in the junior bond owned by the trust. Trust preferred securities pay interest and have maturity dates. The junior bonds owned by the trust have a superior claim to income than any properly classified equity preferred stock from the same issuer which will be junior in priority to all bonds and senior only to common stock in the capital structure.

The European hybrids owned by the preferred stock ETFs are mostly issued by Aegon and ING. Those securities are technically junior bonds. I discuss those types of securities in two old posts of mine: Aegon Hybrids: Gateway Post and ING Hybrids: Links in one Post.

There are equity preferred stocks owed by the "preferred stock" ETFs, mostly issued by REITS and financial institutions.

REIT equity preferred stocks pay cumulative dividends. Stocks, Bonds & Politics: REIT CUMULATIVE PREFERRED LINKS IN ONE POST/Advantages & Disadvantages

The equity preferred stocks issued by bank holding companies are generally non-cumulative which simply means that the dividend can be eliminated just like a common stock dividend. A cumulative dividend can not be eliminated, but may be deferred once the issuer eliminates a cash dividend payment to the common shareholders. The cumulative dividend in arrears must be paid in full prior to the re-initiation of a cash common share dividend. There is a YouTube video that explains the differences between cumulative and non-cumulative in more detail. I only watched a minute of it, and thought that it would be helpful to beginners in this field.

Snapshot of Trade: 

2015 Bought 25 Shares PFF at $39.55+

Security Description: I would describe the following summary provided by the sponsor as misleading and erroneous:

iShares U.S. Preferred Stock ETF | PFF

Some investors accept the name as describing the contents.

A significant number of the securities owned by this fund pay interest rather than dividends and are not traditional preferred stocks. The security may come in a "preferred stock" wrapper like a trust preferred, but that does not change the nature of the security. It is a bond and a bond owner has no equity interest in the business.

Moreover, I would even disagree that the owner of an equity preferred stock has any direct equity interest in the business. The equity preferred stock owner simply has a preferred claim to the income compared to the common share owners. If the business is sold, the equity preferred shareholders are not included in the buyout, unless there is a change of control provision in the prospectus. Even then, the preferred stock issuer may elect to redeem the preferred stock at par value plus the accrued dividend rather than to allow those preferred stock owners to convert into common shares and receive the benefits of a premium share offer to the common shareholders.

The sponsor's statement is misleading when it fails to distinguish traditional "preferred stocks" and bonds that are in fact owned by the fund.

Given adequate information, it would be easy to identify the bonds owned by PFF. I will refer hereafter to some prospectuses and the trading symbols for securities owned by PFF as of 9/30/14. This list is not meant to be comprehensive, but merely a representative sample. The fund makes it difficult to identify the securities properly by refusing to provide the symbols or even the coupon amounts at its main webpage that would enable me easily to identify the true characteristics of each holding. Instead, I went to the last semi-annual report that gave me the coupon information that allowed for an identification of the security.

Semi Annual Report  for the Period Ending 9/30/14.pdf

The list of PFF's holdings start at page 11. The first category in that report is called "automobiles" and that is erroneous too. The securities listed after automobiles are mostly bank trust preferred securities with one trust preferred issued by GMAC. The Countrywide trust preferred securities listed under automobiles are now BAC obligations. There is one senior bond listed in this "automobile" grouping that was issued by Goldman Sachs.

Trust Preferred (junior bonds): 

BAC Capital Trust VIII 6% (symbol: BACPRZ);  BAC Capital Trust VIII Prospectus Supplement

FPL Group Capital Trust (symbol NEEPRC); Prospectus

J. P Morgan Chase Capital XXIX (symbol: JPMPRC); Prospectus Supplement

Merrill Lynch Capital Trust I 6.45% (symbol: MERPRK);  Final Prospectus Supplement

SCE Trust III 5.75% (symbol: SCHPRE); Final Prospectus

European Hybrids (Junior bonds): 

There are several ING hybrids listed at page 13.

ING 7.05% (symbol IND)

ING 7.2% (symbol INZ); Prospectus

Several Aegon hybrids are listed at page 14, and I have owned most of them.

Aegon 6.5% (symbol: AED);  Prospectus

I bought both the ING and Aegon hybrids when they could be purchased at less than 1/2 of their $25 par values during the Near Depression period and no longer own any of them.

For U.S. investors, payments made by these hybrid securities have been treated in the past as "qualified" dividends. Since I no longer own any, I am not positive of their current tax classification. When I owned them in the past, they were called hybrids, because the regulators allowed the financial institutions issuing them to include these junior bonds as part of equity capital. Their potentially perpetual character is also an equity feature that distinguishes them from U.S. trust preferred securities, as explained further in the Aegon hybrid post linked above in the introduction section.

Baby Junior Bonds/Non-Trust Preferred

Stanley Black and Decker (symbol: SWJ); Final Prospectus Supplement

NextEra Energy Capital Holdings 5.125% (symbol: NEEPRI); Prospectus

Baby Senior Unsecured Bonds: 

Ares Capital 7.75% (symbol: ARY) Prospectus

Apollo Investment 6.63% (symbol: AIB); Final Prospectus Supplement

Argo Group 6.5% (symbol AGIIL); Final Prospectus Supplement

Prospect Capital 6.95% (symbol: PRY); Prospectus

Qwest  7% (either CTU or CTX, both senior bonds and maturing in 2052)

Selective Insurance Group (symbol SGZA); Prospectus

Telephone and Data Systems 6.88% (symbol TDE); Prospectus

TravelCenters 8.25% (symbol: TANN); Prospectus

United States Cellular 6.95% (symbol: UZA); Prospectus

Many of the foregoing securities have been discussed in my blog after their purchase.

The reference to the Goldman Sachs 6.13% in the automobile section is believed to be a GS senior bond maturing in 2033. Bonds Detail at FINRA Some of those bonds were owned by Grantor Trusts and were traded in the stock market in the Trust Certificate legal form of ownership. I believe that all of the fixed coupon ones have been called by the owner of the call warrants, but there is still a Synthetic Floater, GJS, that has that 2033 GS senior unsecured bond as its underlying security. That security, however, only pays a .9% per annum float over the 3 month treasury bill rate up to 7.5% for as long as the "swap agreement" remains in force. Prospectus

Baby Senior Secured bonds-First Mortgage

Entergy Arkansas 5.75 (symbol EAA); Prospectus

Entergy Arkansas 4.9% (symbol: EAB);  DEFINITIVE PROSPECTUS SUPPLEMENT

Entergy Louisiana 5.25% (symbol ELJ); Definitive Prospectus Supplement

That was a lot of busy work to prove a point. A large number of securities owned by this fund are properly classified as bonds.

Dividends: This fund does monthly dividends at a variable rate. Morningstar provides the following annual data per share:

2014: $2.4913
2013: $2.4321
2012: $2.383

Rationale: I am an income oriented investor who has no "risk-free" options for income generation due the Fed's long standing Jihad Against the Savings Class. To secure any yield, I have no choice but to take risks, including many that I would normally refrain from assuming when a short term bank CD paid 4%+.

Morningstar has the 12 month yield at 6.33% based on a $39.52 closing price. That is what the sponsor shows as of 12/31/14.

Given the interest rate spike in 2013, the fund held up better than similar CEFs, producing a total return of -.59% that year based on NAV. Based on net asset value, the total  return numbers in 2012 and 2014 were +18.25% and +13.5% respectively. The total return number in 2008 was unacceptable in my opinion at -23.24%. The five year total annualized return through 1/13/15 was 7.57% which is acceptable for this kind of fund in my opinion. Future returns may be harder to come by given the current prices of the securities owned by this fund, and the call option right reserved by the issuers.  

Risks: The risks are summarized in the Prospectus starting at page S-3.

Many of these securities in existence during the recent Near Depression were smashed in price. I bought equity preferred REIT stocks at less than 1/2 of their par values. The European hybrids from ING and AEG fell into the single digits. Trust Preferred securities issued by financial institutions fell so far that many of them could have been bought with 15% to 20% current yields.

Non-cumulative equity preferred stocks issued by financial institutions were smashed worse than trust preferred securities issued by the same institution.

When a bank holding company goes belly up, I seriously doubt that its trust preferred or equity preferred securities will have any value whatsoever. The downside is zero. At their current prices, and considering that these types of securities may be called at the issuer's option five years after issuance, there is limited upside potential now.

With interest rates declining, these securities still have interest rate risk since they are designed to be that way by the issuers. If interest rates fall sufficiently, thereby making it beneficial for the issuer to call the security when it legally can do so, then that is a form of interest rate risk for the owner. The owner is left with proceeds to invest in a similar security with a lower yield or a more risky security with a higher yield.

If interest rates rise, making the current coupon a good deal for the issuer, then the owner is faced with two bad options: sell at a loss or lose the opportunity to secure a higher yield by leaving the funds invested in a security with a lower yield at their cost and a declining price. Interest rate risk is asymmetric between the issuer and the owner which is why these securities are sold to retail investors.

Institutional investors want some kind of make whole provisions that would penalize the issuer for an optional redemption. The standard make whole provision in a long term bond, traded in the bond market with a $1,000 par value, would require the issuer to pay the bond owner the principal amount plus all interest payments to maturity discounted to present value using generally a treasury rate for the same maturity plus a small spread.

Given the low treasury rates now, the discounting to present value results in a huge number for the principal amount and all future interest payments. Those type of long bonds trade at huge premiums to par value since it would be punitive for the issuer to redeem them. That is not the case for exchange traded bonds sold to retail investors which generally allow for an optional redemption at par value plus accrued interest (or dividends for equity preferred stocks) after the expiration of five years from the IPO date.

The GS senior unsecured note maturing in 2033, referenced above, closed today (1/14/15) at $124.98 with a YTM of 4.147% If GS could redeem that bond at par value with no penalties, it would have already done so. The Prospectus for that bond contains a standard make whole provision:

I would reference the 7.55% WMT senior unsecured bond, maturing in 2030, that closed at 148.72 today. The yield to maturity at that substantial premium to par is only 3.4%. Bonds Detail  As I recall, that one does not even allow for an optional redemption which illustrates the impact on price when rates are so low.

I find it annoying that Ishares does not provide credit quality information on the securities owned by PFF. That is just inexcusable. PGX does provide that information, and I suspect that PFF is close to the same division between junk and BBB.

PGX as of 1/13/15: 47% rated BB or B by S & P
Product Detail

Both of these ETFs will have significant ownership of junk rates securities, primarily equity preferred stocks issued by some REITs and financial institutions, but some of the trust preferred securities and senior bonds are junk too.  So there is significant credit risk in addition to the asymmetric interest rate risk.

Future Buys: I will consider averaging down in small lots provided I can do so on a commission free basis.  

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