Wednesday, February 11, 2015

Pared Interest Rate Risk by Selling in a Taxable Account: 200 PDT at $14.26, 50 AMHPRA at $25.4 and 100 EFM at $25.96/Initiated Position in Toronto Dominion (TD) at $43.37

Stable Vix Pattern (Bullish):
Links to SeekingAlpha Instablog, Articles and Comments:

South Gent's Instablog | Seeking Alpha

South Gent's Articles | Seeking Alpha

South Gent's Comments | Seeking Alpha


Recent Developments:

Citigroup believes that the recent bounce in crude oil prices is a "head fake", and the price will soon careen down to as low as $20. Citigroup, who must have a direct connection with the Lord Almighty, reduced its 2015 WTI forecast to $46 per barrel from $55. The $20 price would match the low hit in 2002. There are traders who are buying out of money put options at $20, but it is not known whether any of them are Citigroup employees. Oil prices rallied in response to that report. Light sweet crude for March delivery, referred to by the Journal as the current U.S. benchmark, rose $1.17 or 2.3% to settle at $52.26 per barrel, up 19% from the low hit on 1/28/15.

Another top oil analyst predicts that WTI will decline into the 30s during the second quarter.

Goldman is another just another oil bear.

Virtually all, or possibly even all of the oil bears, are recent converts. Having failed to predict the crude oil price slide, they are now discovering a bevy of reasons for the price to go lower.

I mention these bearish forecasts simply to highlight what could go wrong. We shall see just how good these forecasts prove  to be in the fullness of time. If you are going to predict the future, predict often since that will improve your chances of being right once.

Coca Cola (own) reported better than expected results for the 2014 4th quarter. 2014 Q4 Earnings Release U.S. multinationals will be negatively impacted in 2015 by the USD's strength that will lower reported revenues and profits from overseas. The currency conversion that takes place for accounting purposes does not actually occur.  U.S. multinationals do not bring the cash back to the U.S. since that would generate a tax hit. Given the frequently significant fluctuations in the dollar's value, and the pretend impact on earnings resulting from currency fluctuations, I believe that it is just best to focus on how a company is doing in constant currencies.  On that basis, net revenues grew 4% Y-O-Y and operating income rose 7%.

Closing Price KO Day of Report: $42.4 up $1.17


The rationale for all of the sells discussed in this blog is the same, and is as follows:

Rationale: I am continuing to pare my interest rate risk exposure by selling leveraged closed end bond/preferred stock funds, exchange traded bonds and equity preferred stocks.

The first sell discussed below is a leveraged closed end fund that was bought near the apex of the rate rise in 2013.

When the FED starts to raise the federal funds rate, the leveraged closed end funds will incur increased borrowing costs. Any increase in borrowing costs will narrow the net interest spread and place pressure on the fund's distribution level, but that is not the main problem.

The main danger involves a rise in U.S. intermediate and long term rates that will cause the bonds and bond like securities to go down in price, including those purchased with borrowed money that will become more expensive for every increase in the federal funds rate by the Federal Reserve.

As shown by the interest rate spike occurring in 2013, the percentage decline in market price will generally be more severe than a decline in net asset value per share, which causes the discount to net asset value to expand. This is what I call the Triple Whammy: (1) an increase in borrowing cost; (2) a decline in net asset value aggravated by the use of leverage; and (3) the increase in the discount to net asset value as the market price declines by a larger percentage than the net asset value per share.

Intermediate and long term rates have already started to rise. Interest rates started to rise last week after better than expected economic news, particularly the jobs report for January. As previously discussed many times here and at SeekingAlpha, it is my opinion that the current abnormally low interest rates are not justified by the improving U.S. economy and are best described as the bond market equivalent of stocks in 1999.

In short, I have decreased the odds of the Japan Scenario, which the Stock Jocks have viewed as a Bond Ghoul deranged delusion, and have increased the odds of a major correction in Bond Land.

2/2/15 through 2/15/15

Daily Treasury Yield Curve Rates

Future Buys: I will need to see much lower prices before considering the repurchase of these securities. I am more likely to buy back the Entergy Mississippi first lien bond than the other two, but I would want a price below par value to consider a repurchase of that exchange traded bond.

1. Sold 200 PDT at $14.26  (see Disclaimer):

Snapshot of Trade:

2015 Sold 200 PDT at $14.26

Snapshot of Profit:

2015 Sold 200 PDT +$490.23
Item # 1Bought: 200 PDT at $11.73 (10/24/13 Post)

All of the dividends were taken in cash.

Security Description: The John Hancock Premium Dividend Fund (PDT) is a leveraged balanced closed end fund. The common stock component includes electric utility and natural resource companies that pay decent dividends. Preferred securities would generally encompass more than equity preferred stocks or traditional preferred stocks,  and would include trust preferred securities and European hybrids (in effect junior bonds). Some senior bonds may be found in the portfolio mix.

It would be helpful for a sponsor to specifically break out the various categories in the holdings list. As of 7/31/13, PDT owns several equity preferred stocks that would pay qualified dividends. I noticed several securities that are exchange traded bonds that pay interest including the following:

BGE Capital Trust (BGEPRB) 6.2% Trust Preferred (in effect a junior bond)
DTE Energy (DTQ) 5.25% Junior Subordinated Bond
DTE Energy (DTZ) 6.5% Junior Subordinated Bond
Duke Energy (DUKH) 5.125% Junior Subordinated Bond
Entergy Mississippi (EFM) 6.25% First Mortgage Bond
HECO Capital Trust III 6.5% (HEPRU) Trust Preferred
Next Energy Capital 5.125% (NEEPRI ) Junior Bond
SCE Trust 1 5.625% (SCEPRF) Trust Preferred
SCE Trust II 5.1% (SCEPRG) Trust Preferred
Stanley Black & Decker (SWJ) Junior Subordinated Bond
Telephone and Data Systems (TDI) 6.625% Senior Bond
Telephone and Data Systems (TDE) 6.875%  Senior Bond
United States Cellular (UZA) 6.95% Senior Bond
Verizon (VZA) 5.9% Senior Bond

Trust preferred securities are in effect junior bonds. Regular Preferred and Trust PreferredTrust Preferred Securities: Links in One Post

The foregoing is not a comprehensive list of non-equity preferred stocks owned by this fund. 

Data as of 2/9/15: 
Closing NAV: $15.65
Closing Price: $14.29
Discount: -8.69%

Sourced: CEFConnect Page for PDT

Sponsor's Website: Premium Dividend Fund

SEC Filings for PDT

Last SEC Filed Shareholder Report (period ending 10/31/14)

PDT Page at Morningstar (currently rated 4 stars; some recent ROC dividend support; leveraged at 32.79%)

Dividends have been paid monthly at the current rate of $.09 per share. John Hancock Premium Dividend Fund (PDT) Dividend Date & History

2. Sold 50 AMHPRA at $25.4 (see Disclaimer):

Snapshot of Trade:

Snapshot of Profit:

2015 AMHPRA 50 Shares +$26.58
Bought: 50 AMHPRA at $24.55

Security Description: I will drag and drop my earlier discussion, updating it where relevant.

The American Homes 4 Rent 5% Participating Preferred Series A (AMH.PA) is an equity preferred stock that pays cumulative dividends. The issuer is a relatively new REIT known as American Homes 4 Rent (AMH), formed in 2011 to buy, renovate and lease single family homes. As of 9/30/14, AMH owned 30,877 single family homes in 22 states. American Homes 4 Rent | Corporate Profile

June 2014 Investor Presentation

To understand this one, the investor is going to have to spend some time reading the prospectus. I am just going to hit some of the peculiarities.

Prospectus: Amendment No. 2 to Form S-11

Initially, the issuer will pay a 5% fixed coupon on a $25 par value. The par value can be increased by 50% of the cumulative increase in home price appreciation starting on 6/30/13, calculated using an index tracking the price in AMH's 20 top markets weighted by AMH's total investment as of 7/31/13.

The House Price Index used in this calculation is published by of the Federal Housing Financing Agency and is called the non-seasonally adjusted "Quarterly Purchase-Only Index". (link to press releases published by the FHFA: Federal Housing Finance Agency - News Releases This is a link to the 2013 third quarter report: (table 2 at page 15).

So the first item to know is the relative weightings by market as of 7/31/13 which can not change. I would have a positive view of the overall top 20 markets, though I have no opinion on the relative weightings:

Fortunately, AMH will be updating the increase, if any, in the home price appreciation amount that will be added to the $25 par value and paid upon redemption or conversion into common shares. American Homes 4 Rent Announces Home Price Appreciation Amounts for its Series A Participating Shares Press Release Dated Nov. 27, 2013 (Home Price Appreciation Amount through 9/30/13=$.324). This is an illustration provided by AMH of how this works:

Hypothetical Illustration

I believe that the last computation was made in this Press Release.

Please note the heading in bold type about a 9% cap. This one has the potential to hit a 9% internal rate of return by September 2020 (5% coupon +4% HPA). A 7% internal rate of return may be more likely than 9% in my estimation (future guess!) given the 50% participation rate in the HPA.

If AMHPRA is not redeemed or converted into common shares before 9/30/2020, the dividend rate becomes 10% paid on the $25 par value plus the home price appreciation amount (HPA). 

Even with no increase in the liquidation amount, there would be an incentive to redeem due to the spike in the coupon. Adding a significant HPA to the $25 par value, and then tacking a 10% coupon onto that total, would be a powerful incentive for the issuer to redeem or to convert the preferred shares into common shares. Consequently, this security has far less interest rate risk than a typical equity preferred security due to the likelihood of a 2020 redemption and the potential increases in the principal amount by the HPA calculation.

The conversion into common shares, one of the possibilities, or a redemption can happen at AMH's option after 9/30/15. The HPA amount will be realized upon the exercise of either option. The conversion calculation is beyond the scope of this blog and can be found in the prospectus.

The last ex dividend date was on 12/11/14.

Company Website: American Homes For Rent | Home

AMH Key Statistics

AMH Analyst Estimates

American Homes 4 Rent  Key Developments Page at Reuters

American Homes 4 Rent  Profile Page at Reuters

2014 3rd Quarter 10-Q

SEC Filings For AMH

This preferred stock was selected for disposition due to its current low yield.

3. Sold 100 EFM at $25.95 (see Disclaimer):

Snapshot of Trade:

2015 Sold 100 EFM at $25.95

Snapshot of Profit:

2015 EFM 100 Shares +$91.04

Bought 100 EFM at $24.88 (2/17/14 Post)

4 Quarterly Interest Payments at $38.75=$155

Total Return: $246.04 or 9.86% (holding period 1 year)

The total return number is close to the best case scenario when buying this bond slightly under its $25 par value. The issuer has the right to call this bond at par plus accrued interest at anytime after 4/15/15 which caps the upside price appreciation.

Snapshot of Remaining Entergy Subsidiary First Mortgage Bond Positions: All Roth IRA:

Roth IRA Position EMQ, EFM, ELB-Snapshot Trading Day on 2/10/15

Security Description: The Entergy Mississippi Inc. 6.20% Series First Mortgage Bonds 2040 (EFM) is a first lien bond on substantially all of Entergy Mississippi's assets. Interest is paid quarterly based on a fixed coupon rate of 6.2% on a $25 par value. The issuer has the option to redeem at par value plus accrued interest on or after 4/15/2015. Unless the issuer elects to redeem this bond early, it will mature on 4/15/2040.

It is certainly possible that the issuer will redeem this bond provided interest rates are at current levels, or lower, when the optional redemption right comes into being. I would note, however, that the issuer has not redeemed the functionally equivalent first mortgage bond EMQ, which has a 6% coupon, even though it has that right since November 2007.

EFM Prospectus: Preliminary Prospectus Supplement

:Bought 50 Toronto-Dominion at $43.37 (see Disclaimer):

Snapshot of Trade

Snapshot of Quotes at Time of Trade:

CAD Priced Shares-Toronto Exchange:

USD Priced Shares-NYSE

Without even looking at the CAD/USD exchange rate, I knew that the Canadian Dollar had fallen significantly in value during the day. The disparity in price was caused by the CAD falling in value against the USD.  The TD share price will reflect the CAD TD:CA price converted into USDs.

1 Year Chart: TD vs. TD:CA

To highlight the currency risk of owning any foreign security, I will draw a chart comparing the performance of the same stock priced in two different currencies. The CAD has been declining significantly in value against the USD over the past year and that decline will cause TD to significantly underperform TD:CA:

Looking on the positive side, I bought the USD priced shares near a ten year low of the CAD/USD exchange rate, so I have already missed the adverse impact of the CAD's devaluation up to the time of my purchase. I have that currency risk and potential currency benefit going forward. The benefit can simply be expressed by what happens to the TD price when the exchange rate returns to 1 CAD for 1 USD and the Toronto listed shares are priced C$54.6, the same as shown in the previous snapshot. My TD shares would be at $54.6, up almost 26% in value with no change in the CAD ordinary share price.

The current CAD value is very close to the ten year low: CAD/USD Interactive Chart

Company Description: Toronto-Dominion Bank (TD) is the currently the largest Canadian bank. TD also has one of the largest retail banking networks in the U.S. The U.S. banking operations primarily originate from TD's acquisition of Banknorth Group in 2004 and Commerce Bancorp in 2007.

As of 12/31/14, TD had 1,165 retail branches in Canada and 1,328 branches in the U.S. along the Eastern Seaboard.

SEC Filings for Toronto Dominion

TD Bank Group - Investor Relations

2014 Annual Report.pdf

TD's long term debt is rated Aa1 by Moody's and AA- by S & P: Credit Ratings

Dividend History: The dividend will be paid in CADs after a 15% withholding tax and converted into USDs for payment to the TD stock owners. Consequently, a decline in the CAD's value after purchase of the stock will amount to a dividend cut, while an increase in the CADs value against the USD will in effect be a dividend increase The currency exchange will consequently impact the dividend yield.

The current quarterly dividend is C$.47 per share or C1.88 annually per share.

For purposes of illustration only, I converted that annual rate into USDs and came up with $1.49 as of 2/11/15. At that dollar value, and assuming a total cost per share of $43.37, the dividend yield would be about 3.44%. The actual yield will depend on the dividend and conversion rates going forward as applied to my total cost per share number.

I just took a snapshot of the dividend history going back to 2000 that shows a consistent history of dividend raises, including raises in 2008 and 2009. There have been no dividend cuts.

Dividend History

Claiming Foreign Taxes: Schwab Publication

U.S. Resident Dividend Reinvestment Plan: Prospectus.pdf

The only sure way to participate in a company's DRIP is to own the shares in your own name and then fill out the enrollment form. I thought that the TD plan was a little odd in that it referred to buying the shares at the market price or anywhere from a 0% to 5% discount. I did note that the last dividend was reinvested at no discount to the market price.

Most brokers do not enroll their customers in a company's DRIP plan when the customer selects the reinvestment option. Instead, as I explained in an Instablog here and in my blog, brokers aggregate their customer's dividends and buy the shares in the open market which causes wide disparities in the reinvestment price. Lexington REIT (LXP) - South Gent | Seeking AlphaStocks, Bonds & Politics: Item # 1 Continuation of Discussions Re: Broker Price Differences For Reinvested Dividends

Fidelity is the only broker that I use who enrolls their customers indirectly in the DRIP through participation in a Depository Trust Company plan. That DTC plan covers a limited number of securities and LXP is one of them, so I receive a 5% discount on the dividends paid by LXP and currently owned in a Fidelity Roth IRA.

I am going to select the reinvestment option and see what happens. I bought this stock in a Fidelity taxable account.

Recent Earnings Report: I took some snapshots of relevant material from the 2014 4th quarter earnings report. All amounts are expressed in Canadian Dollars. The 4th quarter ended on 10/31/14.

For  2014, the bank reported diluted E.P.S. of $4.27, up from $3.44 in 2013. On an adjusted basis, excluding certain items, E.P.S. rose to $4.27 from $3.71 on a comparable basis. The adjustments for 2013 included amortization of intangibles, integration expenses relating to the integration of MBNA Canada, and other one time "set up and conversion" costs relating to certain operations (page 7 of earnings release)

Tier 1 equity capital, using fully phased in Basel III standards, was 9.4% as of 10/31/14, up from 9.3% in the prior quarter.

The adjusted efficiency ratio was at 56.2%. Any number below 60% is viewed positively when I look at a bank's stock.

Financial Highlights:

The dividend payout ratio is at 51.3%.

The adjusted return on common equity is good at 14%.

Financial Highlights by Segment:

Canadian Retail: The efficiency ratio for TD's Canadian retail branches is much better than its U.S. operations. The Canadian banks have a reported 45.2% efficiency ratio and a ROE as adjusted of 42.5% which is just stunning.

U.S. Retail: A map of the U.S. branch network can be found here There is a lot of room for improvement in TD's U.S. banking operation. The efficiency ratio is at 67.5% and the ROE is at 7.6%. The net interest margin was a respectable 3.65% under the current circumstances.

Wholesale Banking:

SEC Filed Press Release

Rationale: I am an investor rather than a gambler, but there is some gambling associated with investing. In effect, I am placing a bet that three events will occur within the next three to five years. The following appears to be somewhat simple minded, but sometimes it pays not to over think what may or may not happen in the future.

1. Toronto Dominion will continue to raise its dividend.

2. The Canadian priced shares will rise in value, as fears ebb about exposure to home mortgage and energy loans and E.P.S. continues to grow.

3. At some point in the next five years, the CAD will rally against the USD, hopefully during a period when the ordinary shares traded in Toronto are rising too, and will return to parity with the USD, giving the buyer of TD what I call a Twofer.

It is of course entirely possible that the CAD will continue to weaken and will establish new ten year lows against the USD. I suspect that the CAD will remain weak until there is a recovery in crude prices since investors rightly or wrongly view the CAD as a commodity based currency.

While I may be in the minority, I am more willing to assume the currency risk after the foreign currency gets plastered in value. I am not talking about buying a stock in some third world country whose currency has gone down 50%, but developed nation currencies whose government bonds are rated AAA.

Canadian, Sweden, Norway and Australian government bonds are rated AAA by both Moody's and S & P, and I can not say the same for U.S. government bonds (AA+ rating from S & P). Credit Ratings

My starting price generates a decent dividend yield as noted above.

In my opinion, valuation is currently well within in a fair value range The TD Key Statistics page at Yahoo Finance shows the P/E at 8.81 based on today's closing price of USD$43.53, using the current E.P.S. estimate of $4.94 for F/Y 2016.

Using the estimate for the F/Y ending in October 2015, which is currently $4.55, the P/E is about 9.53 at my purchase price.

Risks: In addition to the currency risk, which I always view as a substantial risk when investing in any foreign security, investors perceive significant risks relating to home mortgage and energy loans.

All of the Canadian bank stocks were hit when crude went into a downside and extreme parabola. It goes beyond the energy loan exposure and would also involve loans to other businesses who depend on a thriving oil based economy, particularly in the oil producing regions in Western Canada.

I am going to drag and drop here my discussion of these two risks contained in a recent Instablog: Bought Back The Canadian ETF iShares Canadian Financial Monthly Income ETF (FIE:CA) - South Gent | Seeking Alpha

Prior to the abrupt decline in energy prices starting last summer, investors were mostly concerned about the Canadian banks' exposure to the overheated housing market. There are numerous articles discussing the issues relating to what many analyst believe is an overvalued housing market. An article published at The Motley Fool Canada correctly points out that a large number of home mortgages are guaranteed by a governmental agency called About Canada Mortgage and Housing Corporation or just CMHC; and the loan to value ratio for the uninsured portion is really low. The article has a chart of the insured loan percentage and the average loan to value ratios for the large Canadian banks. TD had 63% insured and a LTV ratio of 61% for the uninsured mortgages. I have trouble getting worked up above this issue, given those facts and some others, unless prices go parabolic from here.

Canadians have a different view about paying their mortgage obligations compared to many Americans. Home mortgages in arrears trend at less than .5%. The latest statistic that I could find is .28% as of October 2014 or 12,959 mortgages out of 4,652,471: .pdf The average home equity is 66% of the value.

For comparison purposes, the U.S. S&P/Experian First Mortgage Default Index was at 4.76 in December 2009 and at 1.02 last December. A number of U.S. states encourage strategic defaults by allowing the borrower to avoid a deficiency judgment or by requiring court approval before a foreclosure which can take years allowing the defaulted borrower to live rent free in a home. In 2011, the NYT that it would take "49 years" to clear the court foreclosure backlog at the then current pace.

About 70% of Canadians pay off their credit card balances every month. Household Borrowing in Canada

The hand wringing usually starts with some negative statistics including the increases in home prices (particularly in Vancouver and Toronto) and household debt to disposable income ratio which is high. The 2014 third quarter ratio was at 162.6%, Financial Post. The U.S. ratio hit a high slightly over 130% in 2007. Households and Nonprofit Organizations; Credit Market Instruments; Liability, Level/Disposable Personal Income - St. Louis Fed An article published in April 2014 contains the bear case in 11 charts.

There was a barrage of article in the Canadian press over the past week about a McKinsey and Company report that singled out Canada and six other countries as potentially vulnerable due to household debt. (e.g. article at Toronto Star and BNN News)

A pop in home prices can happen due to a number of events. The most important now is that home prices have risen so much that they become unaffordable and a price correction ensues that allows for around 50% of median income families to afford a median price home. Low borrowing costs is also encouraging an accumulation of debt and a rise in interest rates could cause debt servicing problems for highly indebted households, a scenario that could be exacerbated by an economic downturn and job losses. The loss of several thousand high paying energy jobs in a particular locality could be the spark to cause a major price correction in that locality.

The decline in crude prices just added another layer of risks and concerns. The WSJ published an article last January that summarized existing loan exposure and potential undrawn exposure. I will just summarize those statistics here, with all numbers being approximate amounts:

TD: Oil, Gas and Pipeline C$3.6B or .7% of total loans; Undrawn exposure C$5.7B
BOM: Oil and Gas at C$5.9B or 1.9% of total loans; Undrawn exposure C$6.9B
Bank Nova Scotia: Oil and Gas at C$12.9B or 2.9% of total loans; Undrawn exposure C$10B
RBC: C$6.9B or 2.1% of total loans; Undrawn Exposure at C$22.2B

Without knowing more about the loans, the covenants required for drawdowns, and the identity of the debtors, I can only say that those numbers present concerns worth monitoring, but would not impact a decision now for me to invest in Toronto-Dominion or Bank of Montreal. With a fund, I am already diversified and consequently have less reasons for serious concerns unless oil tumbles further and remains at the current prices or lower for more than 12 or 18 months.

The WSJ is correct to note that the banks could suffer from indirect exposure, particularly in regions where oil production is a major part of the local economy.

A summary of BMO Capital's take on energy loans can be found in this January article published by the Financial Post.

The company discusses risk factors relating to its operations starting at page 68 of the 2014 Annual Report, 2014 Annual Report .pdf  That summary is a long one.

Future Buys and Sells: For this kind of stock, I may take the position as high as 200 shares. The next purchase will likely be just a 30 share odd lot in the Roth IRA. I am reducing my bond allocation in the retirement accounts due to interest rate risk concerns.