Saturday, February 7, 2015

Pared Interest Rate Risk: Sold 300 JTP at $8.55, 50 CORPRA at $26.25, 100 NBB at $21.25 (Roth IRA), 50 EMQ $25.61 and Bought 2 Vanguard Natural Resources 7.875% Senior Unsecured Bond Maturing April 2020 at $86.59

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

I provide a longer description of my rationale for the foregoing trades in the introduction setion to this SA Instablog:  Bought 2 Vanguard Natural Resources 7.875% Senior Unsecured Bonds Maturing 4/1/20 At 86.59 - South Gent | Seeking Alpha

1. Bought 2 Vanguard Natural Resources 7.875% Senior Unsecured Bond at 86.59 Maturing 4/1/2020 (see Disclaimer):

Snapshot of Trade:

Order Details:

The order details shows that the bond has junk ratings. The current ratings are B3 from Moody's and B from S & P.

I had to pay the seller of those two bonds accrued interest in the amount of $56.44. I will receive that amount back when Vanguard Resources makes the next semi-annual payment on 4/1/2000. The broker will include the entire semi-annual interest payment in my 1099 for this tax year, which then requires a tax accounting adjustment to reflect that I did not in fact receive $56.44 of that payment.

Many individual investors prefer buying exchange traded bonds that can be bought just like a stock due to par values generally being $25 or less, the ease of transacting in small lots, and the avoidance of an accrued interest payment to the seller. I discuss the categories of exchange traded bonds in an old post titled Exchange Traded Bonds: New Gateway Post. One category of those bonds, which I call Trust Certificates, has now been reduced to a few fixed coupon securities due to redemptions, but was a niche exchange traded bond category that provided easy and significant profits for those willing to buy in 2008-2009 due to the market's substantial and frequently bizarre mispricing of those securities.

Current Yield: 9.09% ($7.875 ÷ 86.59=9.09+%; cost is not adjusted up for the $4 commission)

Yield To Maturity: 11.329% (assumes VNR pays par value at maturity)

Security Description: This security is a $1,000 par value senior unsecured note issued by the MLP Vanguard Natural Resources (VNR).

Bond Prospectus

All of the factual statements made in that previous sentence are material.

A senior bond is going to be senior to all other securities in the capital structure other than a senior secured bond or bank loan for the collateral covered by the lien interest.

It is very important to me that this bond is senior in the capital structure to the equity preferred stocks issued by Vanguard.

Vanguard Resources has three equity preferred stocks outstanding.

Vanguard Natural Resources LLC Series A (VNRAP)
Vanguard Natural Resources LLC 7.625% Cumulative Preferred Series B (VNRBP)
Vanguard Natural Resources LLC 7.75%  Series C (VNRCP)

I find it odd that those potentially perpetual preferred stocks have lower current yields than the senior unsecured bond. This is a summary of the current yields based on last Friday's closing prices as calculated by Marketwatch:

Series A 8.12%
Series B 8.79%
Series C 8.92%

As I sometimes have to say, to each their own.  It is impossible for me to comprehend the pricing of those equity preferred stocks in relation to a senior unsecured bonds whose interest payments can not be deferred and have a superior claim to income, cash and assets both before and during a BK.

The preferred dividends are cumulative and have to be paid in full as long as VNR pays a cash distribution to the common shareholders (standard preferred dividend stopper clause). A preferred stock stopper clause can be found in the Series A Prospectus at page S-22

Once no cash is paid to the common unit owners, and any other remaining terms in the stopper clause are obeyed, VNR can defer the preferred stock dividends.

The MLP structure is a major negative for a bond owner, since capital is not being retained to grow the business, pay down debt or used as a significant rainy day fund. Money is flying out the door to the common unit owners leaving a minimal capital cushion for the bond owners.

Interest payments are paid semi-annually at the fixed coupon rate of 7.875% per annum.

Unless redeemed early, the bond matures on 4/1/2020.

Vanguard would have to pay 103.94 or $1,039.4 per $1,000 per value bond for an optional redemption after 4/1/2016, plus accrued interest to the redemption date. That premium is reduced to 101.97 for a redemption between 4/1/2017 and 4/1/18. Only par value plus accrued interest has to be paid thereafter for an optional redemption (page S-94). If energy prices and rates are favorable at some point before maturity, Vanguard could rationally exercise the call right to refinance this bond, even if the rate was only slightly lower, just to extend the maturity by several years.

There is also a change in control provision that is described starting at page S-94 of the Prospectus.

Common Unit Quote:  Vanguard Natural Resources LLC
SEC Filings for VNR

The FINRA page for this bond contains material information about it, including the trades and a chart showing the price history. This bond was trading at over $108 back in July 2014. When the crude oil price started to crater, so did the value of this bond. The percentage decline for the bond was substantially less than the 50%+ decline in the WTI crude price. There was only a brief period when the bond's price declined below 80 before quickly recovering to mostly a range bound trade between $85 and $90.

The closing trade last Friday (2/6/15) was at $87.96, slightly above my trade price earlier last week.

Another SA Contributor, Downtown Investment Advisor who is a registered investment advisor, recommended that investors "consider" purchasing this bond after doing their own due diligence. Seeking Alpha His reasons include the following: Vanguard lives within its means, has "good" hedges in 2015, and debt service is not an issue with crude in a sustained $40 price environment. There is uncertainty, however, as hedges roll off in 2016 and thereafter.

As noted in the following section, the market has a different view of risk based on the current pricing.

That observation does not mean that bond investors are correctly measuring the risks of any of these bonds. I am simply drawing a conclusion about the market's current risk assessments drawn from price and yields.

Market Disagreement With Bond Ratings: The current and YTM yields of this bond are not consistent with other B3 rated bonds. The Vanguard 2020 yield is more consistent with bonds rated CCC- to CCC+ under some distress.  The pricing of this 2020 Vanguard bond by bond investors reflects a current opinion that this bond is significantly riskier than the average B3 rated bond.

I did a search at FINRA of B rated bonds maturing in 2020 and come up with the following bonds that illustrate this differential, with YTM's based on last Friday's closing prices.  I searched only for B3 rated bonds and found a good size sample with companies whose names started with an "A". I also provide the S & P rating in parenthesis.

Acadia Healthcare 6.125%: 5.572% (B3, B-)
Accuride 9.5%: 5.811% (B3, B-)
Air Canada 8.75%: 5.786%  (B3)
Alcatel-Lucent 8.875%: 4.51% (B3, B)
America Builders and Contractors Supply 5.65%: 5.22% (B3, B)
Amsurg 5.625%: 4.68% (B3, B-)
Aramark 5.75%: 4.368%  (B3, BB)

The average yield range would probably be in the 5% to 6% range. There are some bonds perceived to be higher risk in the 7% to 9% range. An, for example, had a 8.22% YTM, and the Canadian power producer Atlantic Power has a B3 rated 2020 with a 7.515% yield. I am familiar with both of those two companies.  I am surprised  that the Atlantic Power bond is priced to yield so much less than the Vanguard 2020.

It would be my opinion that the yields on those B3 rated bonds are grossly inadequate for their credit risks. Junk bond credit risk is substantially being underpriced now.

Last Earnings Report: I just took a snapshot of the recent numbers:

3Q14 Earnings Press Release

Page 3 VNR 2014 Q3 10-Q

In terms of distributable cash flow, the company reported $53M or $.63 per common unit.

As of 9/30/14, VNR had outstanding $550M of the 2020 senior unsecured note and a $1.375B draw on its senior secured credit facility. In a worse case scenario, the size of that draw will be material in a recovery scenario for the senior unsecured bonds.

The company describes its hedges between pages 13-15 and 42-45. I do not trade in the options or futures markets, and at best a limited understanding of VNR's hedging.

I simply have to accept what the company says about those hedges:

Oil 70% hedged at $91.95
Gas 81% hedged at $4.32

Oil 31% at $90.6
Gas 62% at $4.37

Gas 36% at $4.21

Natural gas liquids, which account for 12-13% of revenues are hedged only at 6% this year.

Page 4 Earnings Call Transcript | Seeking Alpha

Rationale: I am balancing risks with potential rewards. With a bond, I can measure the reward precisely. If Vanguard survives to make all interest payments and pays off the principal amount at maturity on 4/1/2020, and I then own this bond, I know exactly to the penny my reward

Interest Payments: $731.06

04/1/2015: $22.31
10/1/2015: $78.75
2016: $157.5
2017: $157.5
2018: $157.5
2019: $157.5
4/1/2020: $78.75

Profit On Bond: $264.20
Cost $1,731.8 + $4 commission=$1,735.8
Principal at Maturity: $2,000

Total Return: $995.26

Total Percentage Cumulative Return Based on Total Cost = 57.33725%

The return numbers would have to be adjusted when and if Vanguard elects to redeem early.

I can not measure the downside risk in the same way since I would have to know now the unknowable including the recovery value in a bankruptcy. S & P and other rating services make estimates of a recovery value, but those estimates could be way off depending on the then existing circumstances during and at the conclusion of the BK process. One of the main unknowables is the amount of senior secured loans taken out as a firm slides into a BK filing and then the amount of secured secured DIP financing taken out before the firm emerges out of a BK, both taken in conjunction with the then existing asset values.  

In general, I would assume a recovery in the 25% to 50% range, based on par value, which assumes a variety of economic scenarios which then may not exist, including a higher price for crude compared to now and no major increase in the lien debt compared to the value of the assets. Another general rule of thumb is that the common and equity preferred stock owners will receive zilch in a bankruptcy. If I owned one of Vanguard's preferred stocks, and the firm filed for bankruptcy, I would most likely not expect to recover a penny.  

Risks: I have summarized several risks in prior sections. Ultimately the risks are dependent on future unknowable events. The risks will increase or decrease based on future energy prices, hedging, drilling costs, production rates and many other material variables.

The risks now are far less for Vanguard survival's than for a firm that is more heavily leveraged with less hedge protection.

With a recovery in crude prices to over $80, and then steadying, I would reasonably anticipate that this bond will again trade over par value. A slide from the current prices to below $40 will likely increase the downside pricing pressure.

Since I can at best just make an informed guess about material factors impacting Vanguard and this bond over the next five years, I can really only control my risks by limiting my exposure at the front end after making a decision that the yield and potential profit at maturity (or an early redemption) are worth the risks as I judge them now.    

Risks relating to the bond are described starting at page S-15 of the Prospectus.  Risks relating to VNR's operations are described starting at page S-21 and in the last VNR Annual Report starting at page  24, 10-k.

Future Buys/Sells: I am in a trading mode for junk E & P bond buys. I have already flipped three of them. After selling 2 Linn 2020 bonds, I did buy those back recently after a  decline took the price below my last entry point. Bought Back The Linn Energy 8.625% Senior Unsecured Bond Maturing In 2020 - Linn Energy, LLC (NASDAQ:LINE) | Seeking Alpha


The following sells have the same underlying rationale:

Rationale: The last employment report caused me to increase the odds of an interest rate rise that would cause a material price loss in leveraged bond CEFs and other securities with duration risk.

I have a more detailed discussion of the rationale in the introduction section to this Instablog:  Bought 2 Vanguard Natural Resources 7.875% Senior Unsecured Bonds Maturing 4/1/20 At 86.59 - South Gent | Seeking Alpha

Future Buys: I will need significantly lower prices to buy these securities back.

2.  Sold 100 NBB at $21.25+ Roth IRA (see Disclaimer): The Nuveen Build America Fund (NBB) is a long duration and leveraged bond CEF that declined to below $18 during the 2013 rate spike. Nuveen Build America Interactive Chart For a 100 share lot, a decline to $18 from $21.25 would cause a $325 reduction in value, or about 2.33+ years of dividends at the current monthly dividend rate of $.116 per share.

In addition, if I am able to buy back these shares at close to $18, I increase my dividend yield compared to the prior purchase at $20.1.

Snapshot of Trade:

2015 Roth IRA Sold 100 NBB at $21.25

Snapshot of Profit:

2015 Roth IRA 100 NBB +$101.7

Item # 1 Roth IRA: Added 100 NBB at $20.1

With monthly dividends, total return comes to $206.1 or 10.22% in 8+ months.

Prior Trades: My last discussion was in this post: Item # 6 Added 50 of the Bond CEF NBB at $17.76 (November 2013 Post)

Other trades are linked in this post: Item # 2 Added 50 NBB at $18.55 (6/29/13 Post). Some flips have realized to date $184.16 in profits: Sold 100 NBB at $20.13-ROTH IRA November 2011Sold 100 NBB at $20.07 November 2011Sold 50 NBB @ 19.24 in the Regular IRA December 2010.

Security Description: The Nuveen Build America Bond Fund (NBB) owns Build America Bonds which are taxable municipal bonds. The fund will terminate on or about 6/30/2020 and will then distribute the fund's assets to its shareholders.

NBB uses leverage. The sponsor reports a 27.49% effective leverage as of 12/31/14.  Funds are borrowed short term to buy longer term securities.  A rise later this year in the federal funds rate will increase the borrowing costs incurred by leveraged CEFs that borrow short term.

Closing Prices Day of Trade 2/6/15
NAV Per Share: $23.32
Market Price: $21.28
Discount: -8.75%
Average Discounts 1 and 3 Years: -9.13% and -7.59%

Sourced: CEFConnect

The fund is tilted toward "A" or better rated bonds.

NBB: Last SEC Filed Shareholder Report For Period Ending 9/30/14

I am basically trading these long duration funds. I also own them to address a low probability scenario which I usually just call the Japan Scenario. In that low possibility scenario, rates remain range bound at abnormally low levels, possibly even moving lower, due to persistent low inflation with drifts into deflationary periods. The best security to own during a deflationary period would be high quality long term bonds. Since I assign a very low probability to the Japan Scenario, I will address it with a limited number of securities and NBB is just one of them.

When I decrease the odds of a Japan Scenario for the U.S., as I have just done, this is the type of fund that I will quickly jettison.

This CEF has significant interest rate given its long duration number.

As of 12/31/14, the fund calculated the leveraged adjusted duration at 11.65 years. NBB - Holdings and Detail Tab

To calculate how a fund will react to a change in interest rates, the rule of thumb is to multiply the duration by the percentage change in interest rates for similar maturities and bonds. Get to know your bond fund: Duration | Vanguard Thus, a 2% rise in rate could generate almost about a 23+% loss in NBB's value. That is a huge amount of interest rate risk for the yield.

I tread softly with these long duration funds unless I significantly raise the odds of a Japan Scenario for the U.S.

The timing of the liquidation could be disadvantageous to shareholders, which would be the case with interest rates spiking near the liquidation date in 2024 that causes significant price deterioration in the securities just before they are sold by the fund.

3. Sold 50 EMQ at $25.61 (see Disclaimer):

Snapshot of Trade:

Snapshot of Profit:

2015 EMQ 50 Shares +$18.08 

A five year chart shows that there has not been an opportunity to capture much of a price gain. This investment grade bond has only temporarily traded below its par value for the past years and the upside appreciation is restrained to the issuer's call option at par value.

Security Description: The Entergy Mississippi Inc. 6.00% Series First Mortgage Bonds 2032 (EMQ) is a first lien bond issued by Entergy Mississippi, a wholly owned subsidiary of Entergy Corp. (ETR).   

Entergy Mississippi is engaged in the distribution and transmission of electricity that serves 440,000 or so customers in 45 of Mississippi's 82 counties. A map of its service area can be found at Entergy Mississippi - Service Area.

EMQ is a first lien bond on "substantially all" of Entergy Mississippi's property. The coupon is 6% on a $25 par value. EMQ mature on 11/1/2032, but may be called now at the $25 par value plus accrued interest. This security just went ex interest on 1/29/15 for its quarterly distribution.


The secured interest is described starting at page 5 of the Prospectus.

Moody's  has a A3 rating on this first lien bond.

Interest rate risk is the dominant risk.

Interest rate risk is asymmetric between the owner of this bond and its issuer. Entergy Mississippi could redeem it at anytime now when it is in its interest to do so. The reason for a redemption would be that the issuer could refinance this debt at a lower coupon rate and possibly even extend the maturity.

On the other hand, if rates rise, the owner of the security would be stuck with the two undesirable options: sell at a loss and then reinvest the proceeds into a higher yielding security or keep EMQ as the price falls and forego the increased income from another security that could have been acquired with the funds tied up in EMQ.

In this kind of heads the issuer wins, tails the owner loses, there is not much upside when buying near par value but the downside risk could be considerable with a significant spike in long term rates given the long duration of this bond.

This buy has a chance of being productive with longer term interest rates and inflation remaining about where they are now for several years. A 1% rise in long term rates would cause this security to decline significantly in value.

I would roughly estimate that a 1% increase in rates for similar quality and maturity bonds would cause about a 10% to 12% slide in EMQ's price using a Bond Calculator available at SIFMA to formulate a reasonable range. The duration is slightly more than 11 years.

The rise in rates starting in May 2013 resulted in a slide from over $26 to below $25. EMQ Interactive Chart If this bond was not subject to being called, it would likely have been trading well over the prevailing prices in May 2013 and now.

Prior Trade: Item # 2 Paired Trade: Sold 50 EMQ at $26.49 and Bought 50 EFM at $24.99-Item # 5 Roth IRA: Bought 50 EMQ at $24.83 (8/31/13 Post)

I still own 50 EMQ shares held in a Roth IRA. Item # 4 Bought Roth IRA: 50 EMQ at $25.11 (8/23/14 Post)

3.  Sold 300 JTP at $8.55 (see Disclaimer):

Snapshot of Trade:

Snapshot of Profit:

2015 JTP 300 Shares  +$95.1
Bought 300 JTP at $8.18 (1/6/2015 Post)

Security Description: The Nuveen Quality Preferred Income Fund (JTP ) is a leveraged closed end fund that invests in preferred stocks and bonds. "predominantly" in securities rated investment grade by at least one rating agency.

Sponsor's website: JTP-Nuveen Quality Preferred Income Fund (as of 11/28/14, leverage at 27.96% with an annualized cost based on the latest month of 1.01%; 211 holdings; average effective duration was 5.66 years; average leverage adjusted duration was 7.86 years).

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

The discount at the time of my purchase was -11.09%, using my purchase price of $8.18. The closing net asset value per share that day was $9.2.

Closing Data Day of Trade 2/6/15:
NAV Per share: $9.28
Market Price: $8.51
Discounts: -8.3%
Average Discounts 1, 3 and 5 Years: -9.96%, -6.45%, 5.87%

Sourced: CEFConnect

JTP Page at Morningstar (rated 2 stars; no analyst report)

The fund is weighted in investment grade securities.

The monthly distribution rate was $.052 per share through the November 2014 payment. The fund increased that rate to $.053 in December and then to $.055 for January and February 2015. Nuveen Closed-End Funds Declare Monthly Distributions The fund also paid out an additional distribution of $.0905 per share last December. Nuveen Quality Preferred Income Fun  Dividend Date & History

I have one prior round trip trade:

Sold Roth IRA: 200 JTP at $8.38 (7/5/14 Post)(snapshot of profit=$154.9 with a total return of $248.5 or 16.42%)-Bought 200 JTP at $7.53-Regular IRA (10/14/13 Post)

This fund generated substantial realized losses on investments during the Near Depression period. As of 7/31/14, the fund had a loss carryforward of $340.839+M and used $11.57+M of the loss carryforward during its F/Y ending 7/31/14 to shelter long term capital gains from taxation.

The loss carryforward is somewhat advantageous to a new owner who buys this security in a taxable account, assuming the investor views tax efficiency as a benefit. I personally do not view large capital gain distributions favorably when paid into a taxable account. The net asset value per share is adjusted down by the amount of the distribution, and I have a tax obligation even though my wealth was not increased by the distribution.

I did not own this CEF prior to a small purchase made in October 2013. I looked at the fund's portfolio prior to the Near Depression, and there was then no loss carryforwards. Instead, the fund had an unrealized gain of $21.55+M. (page 39-shareholder report for the period ending 12/31/2006). The fund had then a weighting in investment grade securities.

The problem was that many of these securities were issued by banks and REITs, and the prices of those securities were smashed in 2008 and into 2009. In many cases, the price of a $25 par value security went into single digits. If the fund had no leverage, it could have waited until the prices recovered, which happened fairly quickly thereafter. Buying those smashed securities in 2008-2009 was a major profit center for me.

However, given the magnitude of the price declines and the size of the leverage, I suspect that the fund had no choice but to sell positions at the worst possible time in order to reduce leverage. As of 12/31/2006, JTP had investments valued at $1.336+B with a cost of $1.313+B, and the last shareholder report showed that the investments were then valued at $828+M.

Whatever the cause, the foregoing history highlights risks even when the fund has a weighting in investment grade securities. During times of economic distress, those securities can be downgraded into junk status, which happened to securities issued by several financial institutions, and investors will frequently price those securities as if a bankruptcy is likely to happen when the odds are actually substantially less.

The fund summarizes risks starting at page 11 of its last SEC filed shareholder report.

I would emphasize what I call normal CEF risks. The market price is determined by the frequently irrational decisions of investors and may consequently stray a considerable distance from net asset value per share, either above or below.

It is entirely possible for a fund's net asset value per share to go up with the market price declining, or for the market price to decline at a significantly greater percentage rate than the net asset value per share during periods of market stress.

All that I can say now is that the discount to net asset value per share is significantly higher than the historical 3 and 5 year averages. I am consequently playing the possibility that the net asset value per share will increase and the discount will narrow after my purchase. The converse may actually happen, appropriately called the Double Whammy, where the discount widens after my purchase as the net asset value per share declines.

Another risk is that the FED will start to raise short term rates this year. This will increase the cost of borrowed funds for leveraged CEFs and consequently narrow the income spread between that cost and the yields generated by longer term securities bought with those borrowed funds. I do not currently expect more than a .5% increase in the federal funds rate this year, and any additional increases are likely to be slow and measured thereafter. An increase in short term borrowing costs will erode the income advantage of leveraged bond funds. They are able to generate more income for their investors than an unleveraged fund owning the same securities due to that spread.

It remains to be seen whether intermediate and longer term rates will increase or decrease during the next FED tightening cycle. Many bond investors now believe that the yield curve will flatten, as longer term rates continue to move down while short rates increase due to the FED ending ZIRP. It would obviously be unfavorable for leveraged bond funds for their short term borrowing costs to increase and for the securities bought with those borrowed funds to go down in value.

4. Sold 50 CORPRA at $26.25 (Equity REIT Common and Preferred Stock Basket)(see Disclaimer):

Snapshot of Trade:

Snapshot of Profit:

2015 CORPRA 50 Shares +$101.58
Item # 2 Bought 50 CORPRA at $23.9 (3/3/14)

Quarterly Dividends ($22.66 for 50 Shares/4 Periods)=$90.4

Total Return: $191.98 or 15.96% in 11+ months
Security Description: The Coresite Realty Corp. 7.25% Cumulative Preferred Series A (COR.PA) is an equity preferred stock issued by the REIT CoreSite Realty which owns data centers.

This security pays non-qualified and cumulative dividends at the fixed coupon rate of 7.25% on a $25 par value.

The prospectus contains dividend stopper (S-22) and change of controls provisions.


The dividends are cumulative.

The REIT has to pay cash dividends to the common shareholders when it has net income in order to maintain its tax status. The preferred stock owner has to be paid in full as long as the common shareholders receive any cash dividend, irrespective of the amount.

Unlike Mortgage REITs, equity REITs own property that will generally have a market value significantly above the total outstanding debt. In a BK, assuming no forced liquidation at the worst possible time (e.g. a depression), the common shareholders may get their equity wiped out, but there still may be something left for the preferred shareholders.

The liquidation preference clause, found at page S-7, gives the preferred shareholder a "liquidation" preference over the common share owners.

If a Mortgage REIT or a bank holding company went into BK, I would anticipate that their preferred stocks would become worthless, as their debt will far exceed the equity.

An Equity REIT that owns property may have some value for the preferred shareholder even in a BK, so the downside risk may not be zero, with the recoverable value in a BK ultimately dependent of course on the circumstances then existing which are not known now and may never come to pass in my lifetime anyway.

Risks relating to the preferred stock are discussed by the company starting at page S-12. Coresite discusses risks incident to its operations starting at page 17 of its recently filed 2013 Annual Report, SEC Form 10-K

Interest rate and volatility risks are probably the most important risks at the moment. Volatility can be caused by concerns or fears relating primarily to interest rates or creditworthiness or both.

This preferred stock was trading largely between $26-$27 in April/May 2013, same as now. COR.PA Stock Chart

The price hit $22.5 in December 2013.