Fixed Income Alternatives:

A vital long-term objective in my investing discipline is to concentrate on the cashflows of the businesses I own and to maximize the cashflow I receive in my core portfolios. Cashflow is important for a number of reasons and one of the most important for a conservative investor is that you can’t always count on making investment gains exclusively from the price appreciation of the investments you own. There will be times in an economic cycle where the real return (return after inflation) is 0-2% providing minimal returns. Cashflow provides a necessary flexibility that each investor should concentrate on, if they don’t already, because of the additional benefits cash provides to returns over the long-term.

One of my objectives last year in 2008 was to expand my investing knowledge beyond common shares and move up the hierarchy of capital towards preferred shares, bonds and debentures. I began by pulling out old notes from business school and asking various investors for information on classifications of securities taking detailed notes for future reference. After a few months I felt confident enough that I had accumulated an adequate amount of knowledge to understand the basics and constructed a watchlist of various securities trading in North America to observe their trading activity. I constructed a list of reading material and began watching for commentary and opinions from various investors well versed in the debt markets and individual fixed income products.

I will admit that the learning curve for investing in fixed income is much steeper than common equities, but the rewards can be just as lucrative without exposing your capital to additional risk. Any opportunity I have as an investor to protect myself from risk and achieve the same return by moving up in the capital structure of a company is an opportunity that I’m keen on pursuing.

Under normal market conditions debt isn’t considered sexy, but as the markets unravelled in October and November of 2008 I could quickly see how tightening business/consumer credit and market illiquidity could present attractive investment opportunities if an investor knew where to look. My focus was on the three basic principles that an investor needs to examine before they consider investing in debt issued from a corporation:

1. Determine the strength of the company’s balance sheet
2. Determine the cashflow that is needed to avoid default on interest payments
3. Determine the credit risk, liquidity risk and term risk

I’ve publicly acknowledged my investing activities in Canadian preferred shares as a method of diversifying my Canadian dividend portfolio (DivG) for risk, future returns and cashflow. With Canada as my home equity market I knew that I didn’t want to become too focused on opportunities with equally as significant turmoil rolling through US, European and global equity markets. Fear of failures in financials, companies not having access to capital and financing rates going through the roof all led to some interesting observations in the markets. Sadly many of these opportunities came too quickly or I found myself priced out during both the October and November declines. I did initiate some advantageous positions, but with limited capital I had to invest in opportunities that I determined to have the highest margin of safety. One thing I did learn quickly was the unique behaviour and characteristics of various fixed income securities.

Diversifying cashflow in my portfolios is a primary long-term objective and I have to be prepared to look beyond common equities as an equity class since we’ve witnessed that they are much more vulnerable to dividend cuts than senior equity or debt higher up on the capital food chain. The problem with fixed income, as an individual DIY investor, is that there are four serious risks I have to assess:

1. Company risk
2. Interest rate risk
3. Liquidity risk
4. Term risk

For company risk you have to be able to evaluate the balance sheet and cashflow statement to determine what risk your interest payments might be exposed to if the company is no longer able to pay those obligations. When a company issues bonds they have a contractual obligation to pay interest to investors but if they don’t have the cash to do so bond holders could be stuck with nothing; affecting both the credit quality of the bonds and their market value. Interest rate risk is important because fixed income securities react to changes in interest rates both over the short and long-term that will effect their face value on the open market as yields rise and fall. Fixed income products are also far less liquid than shares of common equity. A public company might have a trading volume of 1,000,000 common shares or more in a single day but access to buy or sell fixed income products can be much tighter with increased spreads (difference between Bid & Ask). This can force an investor in some investments to sit in the market for days or weeks waiting to buy or sell a specific investment rather than the seconds or minutes it takes for a common share.

For an investor willing to hold a security until maturity interest rate and liquidity risk are often a secondary concern, but a risk-adverse investor needs to realize that having the ability to exit a position quickly (same day) can be worth a lot more than the additional gain you could receive from an illiquid investment.

Trust Preferred Securities (TPS):

Trust Preferred Securities are a hybrid security that trade like a preferred share with a par value of $25 and pay a distribution in the form of a dividend or interest to the individual holder of the security. Interest payments on debt are tax-deductible for corporations and the benefit of some hybrid securities is the flexibility they provide for companies who can issue shares rather than debt. These trust vehicles give a company the best of both worlds: they issue subordinated debt to a trust and still deduct the interest payments when issuing shares.

Corporate Backed Trust Securities (CorTS):

CorTS’ are a derivative product that trade like a stock on the NYSE, yet are not a preferred share or TPS. CorTS’ are issued by Structured Product Corporation which is a company incorporated as an indirect and wholly owned limited-purpose subsidiary of Salomon Smith Barney. Each individual trust directly holds either bonds or debentures of a public corporation. Instead of a corporation issuing a fixed income security for a value of $1,000 such as the case for a bond the trust purchases a large group of the same fixed income product and re-issues shares at $25 (like a preferred share). Payments on the bonds or debentures pass through the trust to individual investors on a semi-annual basis.

The benefit of a CorTS is that they carry the same credit rating as the individual fixed income security and public parent corporation.

CorTS JC Penney (KTP):

Structured Product Corporation created a trust and placed their purchase of a $100,000,000 block of JC Penney bonds issued in 1997 with a coupon of 7.625% and maturing in 2097. The trust then issued 4,000,000 shares with a value of $25. This redenomination of the bonds gives each share a par value of $25 instead of $1,000. The credit rating of KTP is the identical credit rating as the JC Penney 2097 bonds, but allows individual investors to purchase the bonds through a trust on the NYSE.

KTP also carries a unique call-option: callable at any time at a price that would make the yield equal to the 30-year US Treasury bond plus 20 basis points and never less than par ($25). With a 30-year US Treasury trading at a yield of 2.0% JC Penney CorTS is callable at no less than its par value of $25. In the current environment the likelihood of the CorTS being called is highly unlikely as the cost would be prohibitive.

Potential Situation:

On November 20th KTP closed at $10.25 after reaching an intraday low of $9.30 on a volume of 13,125 shares. If you were fortunate enough to catch a share trading at $10.00 on either the 20th or 21st the yield on your purchase price would have been 19.10% ($1.91/$10.00). A US 30-year Treasury traded on those two days between 3.64% and 3.70%. If an investor decided to hold KTP for five years and the CorTS were called or sold at par the annualized return for an investor would be 39.10% before tax (20.10% annualized plus 19.10%). Again in a low interest rate environment the potential for the call option to be exercised is highly unlikely.

Activities:

I purchased a group (7) of these products throughout November and December as fears of market liquidity, systemic and non-systemic risk caused valuations to fluctuate in extreme directions. Cashflow from operations at each company more than cover their interest obligations and the CorTS’ collectively offer a mix of corporate bonds and debentures in a variety of companies and sectors. The credit risk I’m exposed to is adequately compensated for with the yield and discount to par value for each investment when I consider the additional potential for capital appreciation in the future. I have an objective of holding the group of CorTS’ for a minimum of three years with the likelihood of holding them beyond five.

If US equity markets trade sideways for the foreseeable future (2-3 years) my yield on cost of 13.1% from the group of investments offers more than enough return for my risk tolerance. If I had purchased an equivalent amount of common equities in each of the companies at the same time of purchase my collective yield would be only 3.7%.

My total return with 0% default rate after five years at par value would be 152.8%, 77.0% with a 25% default rate and 26.4% with a 50% default rate. On an annualized basis that’s a pretty decent return considering the income should be tax-free since I hold them within my RSP.

As a Canadian resident these securities would not be tax-advantaged if held in a non-registered portfolio so I hold them within my RSP along with all my other fixed income investments. I can’t say for certain that there are zero tax consequences, but for the moment they look to be free from withholding tax.

Risk:

I want to be very clear with disclosing these investment activities: these are not risk free. The liquidity risk I’ve exposed myself to is significant and I wouldn’t have purchased these securities if I wasn’t confident in the underlying business, their cashflows, credit ratings or business models. The average daily volume in January for each of these investments ranged from a low of 800 to a high of 4,800; that’s tight. I purchased positions in 100 share allotments specifically for the purpose of any future event where I need to exit the position promptly.

There is also risk with Structured Product Corporation since the incorporated, indirect and wholly owned limited-purpose subsidiary of Salomon Smith Barney is owned by Citigroup. A failure of Citigroup or sale of SSB to another party could have volatile results on the price stability of these CorTS’ despite the stability of their underlying holdings.

This group of investments comprises only 8.5% of my overall invested assets (both registered and non-registered) and was not purchased using any amount of leverage. The risk of using borrowed dollars regardless of the yield and higher claim to capital is too great for my risk tolerance.

One positive benefit from a risk perspective is that this group of investments, when measured against their comparable common equity, has a much lower beta than I would have originally expected.

Disclosure: I own shares in the following CorTS’

KNR: Bristol Myers Squibb 6.80%
KTP: JC Penney 7.625%
KVJ: Disney 6.875%
KVM: IBM 7.00%
KVN: Unum 7.50%
KVT: Dow Chemicals 6.375%
KCT: Sherwin Williams 7.50%
KVR: GE Capital 6.00%

Remember to visit on March 30th for a Guide on Canadian Corporate Bonds and to VOTE for the Canadian Bank you want to read about in a future stock analysis!

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