## Tuesday, August 18, 2009

### Love Me Tender

It’s always flattering when someone comes up to you and makes an offer for something you own, even if you weren’t intending to sell it.

Well, bond investors are being flattered enough to blush lately as a spate of tender offers has hit the markets in the past few months.

Here’s what’s happening:

When credit markets “froze” up last year, so did the market for new bond issues. Companies, which were looking to refinance to improve their maturity profiles or simply raise capital for some corporate purpose, were essentially locked out. And we know what happened to the secondary market.

When your “old” bonds are yielding in double digits, who is going to buy some new, probably longer dated ones, at a lower rate. So very few new issues hit the market.

But as the markets have thawed, it has enabled issuers to come to market, selling new longer-dated bonds at “decent” rates and usually accompanying it with an offer to repurchase some outstanding shorter dated.

Just to name a few issuers doing this: International Paper (twice!), Owens Illinois, Corrections Corp of America, Centex/Pulte.

Now a couple of examples to understand that mumbo-jumbo.

Two weeks ago, Jabil Circuit issued $312 million of 7.75% notes at 96.143% (yield 8.50%). Here’s a Link.

At the same time, they offered to buy back the $300 million outstanding of their 5,875% July 15, 2010 (that’s less than 1 year) notes for a “total consideration” of 103.125%. That price is equivalent to a yield of only 2.45% for the remaining term of the bond. LINK.

As a happy owner of the 2010 notes, I was glad to turn them in a year before I expected to collect (2.45% doesn’t meet my yield threshold…might as well pay down my mortgage).

So why would Jabil issue notes at 8.5%, to buy back an equal amount of notes at 2.5%? Well, obviously they want to extend maturities. The market is quite open right now for new issues and they can’t assume it will necessarily stay that way. It’s an extra $18 million in interest expense for the year for a company that only earned $157 million pre-tax in its last full fiscal year. The comfort that liquidity offers comes at a hefty price.

The holders of the 2010 note had a relatively easy choice. Accept the attractive tender (98% did accept) or keep their 5.875 % note and collect the principal next June. There is little doubt they will be paid. The 2010 bond will obviously have reduced liquidity now, but frankly, most of these notes are bought to be held to maturity.

Of course, once Jabil pays for the tendered bonds, what do you do with the money? Well, the Jabil 2016 notes don’t look too bad (can you get me some?).

Another recent example is Brunswick Corporation (bowling, marine equipment). Brunswick, being heavily in the non-discrectionary consumer category, is having a hard time with the recession.

The folks at Brunswick sold $350 million of 11.25% SECURED (i.e. collateralized) notes due 2016 at 97.036% (yield 11.89%) and have tendered for $150 million of their 5% June 2011 notes. They’re offering 97% for the notes, plus a 3% “consent fee”, for a total of 100%. LINK

No premium this time, but I’ll be tendering happily again since this credit was making me a bit nervous. The terms that Brunswick has paid to make the new bond happen, clearly shows that others are a bit skittish also.

In any case, I can’t buy the new issue, since it is a Rule 144A/Reg S. Non-US persons can, but frankly I’m not recommending this risk right now.

Although at some times its hard to say goodbye to a bond for which a tender has been made, it also allows you to adjust your portfolio and move to a more profitable section of the yield curve. Selling those notes with 1 or 2 years left and where most of the profit has been made –with very little cost-, is a great deal.

So for now…keep ‘em coming. I’m loving these tenders. On the other hand, the bond calls…well that’s another issue. (and another post).

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Alex said,

ReplyDelete"As a happy owner of the 2010 notes, I was glad to turn them in a year before I expected to collect (2.45% doesn’t meet my yield threshold…might as well pay down my mortgage)."

Did you mean 5.875% instead of 2.45% or is my complete lack of understanding of these things showing once again?

Ah.. Johnny AAPLseed! It is my lack of explanation!

ReplyDeleteI shall explain,

5.875% is the coupon. That's what they will pay -in cash- in term of interest. If the tender were at 100%, that would be the yield.

But JABIL offered 103.125% and that became my cost of opportunity of holding the bond.

The choice was between 103.125% NOW or 100% in a year PLUS the 5.875% in interest.

That's where the 2.45% comes from. Its the cost of opportunity. In this case, the "cost" (if you will) of NOT tendering.

Ok thanks for explaining, I think I got it now: the choice between getting 103.125 now and 105.875 a year from now would change the yield equation to something like this:

ReplyDelete105.875/103.125 - 1 = 2.67%

Getting closer to the 2.45... which I first thought might come from annualizing it since it's less than a year until July, and then I realized such an adjustment would push it further off. But at least I understand your reasoning now.

LOL @ AAPLseed... up 116% baby! :D

The 2.45% does come from anualizing it. Because it is less than a year, you have less time to amortize the 3.125% premium (and the yield is lower).

ReplyDeleteI was paid Aug 11. I used that date for my calculation.

Remember that when you buy/sell a bond, you pay/collect all the accrued and unpaid interest up until the transaction date.

En in the tender, JABIL paid a few weeks of accrued, yet unaid interest.

In any case, Deagol. We all use some version of the YIELD spreadheet function to calculate these yields to maturity. So in essense, EXCEL told me.

Ahh Excel, I love Excel! I use it all the time for all kinds of crazy things. But you do know Excel is the devil, right? :P

ReplyDeleteLike, look at how they explain that YIELD function:

http://office.microsoft.com/en-us/excel/HP052093451033.aspx

Even though I was able to reproduce your 2.45 in an actual worksheet in Excel (the only extra bit of info I needed was to use a semiannual schedule for the coupon payments), I wanted to actually understand what the function does. It's a distrust thing I have in general, like with pseudo-scientific research, analysts, big media, etc, not singling out Excel or Microsoft.

So after reading the above link a couple of times, I was forced down the long and winding road of some really obscure stuff to try to get what they were talking about, for example:

http://en.wikipedia.org/wiki/Day_count_convention

Turns out that because of the semiannual schedule there is more than one coupon period before maturity for your Jabil example, so this is what it does:

"If there is more than one coupon period until redemption, YIELD is calculated through a hundred iterations. The resolution uses the Newton method, based on the formula used for the function PRICE. The yield is changed until the estimated price given the yield is close to price."

I remember the Newton method from ages ago in engineering (Calculus 3 IIRC) at the uni (la Católica), and I remember some important caveats and cases where the method wouldn't converge or even converge to the wrong result. In any case, I can't imagine the regular investor having to understand how that works just to obtain a simple yield, i.e. what's wrong with the simple formula I used in my previous post?

Anyway, I setup a PRICE function in Excel and used "Goal Seek" to verify this, and it worked. But once again I have my distrust issues, so I would now have to go figure out what Excel actually does for the PRICE function:

http://office.microsoft.com/en-us/excel/HP052092191033.aspx

And here's the actual formula I wanted to check:

http://office.microsoft.com/global/images/default.aspx?AssetID=ZA060512351033

Now as I said I studied engineering so I wasn't daunted by that monstrosity. And I can sort of understand that as the PV of the note's 100% redemption plus the PV of the coupons (but discounting the first coupon's accrued fraction which is the part I'm still kind of confused about). So assuming that's the right formula, I still wanted to work it all out carefully and built up my own PRICE formula, and of course it spit out 103.125 when feeding it with a 2.45% yield. Damn it. LOL (no actually I was quite satisfied it's just I'm still not trusting that accrued discounting bit).

You said,

"The 2.45% does come from anualizing it. Because it is less than a year, you have less time to amortize the 3.125% premium (and the yield is lower)."

See this is where I feel like my brain must be wired the wrong way to grasp these debt instruments. Let me try to illustrate my reasoning by making the remaining time to maturity really short, say it was just a month left. Everything else the same: the choice between 103 NOW or 106 in 30 days. Going by your explanation, holding the note to maturity would now have an extremely lower yield, negative? Excel's YIELD mumbo-jumbo says -30%! But the way I see it is, this time I would much rather hold on to it to maturity as I'm getting an extra 2.67% IN A MONTH, no? How is that worse than waiting a whole year to get the same amount? I know I must be ignoring some obvious thing about how these notes work, just wondering what the heck it is.

And now that I've rambled on forever (I think I did this before here on your blog so I'll go for a record comment now hehe) I'd like to give you a sense of why I'm so nit-picky with this Excel and debt and financing mumbo-jumbo. I'll tell you about how they were trying to sell us some health insurance with a great financing plan here. The agent guy talking to my wife quoted her something like a 15% interest financing, which I'm sure you know is just too good to be true here in Venezuela unless it's one of those bolivarian phony loans. So the wife asks me what I think and I told her it must be a mistake and to ask the guy what the terms were. She asked and something didn't feel right about it and the guy kept telling her it was all good. Interest and principal and such isn't her thing (she's a psychologist), and so the guy was giving her the whole sales pitch for like 10 minutes. Only hearing her side of the conversation, I told her to let me speak to the guy. So the guy once again starts all over for me and this is kinda how it goes:

ReplyDeleteGuy: The insurance prime is X [let's say $2000]. If you finance through our very competitive plan, you'll pay Y total [say $2300], so that's just 15% in extra interest, see?

Me: Wait a sec... you mean I make no payments at all for the whole year and then I pay the $2300? Or what's the payment plan?

Guy [condescending tone]: No, let me explain, this is kinda like a car loan, if you've ever gotten one of those? Well, it's a monthly plan and the system works out all the complicated math for a given rate so that you end up with a single monthly payment. With our plan the first payment is 40% of the total [.4*$2300 = 920 in our hypothetical example]. We require this so that you amortize early on and you won't be paying that much in interest later on, and thus the risk is minimized. This is how we're able to quote such a low rate of 15%. After that first payment due on signing, it's a single amount per month, 5 easy payments for the remaining balance [1380/5 = 276].

Me [thinking]: err... ok wait... no that can't be. Are you sure about that? I think there's a mistake.

Guy: No mistake, that's what the computer says, the computer can't make a mistake. I've helped a lot of customers with plans similar to this one, of course there's differences because not everyone has exactly the same prime, but this is a great deal, 15% is a great rate here in Venezuela, believe me, I've done this a lot.

Me [in shock after what I've just realized]: No no, what great deal? quite the opposite! If those are the payments, then, WTF... then the real rate is much much higher! See, with the 40% upfront I'm actually financing only about 60%, say about $1200... although it's even less because I'm paying upfront part of the $2300 total including interest... so that right there represents almost twice the rate you quoted me. But then, the duration is only over 6 months... no actually 5... so the effective rate would again get doubled for it to be an annual rate, so it's now 4 times what you quoted me! [laughing now] BUT it's even more... that would be if there were no monthly payments and I were to pay the the whole 60% at the end of the 5 or 6 months (I'm assuming 5), but since I'm actually paying every month I should be amortizing rather quickly... I'd say that, once again, would at least double it yet again, so now I'm seeing that 15% rate actually being 8 times... that's... 120% effective annual rate??? no way, that's gotta be a mistake. You understand what I'm saying?

(continues in next comment...)

(continued from previous comment...)

ReplyDeleteGuy: No no no, I'm telling you it's 15% I put it myself in the computer. Why would I put 120%?? that's impossible because the payments would be huge! like, you'd be paying over $4000 total and that's just crazy. Look, sir, I'm sorry if you can't take advantage of our financing plan because it is very competitive, this is industry standard, anywhere you go you'll probably get quoted a slightly higher rate and a similar 6-month plan. Our financing partner works with many many agents and insurance companies and thus are able to work out some of the best plans around, again 15% is a great deal.

Me: Yea.. no. Wait, I'm working out the real effective rate, give me a minute.

Guy: Ok well blah blah blah [keeps on selling it]

Me [after a couple of minutes working it in Excel and now really mad]: Well Mr. Guy, the effective rate for this amazing plan turns out to be 14% PER MONTH. That is a 168% ANNUAL RATE. I couldn't believe it at first so I had to triple check. You either made a mistake or are a crook, or your "financial partners" are. Thanks for the "great deal", but no thanks. I'll see if I can find a nicer crook elsewhere. Good bye. [click]

Am I wrong in getting so flustered about these things? I can't believe this is possibly "industry standard" although I know there are crooks out there, I'd hope they were more subtle about it. See why I prefer working things out myself? It's like, I knew from the beginning that I was getting hosed, but I still wanted to work it out, and then it turned out sooo nasty that I thought that RATE Excel function must have been wrong, so later I went and verified how the function worked, and also worked it out with some online calculator, and I'm still not sure of the 168% since there's something about the payments being at the end of the month so in that case it would result in a 105% rate, I think. Even so, I still can't believe the guy was quoting me 15% annual rate with a straight face. There's just something wrong in the financial world and all this mumbo-jumbo that makes these scams possible.

Sorry for the off-topic rant, but this issue I have with financial crookedness is the main reason your blog caught my attention. Your Duck Tales was great, but pale in comparison to the blatant, most onerous scams that many people actually fall for. Makes me sick, and embarrassed of our sorry state of affairs.

Wow I really blew up that post-length record this time! Please don't hate me. :D

How can I hate you? You are one of 5 people who read my blog.

ReplyDeleteYour ramble is fine. It’s not like this blog is putting a dent into Google’s bandwith expenses.

EXCEL is not the devil. It is only one of its evil master’s (MSFT) demons.

As for your question, since I think there is one in there somewhere.

Here’s what you need to know: the coupons are semi-annual, but accrued interest is always paid when you buy/sell. It is NOT like a dividend where there is a cut-off date and you get the payment or you don’t.

That is probably why your logic seems to fail.

Here are your YIELD parameters

Settlement: Aug 11, 2009 (DATE(2009,8,11)

Maturity July 15, 2010

Rate: 5.875%

Price 103.125 (not % or Excel will freak out).

Redemption 100

Frequency 2

The function returns 2.4454173%

Add 30 days to the settlement date and the yield goes down to 2.11%.

Why would that be, if the payout is now closer?

Yield understands that when you buy the bond you must pay accrued interest. So the amount that is paid is not $1031.25 per $1000.00 bond on Aug 11, but an additional $4.24 is required (for 26 days interest). A month later the accrued interest is $9.14. So you can see if you get too close to the maturity date…you will see a negative yield, because the “purchase price” (opportunity cost) is higher than the payout at redemption (100%).

As for the “financing” that you were offered on your insurance, I’ve seen calculations like that before. If you want to know exactly what the “average” rate of interest was, EXCEL has a function for that. It’s XIRR. Put every cash flow with its date in a table and watch the magic. Remember to put the amount you are financing at day 0 with a negative sign. The rate on these “financings” are insane. Those pushing them RELY on people not doing the math and usually not knowing the math.

And that is the “tip of the iceberg”. The Madoffs, Stanfords and Nadels make the headlines, but those “mini-ripoffs” amount to billions on a daily basis.

But you have to do the math. And you have to ask yourself: “what’s in it for them?”

There is no substitute for common sense.

BTW. I didn’t really use EXCEL. Mostly NUMBERS from Apple’s iWork. All the functionality of Excel, with Apple usabilty and a fraction of the cost.

I just can't work without Excel, really amazing for a MSFT product. Even more bizarre, I prefer the Windows version. Now I'd love to move to beautiful Numbers but I need multiple regression analysis so it's not there yet for me. In Excel I used the RATE function (for an annuity) which gave me a rate of 14% per period (monthly). Thanks for the XIRR tip.

ReplyDelete"But you have to do the math."

If this "simple" stuff like annuities and compound interest and 100 iterations of Newton's method is actually expected of Joe six-pack to understand a simple personal insurance financing or a yield on their slightly more adventurous 401K investment, then we're screwed. It won't happen (regular guy doing such "simple" math). Now, with the tools and the young and ambitious math and physics PhDs available to the Madoffs and Stanfords and Govment Saks, there's some really funky math that I know I can't ever do (and I consider myself relatively good at math). No wonder they get away with the things they do.

Society just can't work if we can't trust our professional experts. People simply need to trust their doctors, or we'll all get swamped in litigation and taxes, which even the good guys must cover for and charge us all. We all pay for costlier services to cover for the lawyer's fees and the bureaucracy in government regulation needed to protect us from rampant abuses from a few (or a lot of) bad guys. That's what's wrong with the system, particularly in the US. The current system's darwinistic dynamics favor the bad behavior becoming more rampant, the lawyers and bureaucrats need the crooks to justify their jobs, and the crooks will keep doing the cost-benefit analysis and find there's a good chance they'll get away with it, while we all bailout "poor ol' Joe" and his clunker car or mortgage, and we also bailout GS and Friends. Now that's common sense for most within this system.

I don't know how it can be fixed, other than everyone suddenly growing a conscience, or everyone getting math/finance/computer science/medicine/law degrees. I'm not holding my breath.

PS: Thanks for finding the buried question in all of that. I had no idea about that little extra something on the side of the bond price, which I'm sure is just an obvious fact of bonds that everyone just knows. I feel like that short-circuiting wire got sorted out in my mind :)