Getting up to speed

I haven’t blogged for a while, so I thought we’d catch up on some things written about over the past year or so.

First, bonds in general. LINK. There is no doubt that corporate debt has been the asset star of the last year or so. While stocks have made their way back and are closing on their high-water marks, most bond portfolios and funds are hitting new highs.

The category is still very much in favor and there is some value still to be found. Don’t get too greedy and you’ll be ok. There are a lot of new issues coming to market both in the developed and emerging markets, so there is quite a bit to choose from. The big gains are over now, its coupon-clipping time.

As for more specific issues, our friend Borat must be happy. LINK. Kazakstan’s sovereign risk is now lower than many Eurozone countries. Not only Greece (duh), but Hungary , Portugal and almost Spain. The fact that Kazakh debt trades better than California’s was widely remarked in the press. LINK.

In Ukraine, things have calmed down. Elections were held in January/February and the pro-Russian candidate Victor Yankovych won a close second-round victory over Yulia Tymoshenko, despite her good looks. LINK. And so the “Orange Revolution” was reversed. Tension between Russia and Ukraine which contributed to the “gas war” between Gazprom and Naftogaz has come down dramatically and there are even talks of joint ventures. LINK. Russia has agreed to give Ukraine a price break on the gas it consumes, while Ukraine will extend Russia’s lease on its Black Sea Naval ports. LINK.
Naftogaz bonds, which defaulted briefly in October (swapped for new issue- LINK) are now trading at 108%. I remember an analyst stating that he “wouldn’t be surprised if the new Naftogaz bonds were trading above par in less than a year”. Oh wait, that was ME.
Isn’t it nice when neighbors get along?

As for corporate issuers: AIG and its subsidiaries are still current with their bonds all of which have rallied sharply. LINK. LINK. LINK. An important “turning point” was reached when airplane-leasing subsidiary ILFC returned to the bond market, thereby reducing the refinancing risk of its outstanding bonds. LINK.

Herrtz quietly dropped the suit against an analyst who had named the company as a possible bankruptcy candidate. They figured out it would only get them bad publicity. Took them a couple of months to figure that out. LINK.

Despite my skepticism, Kodak’s bonds and stock have rallied, as the company raises cash selling or licensing some patents and is trying to raise more by suing the likes of Apple and Research in Motion. I could have held on…oh well. LINK. LINK.

The price of Gold has stagnated, ruining a speculative gold trade I had set up, Sometimes investors DON”T go bananas. Especially when you expect them to. LINK.

Venezuelan bonds have rallied of late, but still yield much more than their credit rating would suggest. What good are the numbers if you can’t believe them? LINK.
Analysts are looking at a $1.5 billion bond maturity in August, as Central Bank reserves drop.

Blockbuster and Netflix continue their lopsided battle. The Hollywood studios have realized that Blockbuster’s survival is in their best interest. How much they will help keep Blockbuster away from bankruptcy remains to be seen. Anyway, the four trades proposed back in February are winners at this point. LINK. LINK.

Now that we’re up to date on these trailing issues, maybe we can move forward and I can get around to blogging more consistently.

Resolutions

Year end. Time for recaps and predictions. Looking back and looking ahead. Time for resolutions in the two senses of the word: those things that were resolved and those things we promise to address in the future.

Looking back, 2009 was a banner year for most investment categories. Financial markets recovered from the brink of despair, in a move so quick and furious that it offered great opportunity to those who remained alert, while those who passively stuck with their positions throughout could still find comfort in meaningful recovery. On the other hand, those investors who bailed out of the crisis at the wrong time, found themselves longing for those opportunities which passed them by, while they scoffed with skepticism or cowered with fear, unable to pull the trigger and return to the game.

Risk taking was richly rewarded, as the pendulum, which had swung high in favor of safety in 2008, came rushing back in the opposite direction. Playing defense was a losing game this year.

Two of my favorite categories: high yield fixed income and emerging markets, were the hottest tickets of the year. Russian Bonds, for example, with a little bit of both characteristics, were a great place to be.

On balance, it was terrific year for me personally also. My health improved, my family has been wonderful and Uncle Sam is going to smile when he gets my check next April. My clients are very happy to have heeded my advice. Vision and/or luck? A little of both perhaps, but does it matter?

I also had the opportunity to strike a few things off my “bucket list”. Check out the picture at the top. I’m sure you’ll recognize the place. (If not, please rent the whole Indiana Jones series).

The Stanford affair was perhaps the icing on the cake (my 15 minutes?). Aside from the excitement and the attention, it was a messy issue that helped put things in perspective for me. Everything can change in a minute, so don’t take anything for granted. I still follow the case but stopped writing about it. Maybe I’ll do a book about the whole ordeal some day. I certainly have enough material and it’s the only way I can think of to get on “The Daily Show with Jon Stewart”. Nowadays everyone writes a book. Even Sarah Palin!

Looking forward to 2010, challenges abound (there’s a cliché!). Starting with the markets, the easy gains have been made. I still see some opportunities in fixed income, because the dynamics of that market are still favorable. Low base rates, stingy banks, aging populations with more retirees (looking for income) and a few decades of “underhyping” of the asset class. Let’s face it, the media forgot bonds existed back in the early 80s (the 1780‘s) and are only now beginning to rediscover them.
Equity markets don’t appear so clear to me, although accommodative monetary policy lends little reason for selling. It’s a simple case of “what are you going to do with the money?” I have read a lot of research looking for enlightenment on the issue.

As for New Years resolutions, aside from the 20 pounds I vow to lose (this year I’m serious!), I will try my best to blog more. This humble little blog is receiving some pretty consistent traffic and when you have an audience, even a small one, you have an obligation to it. I’ll blog about the markets, investments and probably a lot about bonds and fixed income. It’s not the idea to “fixate” about fixed income, but while there are millions of blogs on stocks, there isn’t a lot of free commentary about bonds.
I’m going to try my best to make a least a post per week, which may not sound like much, but remember this is not my real job.

So, have a really peaceful and joyful rest of this holiday season, a great year in 2010 and thanks for reading my junk.

The Long and Short of Naftogaz

Ukraine’s state-owned gas company is not usually at the top of the business news here in the Western Hemisphere. But there is a story to it, and like usual in this blog, an investment opportunity.

So here’s the short story and the long story.

The Short Version

Naftogaz, 100% owned by the Ukraine Government, is not in the finest of financial conditions these days. But as a government entity, the Ukraine government by way of subsidy or capital infusion has bailed it out, time after time.

The company has a series of loans and other debt obligations coming due over the next two years, which it wishes to reschedule. The total is $1.7 billion. The interesting part (for us) of these obligations is a $500 million bond issue coming due September 30. Two weeks from now.

All summer long, Naftogaz has fueled speculation about whether it would pay these bonds on time. At one point, it seemed they would pay. And then they’d be back in the “restructuring” mood.

Two weeks ago, they hired Credit Suisse to help them with the process, so the “restructuring” seemed to back on. LINK. Yesterday it was announced that talks with bondholders were beginning. Some tentative terms were leaked to the press. LINK.
Not everyone is happy with this, and there is a dissident group trying to block the efforts and make Naftogaz pay up on time. LINK.

Naturally, all this has bondholders quite nervous and that 2009 bond (with a 8.125% coupon) maturing in two weeks is trading at 85-86%.

The terms “leaked” about the restructuring are a coupon of 9.5%, an additional five years, an explicit government guarantee and possibly an upfront “consent” payment. If that’s it, sign me up.

Certainly, Ukraine is not an easy place to invest, and there is a rocky road ahead. But it’s not easy finding double digit yields anymore, not even in the emerging markets. This is a risk I can stomach. This isn’t Ecuador, who thumbed its nose at the international financial markets, recently. LINK.
Ukraine has a $16 billion program with the IMF established last year in the midst of the global crisis. You don’t sign on with the IMF, if your plan is to default a few months later. (You default FIRST, and THEN go to the IMF)

Now the LONG version
(more interesting…but well, LONGER)

The Ukraine and Russia have had a complicated relationship going back centuries. I’ll let you wiki that if you will, but here’s how it all relates to gas.

Russia has gas, with 25% of the worlds known reserves. Europe needs gas, since it gets cold in the winter (and at other times also) Since the 1970’s, the Soviet Union has been exporting gas to Eastern and Western European countries through a network of pipelines.

Here’s a great map of those pipelines. LINK. (Don’t you just love maps?)

I did write “Soviet Union”, but the USSR is no more and the main trunkline of the pipeline now goes straight through now independent Ukraine. That pipeline now belongs to Naftogaz. But the gas belongs to Gazprom (Russia).

If this sounds like fertile grounds for conflict, it has been. Through the 1990s, Ukraine and Russia quibbled about these issues and in particular gas debts, since Ukraine had the habit of getting behind on payments for the gas it consumed.

Not surprisingly, things really started to get testy after the Ukrainian “Orange Revolution” of November 2004-January 2005, from which a pro-Western government emerged with talk of joining the European Union and (OMG) even NATO.

So at that time, Gazprom figured out that it was about time to look at the easy terms (below “market”) that Ukraine was enjoying for the gas it consumed, and of course, Ukraine wanted more money for “transit fees” through its territory. Naftogaz admitted to “turning the valves” its way (diverting gas for domestic needs).

The dispute culminated with Gazprom turning off the gas for EVERYONE on Jan 1, 2006. The Europeans, not really enjoying the prospect of freezing in January, helped broker a deal and supply resumed. A similar spats over debts and prices resulted in a disruption in supply earlier this year, again with some Western European intervention.

At the moment, Naftogaz is current with its payments to Gazprom, but that probably doesn’t leave a lot of room for other creditors (hence the proposed restructuring). Add to this the fact that Naftogaz still subsidizes local gas consumption heavily (something the IMF isn’t particularly happy about) and Naftogaz’ financial situation is still suspect. But, as stated above, there is an “implicit” government backing and frankly for all practical purposes, Ukraine can not cut Naftogaz loose.

If all this weren’t convoluted enough, Ukraine is scheduled for presidential elections in early 2010. The incument president (Yushenko) AND primer minister (Tymoshenko) are expected to run, as well as former president (and loser in the “Orange Revolution”) Victor Yanukovych, (Putin’s favorite., BTW)

If all this is a little too complex for your stomach, well, maybe investing in the emerging markets is not your cup of tea. Personally, I love this stuff, especially when I’m sitting 6,000 miles away. I’ll take the Florida heat over the Ukrainian winter (with or without gas) anytime.

PS. The picture is of Prime Minister Yulia Tymoshenko, who has the Princess Leia look down pat. She appears to be Yanukovych’s (the pro-Russia ex-prez) strongest opponent in the upcoming elections. Incumbent President Yushenko, the Orange Revolution “Victor”, is nowhere to be seen in the polls.

Death of a Model?

While the Chicken Littles of the financial world have been relatively quiet in the past few months, there continue to be pockets of anxiety. Perhaps the name most mentioned in the past few weeks is CIT.

This relatively obscure financing company deals in what they call “middle market business and commercial loans, financial services and solutions”. So we’re talking about Small Business Administration Loans, Factoring (lending with receivables as collateral), leasing, etc. Middle sized companies, like retail chains, service providers and specialty manufacturers turn to these guys for money. On the consumer side, they finance student loans.

So basically no “mortgage meltdown” here, although the recession has affected their loan and lease portfolio and write-downs put the company’s results into the red for the last few quarters (not unlike most financial institutions). CIT received TARP money last year (again…like everyone else).

The balance sheet appears to be solvent, with $64 billion in liabilities to $6.1 billion of equity. Hardly levered compared to most, you could say. Cash flow is quite positive.

Nonetheless, CIT tethers on the edge of bankruptcy. Why?

The problem is funding. For years, CIT has financed its operations by issuing notes and commercial paper to the “market” and then using those proceeds to lend out. They call it the “wholesale model”. Get money in the market at 4, 5, or 7%, lend it out at 9-12% effective rate. Live happy ever after.

Of course, something happened on the way to the bank (or middle market finance company). The credit freeze happened. All of a sudden the “market” for CIT’s paper was no longer there. CIT did a few things, like issuing commercial paper with a government guarantee (for a while) and converting to a bank holding company, which allows it to get FDIC-insured deposits. Additionally, CIT reduced its portfolio (essentially lending out less than it was collecting).

But it hasn’t been enough. Notes issued in previous years are coming due at a quick pace ($13 billion for the next 12 months). Funding has not been forthcoming quickly enough (deposits at the CIT bank are only $5 billion). At least not CHEAP funding.

There is a price for everything and CIT recently got a SECURED $3 billion credit line from Barclays and a syndicate of banks. But at a price: LIBOR plus 10%, with a 3% LIBOR floor. (That’s a 13% floor and there are other fees associated,too). They got some of the cost back buying back some notes at a discount, but it doesn’t offset that much.

This is obviously not a permanent solution. CIT can’t operate funding at over 13%. And of course, while its liquidity problems remain, it can’t fund cheaply. S&P already has them at CC.

It’s a catch-22. CIT can’t get the money it needs because it has no money. Rinse, lather, and repeat. Can the “wholesale model” escape this circle?

Of course, CIT itself is lobbying quite clearly for a bailout. Just check out its website. HERE. They have a point. How is CIT that much different from another banking holding company (Citi? Morgan Stanley?) or GE Capital for that matter (GE continues to get TALF support). On the other hand, shouldn’t the “market” have a market-based solution for this?

If CIT is indeed solvent as it’s balance sheet indicates (you can never be sure), shouldn’t there be a buyer for it? And also if so, shouldn’t CIT be able to return to its original business model (selling notes at “normal” yields).

Of course, there is an investment opportunity here. These “survival” plays tend to carry a very interesting risk/reward ratio. CIT’s stock has been volatile for sure. But a bailout could carry a hefty price in terms of dilution, so no simple solution there. Potentially large payout, however, CIT trades at a market cap of only $600 million (excluding the TARP money…which could convert).

And there are bonds, of course. Bets on “survival” generally have worked well since Lehman collapsed last year. Solvent companies with liquidity problems can find buyers (as was the case with Nova Chemicals) or a government hand if they are “too big to fail” (Banks, AIG and subsidiaries) or something in between (Ford Credit. GMAC).

In any case, CIT paper maturing in the next 2-4 months is trading at 60-70% of par. Putting down 60 with an upside of 100 in a few months, with only one major outcome in play (survival), is a tempting bet. In the case of bankruptcy, CIT’s long-term notes, trading at around 45-47%, would seem to indicate that the expectation of recovery is relatively high.
So overall, I kind of like those “pot odds”.

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).

Too Good to be True?

Corporate Bonds have gotten quite a bit of ink lately.

Here’s a link from Reuters “Nonstop corporate bond rally raises eyebrows"”and the more sensational headline from Bloomberg "Junk Bonds Make Loomis Sense Dot-Com-Like Danger”. Take some time to read those links.
Don’t panic, yet.

Basically, the storyline is “Hey, look at this great rally we all missed”. Since we all missed it, it has to stop. It’s a bubble, help us!

Or something like that.

As a confessed bond junkie (bond junker?). I’ll admit that things have been good. Unexpectedly good. Historically good.

Not unlike the equity markets, the rebound of the bond market has been fast and furious. Perhaps even more furious than stocks. According to the Reuters article July was the first month in many in which stocks outperformed bonds.

Here’s a graph from the St. Louis fed showing the yields of Baa rated (Moody’s – think BBB for S&P).



Since prices move in the opposite direction as yields, prices have been shooting up as those yields have collapsed. The move in junkier bonds has been even more dramatic.

Which is good, but it’s also bad because unlike stocks (remember the dot coms), bond prices are bound by rational limits. A risky (non-treasury) bond should not trade a yield below the corresponding treasury of the same duration. And of course, it makes no sense to buy a bond with a negative yield.

Treasury yields have trended up, as evidenced by this nice graph of the US yield curve.




Bond yields collapsing, treasury yields rising, spreads (the premium over the treasury yield) falling .we’re in for trouble, right?

Not so fast. Here’s a practical example. Let’s say back at the end of April you decided to buy some Alcoa 6% July 2013 at 92.75%, to yield a solid yet unspectacular 8.2%. Not bad for 4 years and Alcoa isn’t an extreme risk (BBB-, just what they call “investment grade). Good for you.
Today that bond is trading around par (100%), yielding 6% to maturity and you’ve made more in a single quarter (9.4%....the 1.5% coupon plus the price appreciation of 7.8%), than you expected to make on average in a year of holding the bond. Time to take profits and move on, right?

Well sure…you can sell. And do what exactly with the money? Put in in CDs? You’re lucky to get 1% on a three-month CD and 3% on a 5-year one. Treasuries? 2.63% for 5 years.
Less yield, lower risk.

You could increase risk, moving down in credit quality or longer in duration, looking for a bigger payout. Higher yield, higher risk.

Or you can stay put, which makes a lot of sense. First of all, because 6% YTM ain’t bad for 4 years and second because ot the shape of that yield curve.

The yield curve is seriously inclined and looks to continue to be that way for a while, even if it does move around a bit. For argument’s sake, let’s say that Alcoa’s spread vs. treasuries remains the same a year from now (330 bps) and that the three yield treasury remains at 1.66%. The bond would yield about 5% and trade around 102.75%.

So…it nothing changes and you wait a year on the bond, you’re looking for 6% in interest and 2.75% in capital appreciation over the next year. 8.75%!!! Not bad.
Sure, things can move, but as of now 8.75% is your base scenario for the next 12 months, not 6%.

That’s how powerful that incline in the yield curve is.

So, yes…this may be the beginning of a bubble. And yes, it the market has run quickly and far. And yes…this is like a bargain basement, all the good stuff gets picked up first (and is gone now), so you have to rummage through the bins to find value.

But when the yield curve is like now, think of how much fun it is to “slide down” as if it were a water slide.

So for now, I’m still buying bonds, and selling the bubble story.