Anatomy of a trade decision

As I indicated previously, I am interested in trimming my long-term bond positions since I believe the market for less-than-stellar debt is becoming expensive for the risk taken.

Although I am adverse to income taxes, you should never let income taxation be the overriding factor in the decision to sell – valuation should be the primary consideration, along with your portfolio considerations, and then income taxes should be a secondary consideration.

An example today was trimming a trust preferred (which held a corporate bond) position in Limited Brands (NYSE: LTD) that I have held onto since late 2008. The security is due to mature in 23 years from now (March 1, 2033) and pays a 7% coupon semi-annually. The underlying company’s equity is trading relatively high, has a moderate amount of debt ($2.6 billion debt vs. $1.2 billion cash on hand), good income ($560M in the last 12 months) and an excellent brand name. So the underlying company, in the short and medium run, is likely to be solvent and be able to raise money and retain their cash generation abilities. It would not surprise me if they were able to be solvent in 23 years to pay off the underlying debt. My cost basis on the units are 35 cents on the dollar, which represents one of the best trades I have done in some time, but this will also represent a large capital gain when liquidating.

Back then, 35 cents on the dollar meant you got to collect a 20% current yield, and another 4.5% implied capital gain by waiting patiently. Now, the market has taken all of those coupon payments and gains and transformed them into a higher unit price – so instead of waiting 20+ years to realize that money, you can do it now. What I am trying to say here is – your cost basis is irrelevant except for factoring in the cost of capital gains taxation. The current market value that you can liquidate the securities with is the relevant factor – if I have $X that I can liquidate from this security, can I deploy it elsewhere more efficiently than the implied 7.7% it is paying me?

So why trim the position? 7.7% sounds pretty good over 23 years, doesn’t it?

There are a few reasons.

– The valuation appears high. At the current trading price (94 cents on the dollar) it is significantly higher than the underlying bond’s price that is available through TRACE. At 94 cents, your current yield is 7.4%, and your implied capital gain (which is the 6 cents of appreciation you earn upon maturity) is another 0.3%, so your total yield is 7.7%. While a 7.7% yield is about 4% higher than you can get with underlying treasury bonds, it still is not a sufficient threshold.

– I want to increase my cash balances. While I believe the next big macroeconomic move in the economy will be an inflationary cycle, it will completely depend on the timing of US politics. Right now the US economy is dominated by political considerations and this is why most businesses are choosing to hoard cash – since in times of political uncertainty you do not know the return on investment. A more business-friendly administration would result in a large inflationary spike. Right now we have the exact opposite of a business-friendly administration.

– I want to shorten the duration and term of my bond portfolio, for pretty much the point I made above.

– I do not need the yield, but apparently others do. They are willing to pay for liquidity, so I am willing to give it to them for a cost – they have to meet my asking price on the exchange.

– I am afraid that interest rates, while very low by historical standards, may increase. I am also not concerned to waiting a longer period of time for those rates to rise, and get to hold onto my capital in the meantime to perhaps deploy to a better area.

– Maybe the underlying business will face a downturn. It is in the consumer fashion industry, and while the Victoria’s Secret brand is unlikely to degrade anytime soon, maybe consumers will be a little more fickle in the future. I have no clue when it comes to retail fashion which trends will stay and which will not and can only evaluate these companies from a financial perspective. A great example is Coach (NYSE: COH), which to my neanderthal male mind, mainly makes handbags and accessories. But somehow this company produces insane amounts of cash. Will this trend continue? Who knows. But what I see financially there is a cash machine. I generally ask fashion conscious women for insight on these various names once in awhile to see what the intangible aspects of the brands are.

I am giving up a further potential upside of about 6% capital appreciation (since the trust preferreds contain a call provision they will not trade much above par value) in exchange for the safety and security of cold, hard cash. Right now I do not have any targets for my cash, so I will continue to be patient. Eventually the equity markets will contract and some opportunities will present themselves. It is unlikely it will ever be like late 2008 for awhile, but we will see.

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