Another week of summer trading

I don’t think price movements should be taken too seriously this week or for the rest of the month. The price changes do create volatility that can be taken advantage of, however.

That said, I am beginning to have a few “hits” on my equity radar that are deserving of more research, so hopefully I will have enough time to look at them since I have been taking things relatively easy myself.

I continue to trim my long-term bond position in Limited Brands; I had the selling side of the trade at the 52-week high, but I didn’t have my entire position filled and now the position is trading about 1% less than that amount which is somewhat frustrating – I just wanted to clear out the whole thing at 96 cents. TRACE has the bonds at 92 cents on the dollar, while the exchange-traded version had them at 96 cents on the dollar, so I am unloading and taking my money. I remember the days that TRACE had them at least 5-10 cents higher in the bond market vs. the exchanges, so the market is relatively inefficient on these illiquid issues – a high volume day is considered to be $50,000 traded.

I also note my other long-term bond positions are creeping higher. If they get to the 8% yield stage I’ll consider a liquidation of them, and leak the position and fully dump them at around 7.5%. I also have to time whether I can unload them in 2011 for roughly the same value for tax reasons. TRACE has those exchange-traded issues and the bond values at roughly the same value at present so I am not losing a premium valuation by waiting.

I am also trimming my only equity position, which I had a very minor stake in. It was an obscure play that was slightly under-valued and had a market catalyst that never emerged. It has appreciated somewhat, so I am selling it. With my track record it will probably go up 2000% over the next 3 years after I dispose of it all.

All of this should make for a third quarter update that should hopefully show some more cash in the portfolio – assuming I don’t buy anything, it will get over 10%. Although cash yields a paltry 2% at present, it gives me the opportunity to strike at other opportunities when they arise and come to my attention. It is very difficult to do this when “fully invested” since going into margin to invest involves its own separate set of risks.

I am playing things ultra-conservatively, which doesn’t make for good writing, but at least I will be solvent.

I am also still looking for income-oriented securities, but I am finding this entire sector to be swamped with over-valued issues. It is painfully clear to me that the large amount of money sloshing around there is looking for yield.

Equal Energy – Debentures

Equal Energy – Equity (TSX: EQU) is trading relatively high (roughly a market cap of $160 million) and the balance sheet is strong for a small oil and gas producer by virtue of recently doing some equity fundraising and asset disposals. They still have a net debt position but it is easily buffered by cash flows from operations.

Their CFO did resign today over a compensation dispute – a yellow flag, but the market did not appear to be too concerned about this. I do not believe this will compromise their ability to pay off their debentures.

They have two series of debentures outstanding, including EQU.DB – $80 million outstanding, matures on December 31, 2011, pays an 8% coupon. Perhaps more importantly, they are callable presently at 105 and 102.5 after January 1, 2011 with 30-60 days of notice. Current market price at the ask is about 102, although if you floated a bid at 101.75, you would likely get hit. The following assumes a purchase at 102.

It is a respectably high probability event that they will refinance debt and call out their existing debt on January 1, 2011 for 102.5. If so, this represents an annualized gain of 9.1% – approximately 7.8% of that is a cash yield and a 1.2% premium for being called out between now and January 1, 2011. If not called out, then assuming you hold onto maturity for the final year, the gain would be 6.4% – approximately a 7.8% current yield and -1.4% capital loss.

Putting this into raw numbers, $100 invested today would give you $103.57 on January 1, 2011 assuming a call-out as anticipated. If not, $100 invested today would give you $109.12 on December 31, 2011 assuming maturity at par. None of this includes commissions and assumes a purchase at 102.

Considering that your risk-free yield at 4 months and 16 months is roughly 2% in a cash account, parking your capital in a manner such as this is a relatively low-risk, low-reward alternative that can give you more yield.

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.

Bank of Canada Interest Rate Projections

Since the last 0.25% rate increase on July 20, the bankers’ acceptance futures have been quite calm. We have the following quotations:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 AU 0.000 0.000 98.905 -0.005 0
+ 10 SE 98.825 98.835 98.825 0.000 1825
+ 10 OC 0.000 0.000 98.725 -0.005 0
+ 10 DE 98.700 98.710 98.700 0.010 6190
+ 11 MR 98.580 98.590 98.580 0.010 4636
+ 11 JN 98.460 98.470 98.460 0.010 2213
+ 11 SE 98.310 98.320 98.310 0.000 904
+ 11 DE 98.140 98.150 98.130 0.010 303
+ 12 MR 97.950 97.960 97.940 0.020 104
+ 12 JN 97.770 97.790 97.760 0.020 54

This still hints that the short term rate will rise 0.25% by the September 8 or October 20 meeting, and the short term rate will end the year at 1.00% with a possibility of 1.25%. For the year 2011, rates are expected to inch higher by about 0.5 to 0.75%.

It should also be noted that at present, 3-month corporate paper is yielding 0.89%. This was approximately 0.4% half a year ago.

Finally, since 5-year bond rates have dropped considerably over the same time period (which is counter-intuitive to the economics 101 texts that state that longer-term bond yields will rise with an increase in interest rates), 5-year fixed term mortgages should also drop – the best one I can see so far is 3.87%.

Credit card review – MBNA Smartcash Platinum

I have been using the MBNA Smartcash (3% off groceries/gas (5% in the first 6 months), 1% off everything else, paid in $50 increments) for the last five months and I generally am impressed that it has worked as advertised. They have an online interface where you can review your transactions and it is a functional, no-frills site. The two $50 cheques they have sent to me so far come in the mail a couple weeks after the statement date, and slightly to my surprise, have not bounced or come with ridiculous conditions and such.

I am guessing they send cheques instead of crediting the account automatically because they anticipate a certain fraction of people will not actually cash in their $50 cheques.

I used to use the Starbucks Visa Duetto Card (sponsored by RBC) which gave you 1% in “Starbucks money” which I used as a luxury item since there is no way that I could have otherwise rationalized it. They (either RBC or Starbucks, depending on who you believe) canceled the cards this spring, so when doing my shopping for a better credit card, I settled on the MBNA one.

My only negative is that they send out cheques in the monthly statements, and I always put these through the paper shredder simply because writing cheques off a credit card is hideously expensive and also because of the fraud consideration. I also was very quick to get off of their telemarketing spam list since they were selling useless products (likely “balance protection insurance”), but after that they have been non-spammers.

Note I was not paid to write this, these are my germane thoughts as a retail consumer on the product in question.