Subordinated debentures, Anyone?

Investment Analysis Clubs Jim Royal
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As I am nearing retirement, I have shifted my portfolio toward dividend paying stocks to replace the income that won’t be coming in after retirement. I’ve run into subordinated debentures issued by insurance companies. They tend to be very long term instruments - 25-ish years to maturity and pay 6-7% on cash, as they are trading at a discount to their $25 issue price. Dividends are 1.30-1.40 per year, paid quarterly. I’ve bought some AFGC, as I am very familiar with the company, having worked there for many years. There are others out there - WRB has a series E, for example. I used to follow the company ages ago, but have little current knowledge about it.

My strategy would be to collect the 6% until or unless rate cuts result in the price moving up 10% from the $20-22 current price. Getting the dividend and the slow march to $25 is fine with me as well.
Anyone have thoughts on these instruments?

Vinnie G

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Investopedia has a good article on them.

Also, Quantum Online offers a good screener.

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Vinnie,

There are lots of ways to play the divvie game, and there are lots of risks which come in two main forms: default and inflation.

To some extent, one can hedge against default by digging into the issuer’s fundamentals and by not over-betting one’s hand. Inflation is harder to hedge against, and the rate reported by our dear government’s Bureau of Economic Propaganda (alias, the BLS) cannot be trusted, nor is even relevant if it were accurate, because inflation --in the way that laymen understand the term-- is always a matter that will vary from household to household according to their own shopping basket of goods and services.

But the grim reality is this. Generally, some taxes will probably have to be paid on the divs received, and what’s left might not even cover inflation. Furthermore, the principal received back at maturity, especially if it’s pretty far out, will have been seriously degraded in terms of its purchasing-power.

Here’s a quick example. If you spend $22 to buy a debenture today and the bond matures in 20 years at $25 and inflation has meanwhile run at a modest 4%, what will be the effective purchasing money of that lump sum when it is received?

Are you ready for this? Exactly $11.41. If that’s not trading elephants for rabbits, I don’t know what is.

Now come some disclaimers. I own bills, notes, bonds, debentures, preferreds, etc., a lot of them, because I find the asset class interesting. But I don’t own them because I expect to make much money from them. I own them because I can, not because I have to. They are a way to spread risk.

Footnote: The impact of inflation on purchasing-power is simply the reciprocal of the average of the inflation rate that prevailed over one’s holding-period raised by a power that is equal to the holding-period.

Yes, that’s a mind-numbing bit of pedantry. So let’s work an example.

If the average inflation rate is 4%, enter 1.04 into your calculator. If your holding-period is 20 years, hit the power key and enter 20. The returned answer should be 2.1911 etc. Hit the reciprocal key, and your answer should be 0.45638 etc. That’s what’s left of the original sum of ‘1’ you began with. [Think radiation and half lives.] Lastly, multiply that residual number times the principal received at maturity.

Yeah, this post is already way too long. But let’s get serious for a moment. There are smart ways to buy bonds, debenture, preferreds, etc, and there are dumb ways. The dumb ways involve not understanding why an issue is priced as it is and letting oneself be seduced into buying it because of a seemingly fat current yield. The smart ways involve being able to price issues as a shrewd , Ben Graham-style value investor would price them and only buying those that truly offer a discount to fair value. Plus, there are other tricks as well, such seeing where the common is trading and asking --on a total returns basis-- whether it wouldn’t be better to buy that instead.

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Arindam,

Tempted to add ‘you’ after your name there - just kidding, of course.

I like what you are saying. I think what I should do is take (yield on cash - inflation) and assign a portion or all of the residual to cover lost purchasing power of the cash price. I am going to use round numbers. My AFGC is at 19 today. It pays 1.28 per year, or about 6.75%. For the sake of argument, inflation is 2.75%. So I am beating inflation by 4% on cash return. In a year, I should have a value of 19.25 as the price will move toward 25 over the next 25 years. That’s a 1.25% gain, but I need another 1.5% to keep even with inflation. That comes from the ‘excess’ 4%, which is now an excess 2.5%.
So I would argue that AFGC at 19 could be a decent investment because the return on cash covers inflation and loss of purchasing power on the principal invested. I should extend the analysis beyond 1 year to see if it breaks apart in later years.

Am I thinking about it correctly?

Vinnie G

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“Am I thinking about it correctly?”

Vinnie,

A lower-tier, BBB2/BBB- issue, due in '59 and not eligible for the 15% tax-rate, that can be estimated to lose money over the long haul due to the impact of inflation isn’t “an investment”. It’s just a bad idea.

Give me time to find the spreadsheet I built for bonds years ago, and I’ll run the numbers, plus offer some explanations that get into things like the diff between agency-assigned ratings versus market-implied ratings and how to estimate whether a bond is priced fairly or not.

Yes, bonds can have a role to play in retirement portfolios, and even a big role. It all depends --as always-- on one’s means, needs, interests, skills, goals, and opportunities. There is no "one size fits all " and the various allocations offered by financial planners along with assumptions about “safe withdrawal rates” are nonsense that works well in backtests but not out of sample, going forward.

Suggestion. If you want to break into the bond game, you should do some reading, and I’ll make the same suggestions I made in another post which you can find here.

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Vinnie,

Online calculators suggest that your YTM on that bond, if bought 12/02/2025 and held to maturity which I arbitrarily guessed would be 12/02/2059, would be a decent 6.99%.

My numbers suggest that the achieved YTM would be (-2.99%) when the following assumptions are made: an inflation-rate of your 2.75%, a tax-rate on the divs of 25%, and a 15% tax-rate on the cap-gains achieved when the bond matures.

I need to recheck my formulas, just as I need to check the formulas being used by the online calculators which often assume that divs will be reinvested at the coupon rate. But my bet is that buying --or holding-- that AFGB bond will not offer a positive return after taxes and inflation. What it offers in the near term is an income stream that is eventually erased by taxes and inflation.

So, what to do? You might take a look at covered call ETFs, which, if very aggressively managed so as to avoid share price erosion, could offer a very fat income stream. Also look at what the corporate market is offering. (Both Schwab and E*Trade have easy to use bond scanners, though you’d want to be executing through Fidelity due to the latter’s better commish schedule.)

Lastly, as last resort, you could do the Peter Lynch thing and skip bonds entirely in favorable of selling off stocks as the need for income arises. But you also need to confront this reality. Stocks tend to offer higher returns than fixed income instruments because they are riskier. But if one can grab 6%, 8% or better from a short-term trade in the stock market, that money can be parked in T-bills the rest of the year, creating what amounts to a synthetic bond. And if gains of 200% or better are being made, such as I making on some of my precious metals positions, especially the miners, very little money has to be put at risk, and the rest can be parked in T-bills, debentures, whatever.

If you do read Ben Graham’s book, you should take from it his three categories: ‘defensive’, ‘enterprising’, ‘speculative’ and allocate your capital and efforts in such as way that you can meet your financial goals AND sleep comfortably at night.

“It’s a jungle out there.”

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Ari,

I can see now that our methods are in alignment - and yes, I need to factor taxes into that spreadsheet to see if/when the tide turns against me. When I first saw this debenture in June, it was priced at $18, which was very attractive, but I needed to study it a bit to become comfortable with this new shiny thing. I should have come to this board first, as my other sources were disappointing in their feedback. My theory was to collect 7.1% on cash unless or until there was a bump in price, perhaps related to fed rate cuts. In reality, this scenario played out as it reached 20.75 in September.
As you have discussed, why take 7% if the market gives you 15%?

I have spent very little time looking a CC ETFs, but I like that idea. I have done much work on divvies as you call them. My main screens are: Dividend growth over 10%/year on average, payout ratio under 60%, total returns averaging above 10% and all the better if share count is being reduced. I am just now looking to add shareholder return - the sum of dividends, buybacks and debt reduction - to the mix.

I greatly appreciate the time you have taken to school me on your philosophies and i wish you contiunued investing success!

Vinnie G

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Vinnie,

Every investor, as I keep saying, is his or her own unique person with their own means, needs, interests, skills, goals, and opportunities. And as Jack Schwager has shown in his series of books on “market wizards”, a method of investing/trading that works for one person, another person just makes a hash of.

If your methods and goals are clear to you, then stick with them, and ignore people like me who are looking at things from a very different point of view.

To my way of thinking, the impact of taxes on gains matters. The impact of inflation on future income streams and the eventual payout matters. Additionally, the likelihood of default matters. So, the question I always ask of a potential fixed income investment is this, “Am I being paid enough to accept the risks of this investment?”

I don’t know your age. But if you’re discussing eventual retirement, let’s guess 60. That AFGC bond isn’t due until 2059 when you’ll be 93, or likely dead, in which case your heirs inherit a security that, that each share of which, won’t even buy a cup of coffee.

Now come some disclaimers. Even my heirs won’t outlive some of the bonds I own. But they aren’t big bets, because I never bet big on anything. I’m constantly nibbling and exploring, always experimenting. The long-dated bonds I did buy were just that, experiments.

Last night, I did rerun the tax and inflation numbers on AFGC, and the results suggest --to me anyway-- that AFGC should NOT be bought, not when a site like Quantum Online lists plenty of opportunities coming due in under 5 years.

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“My strategy would be to collect the 6% until or unless rate cuts result in the price moving up 10% from the $20-22 current price. Getting the dividend and the slow march to $25 is fine with me as well.”

Vinnie,

The likelihood of the Fed cutting rates is less than the likelihood the market itself will raise them. Yes, they and Wall Street want rates cut, so the asset bubble can continue. But some other things are happening, like the short squeeze in silver, that’s going to put the kabash on that. [Explaining what’s unfolding on the metal exchanges and the likely eventual impact on interest rates is a post for another time.]

Initially you were attracted to AFGC by its discount from par. But that should have been a warning sign, prompting you to ask, “Why that price?” “What are the risks hidden in that price?”

In bond investing, one is always making either of two bets. Either you’re betting on the level and direction of interest rates, or on the level and direction of an issuer’s creditworthiness. The former is mostly an institutional level game, better avoided by retail investors who just don’t have the informational resources --or control over outcomes— the big boys do. The latter game is accessible by small investors. If they can do financial statement analysis and chart reading well enough to buy individual stocks responsibly, they know enough to be able to buy their own bonds. (Else, they should access FI instruments through funds. IMHO, 'natch, with the exception being Treasuries, which is a very user-friendly market.)

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Ari,

If you could share your spreadsheet, I would appreciate it. I have the erosion of par value calculated correctly, but not sure about the right way to assess the erosion of the excess return due to inflation. I believe your calculation would value the debenture at around 6.75 today, but I am not getting that. Thanks!

Vinnie G

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Vinnie,

Happy to share with you what I’ve done. But it’ll have to be later today after market close.

Incidentally, I put on 19 new positions today spread across gold, silver, copper, platinum, and palladium. 16 are ITM, 3 OTM. for an avg gain of a very modest 1%. But do that trade even once a month, and you’d be making better money than AFGC offers.

I’m not saying you should trade. I’m just saying that if it’s gains you want, things like AFGC aren’t going to offer them. They’re just a way to park money while looking for better opportunities or a way of creating reserves. They’re a necessary part of a prudently structured portfolio, but they needn’t be the whole it. (IMHO, natch, says a guy who’s carrying 65% of AUM in treasuries. )

Later.

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Vinnie,

To my surprise, that AFGC bond doesn’t score as badly as I first estimated.

Assumptions:

Purchase Price, $18.95
Par, $25
Coupon, 5.125% prorated quarterly
Cap-gains tax-rate, 15%,
Ordinary Income tax-rate, 25%.
Maturity, 2059.
Inflation rate, 4%

I estimate the yearly, after-tax, after-inflation gain for that AFGC bond to be 3.4%, or about half of its nominally projected, before taxes and inflation YTM of 6.99%. Therefore, buying that bond does preserve purchasing-power over the long haul. Not hugely. But buying it doesn’t create a loss for the portfolio.

It’s going to take me some time to clean up the spreadsheet so it is self-explanatory, the variables can be changed, and the columns auto-populate. Then I’ll have to figure out a way to post it.

It was mind-numbing day for me. Put on 25 new positions. But most of them ended ITM for the day, which is why I was shopping the bargains.

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Appreciate it! Looking forward to it.

Vinnie g

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Vinnie,

Sorry to beg off on this project, but I’m going to. Other things have come to the forefront, like me starting to buy preferreds again and exchanged traded debt. I put on a dozen positions Weds and some more today. But I’m keeping maturities short, under 5 years. Inflation will still rob me. But I don’t have to calculate its impact. I just know it’s there, not that any projections about the level of future inflation aren’t just guesses.

I would suggest you check out two resources for income investors. One is Quantum Online, which has an excellent scanner. The other is Fidelity’s bond yield calculator. Between the two and some old-fashioned, green eye shade, fundamental work, you should be able to find some exchange traded debt and preferreds and MLPs, etc., that offer comparable or better returns than that AFGC bond.

Best wishes for success in the coming year.

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And to you. I appreciate the framework for thinking about this issue. I’m thinking a covered call or put writing strategy along side the dividend companies will help beat the inflation hurdle.

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Vinnie,

Another thing you might consider is shortening maturities. Quantum Online lists dozens of preferreds and exchange trade debt instruments that have CYs and YTMs comparable to that AFGC bond but that come due a whole lot sooner than 2059. But caution is needed. Those with the fatest yields typically have shaky financials. One way to try to manage that problem is to bet widely and small.

Also, pay attention to what the Fed is doing, not just what they are saying. Within the past week, they’ve bailed out banks that were short silver to the tune of $40 billion, all the while saying they aren’t doing QE. They’re trashing the currency to preserve market place liquidity. That could spill over into higher interest rates and, for sure, higher inflation. Meanwhile, everyone’s favorite orange pirate is wrecking havoc in the energy market with his attempted resource grab that’s likely not to bring a single barrel onto the market any time soon, if ever.

Think, DEFENSE.

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