Cohen's Bond Bets

12/03/2004 12:00 am EST


Marilyn Cohen

President & CEO, Envision Capital Management, Inc.

Marilyn Cohen, president of Envision Capital Management, and author of The Bond Bible, is one of the nation's leading experts on bonds. Here, she explains two fixed income strategies, one to benefit from the troubled auto sector and one to protect investors from rising rates. 

"Bond market history teaches us that the mighty can be brought low. As recently as 1980 S&P gave AAA ratings to both General Motors and Ford Motor. Right now the two are BBB-, one notch above junk. The way things are trending lately, I believe that at least one rating agency will downgrade the auto giants to junk by this time next year. But don't let that stop you from buying Ford's and GM's bonds, with their nice yields. What's gone wrong with the big two car companies? Just about everything: loss of market share, humongous retiree costs, union difficulties, restructuring, rising raw materials prices, excessive inventory, lackluster new products. And what's right with them? They are big companies and won't disappear.

"Ford and GM are two of the largest corporate bond issuers, with $168 billion and $284 billion, respectively, in consolidated debt (that is, with finance arms included). That means almost every sizable public pension fund and bond mutual fund holds their paper. A downgrade to junk would disqualify some of these investors, and they would have to sell their bonds eventually. But they will not be forced to do so suddenly. Prices, after a brief downdraft, will rebound. Someone buying now and holding for years (better still, to maturity) can afford to shrug off the downgrade.

"GM and Ford may be sick, but they are far from dead. They still have strengths, particularly tremendous liquidity huge amounts of cash, marketable securities, and bank lines. Plus, their finance units are profitable; indeed, they carry the parent companies. If you have a lot of money to put into a single bond position, you should consider buying in stages, a third now, another piece after the fourth-quarter earnings numbers are released in early 2005 (they can't be good), and a third after the rating agencies pull the junk trigger. By ‘a lot of money’ I mean $100,000; small bond positions are costly to trade. Your entire bond portfolio should be at least $1.5 million.

"At a time when decent bond income without scary risk is scarce, the automakers' yields look enticing. If you hold the bonds, don't panic and sell them, since the prices likely will recover after a few months when people see the auto firms aren't doomed. However, not every GM or Ford issue is a buy. Avoid creatures called Smart notes or Direct notes. These are usually loaded with fees and trade at significantly lower yields than the larger issues. And there's poor liquidity.

"My favorite is General Motors 6.875s, due Sept. 15, 2011 (cusip number: 370425RX0). This is a huge $5.5 billion issue, and the bonds trade every day. At a recent price of 103.4 cents on the dollar, this bond has a 6.25% yield to maturity, which is 2.17 points more than the ten-year Treasury. The price will, of course, drift down to 100 over seven years. But in three and a half years, half the bond's ‘duration’ disappears because of the shortened maturity. In other words, the bond price will be less susceptible to interest rate swings. So no matter how choppy long-term rates get, the price should hold up fairly well. Also buy Ford Motor Credit 7s, due Oct. 1, 2013 (cusip number: 345397TZ6). At 105, they yield 6.2% to maturity. This, too, is a large $3 billion issue and trades every day. On Oct. 22 there were 82 trades, pretty good for a corporate issue.

"Meanwhile, investors are worried about higher interest rates. It's only rational to assume that higher rates and accelerating inflation will erode the value of their bond portfolios. Sitting in cash and money markets isn't the answer. You can't buy a tank of gas on your earnings from a Treasury bill. Treasury Inflation Protected Securities and inflation-linked corporate bonds are not the answer. They protect against inflation, not against higher interest rates. These are not the same thing. In the mid-1990s we had high rates and low inflation. Investors are concerned this could happen again. But there is an answer. Maybe not a perfect one, but a strategy that helps protect investors in this kind of impending storm.

"Invest in variable-rate securities whose payouts keep pace with rising interest rates. These are what I lovingly call my ‘hell in a handbasket’ investments. If interest rates rise, they won't go to hell in a handbasket with the rest of your fixed-income portfolio. The coupons or dividends of variable-rate securities (which come in both bond and preferred forms) are not fixed. The newest example from the student loan entity Sallie Mae a $175 million SLM Corp. bond issued July 8, 2004. This security has a floor of 4%, which protects you from a rate slide. Should the ten-year Treasury rate go back to last year's historic lows of 3.11%, you'll still clock 4%.

"For the life of the bond, which matures July 25, 2014, the coupon is linked to 80% of the ten-year Treasury. This means whatever the ten-year rate is in the future, you will be protected. So two years from now, say the ten-year Treasury yields 7%, you will receive 5.6%. The calculation and payment is done monthly and thus truly keeps pace with rate gyrations. This bond is priced at par. The ten-year Treasury, at 4.2%, now yields so little that you are bumping against the 4% floor. But that shortfall is likely a short-term phenomenon. You're really buying insurance for the next ten years. Odds are that rates will rise. You will be earning less this year than you could on a Treasury, but next year, and for the next eight, the floating rate will probably pay off and your bond's price should hold up quite well.

"What can go wrong? We can have an inverted yield curve and short-term rates may be higher than long-term, as we last did in 1989 (and in 2000 for just one- to ten-year bonds), according to Bianco Research. But inverted curves rarely last long. Corporate preferreds also are part of this game, and they pay more because they can be called every 30 days though none has been called yet, a hopeful sign. The yield is figured out against the highest yield among the current issue three-month, ten-year or 30-year Treasurys, calculated quarterly.

"Finding these FRAPS (floating rate adjustable preferred securities) in the secondary market may take a few calls to brokerages. It's certainly worth the effort. One dandy variable rate security to protect your portfolio in an interest rate storm is a perpetual preferred stock issued by J.P. Morgan Chase (50, JPM CP). The minimum dividend is 5.46%. And that's not too bad today. These have a maximum rate of 11.46%. Regardless of what happens to the yield curve, you are guaranteed to earn just 0.2 percentage points less than the highest-yielding new Treasury. That means that if the then-current 30-year Treasury bond goes to 10%, you will earn 9.8%. This preferred has been with us since 1998, and Chase hasn't called it yet. To be on the safe side, though, be sure you never pay much more than the original price of $50 per share. Another floating rate preferred, J.P. Morgan Chase, outstanding since 1994 (101, JPM L) and not yet called, has a quarterly dividend that yields 84% of the highest Treasury. It has a 4.5% floor and 10.5% maximum dividend cap. The short call keeps the prices close to par.

"Another veteran FRAPS is a perpetual preferred issued by Citibank (100, C A), with a minimum dividend of 6.34% and maximum of 12.34%. Its rate adjusts to 0.05 points above the highest Treasury. It has survived since its 2001 issue without being called. Don't pay much above the $100 par. Any of these preferreds would suffer if the issuer's earnings fall apart, since dividends can be suspended if the company lacks the financial ability to pay. Nevertheless, these dividends are cumulative and are likely to be made current. Moody's rates the two Chase issues A2 and the Citibank preferreds Aa3. You should put 20% of your fixed-income money in FRAPS or other adjustables. Worry some, but not a lot, about credit risk. Interest rate risk is the bigger hazard these days."

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