Friday, October 10, 2008

Income Investing Today—Safety and High Income through Diversification. Your Essential Investment Guide


Securities And Other Investments To Avoid

Unit Investment Trusts (UITs)
One of the worst investment products ever devised by Wall Street are UITs. These trusts are an unmanaged pool of fixed-income securities that are put in trust for a fixed amount of time (e.g., 20 years), without being traded. At the conclusion of that period, any remaining securities will be sold and the proceeds distributed to the holders. I say “remaining,” because during those 20 years, securities will be called, in which case the cash proceeds will be paid out to the holders along with the interest income. The reasons investors buy UITs are the low fees and the high payout rates, which, because of frequent returns of principal, will run in the double digits with lower taxes, because a portion of the payments is a return of capital.

What UIT investors fail to appreciate is that at the end of the life of the UIT, very little residual value remains. Many were sold on the idea that this was like buying an annuity, only much cheaper, and if you died before maturity, unlike an annuity, you still had a residual value. The fact is that if a UIT is a major source of your income, you need to be sure that you and your spouse don’t outlive it, because little is left at the end. You also need to adjust for the erratic cash flow generated by early calls. This money is merely a return of capital and means future payouts must necessarily by smaller. Too many UIT investors forget these small subtleties over the years, or worse, don’t alert their spouse before they punch out.

A basic problem with these trusts is conceptual. While you can build a trust with investment-grade securities, over the course of 20 years some obvious sell candidates will appear. Very few securities should be bought and held blindly, just to save fees. In fact, over time, the good stuff tends to be called away, leaving an ever-deteriorating residual. Second, there is no market for these securities, since it is an exercise to value them at any given point in time. The sponsoring brokerage houses will buy a client’s position, but expect to take a haircut. Also, you can’t transfer this holding to another broker if you decide to move, so be sure of the relationship. But the worst thing about UITs is that they can be the dumping ground for any bond underwriting that didn’t sell or any other holdings the firm may own and would rather not. Not exactly the kind of securities an investor would want put into an unmanaged trust, but a great way for a brokerage firm to hide its mistakes.

Derivatives
You have probably read about derivatives and wondered what they were about. The term derivatives, in a broad sense, encompasses any security that derives its value from another security. Hence, stock options, commodity contracts, collateralized mortgage obligations (CMOs), and trust preferreds can all be defined as derivatives. However, when used by the media, it most often refers to a class of securities that are really not securities. It has gained prominence because it has grown into a trillion-dollar market, so massive that it will some day jeopardize our entire financial system. It is also an unregulated market in which only large institutions should be participating. But don’t think this will stop Wall Street from trying to come up with new ways to let Main Street investors lose money as well (see the following section, “SEQUINS and ELKS”).

The derivative market came about to allow large institutions to hedge their portfolios against adverse events in interest rates, currencies, commodities, or credit defaults. The market came about precisely because funds have grown too large to move quickly in reaction to the events they are hedging against. This is done not by trading securities, but simply by making a contract with a counterparty where, for a specified fee, one party will agree to settle a certain amount of contract value at a specific date in the future at the then-existing market prices. It’s much the same as a stock option, but is more like an option on the economy itself. The risks come about because the counterparty with whom you are dealing may not be as financially strong as it appears, or may it be overextended in money-losing arrangements. The 1998 blowup of Long-Term Capital Management was such a situation. That firm had leveraged its capital base some 300 times, so when things went bad, its contractual promises became worthless. In that instance, the Federal Reserve Bank had to step in to stop a market panic, since the counterparties to LTCM’s contracts were banking institutions that were suddenly in violation of their capital requirements. Today, exposures are many times greater than back then, making a successful Fed intervention more problematic. One difficulty in overseeing the level of systemic risk caused by derivatives is that there is no relationship between the level of contracts and the risks being insured. By way of example, when GM began its ratings downgrade cycle, credit default swaps against GM debt became a popular speculation. The problem is that although GM has only $30 billion in outstanding debt, credit derivative contracts totaled $100 billion. This is probably not a problem if GM never defaults. However, it could be a major problem if it does, since it is generally the weaker party, such as a hedge fund, that takes the higher-risk side of such contracts. This market can also be a direct influence on events. For example, when Mirant Corporation tried to restructure its debt outside of bankruptcy, it tried to force its bank lenders into sharing some of the asset collateral. One bank held out and forced the bankruptcy filing. It turns out that bank had insured itself in the credit default swap market and so had every reason to say no (sort of like when the baseball team owners insured themselves against a player strike and then precipitated one).

SEQUINS and ELKS
Underwriters sometimes create securities that look good on the surface, but they reserve the really big payoff for themselves. With a resurging stock market, these folks are once again busy creating derivative investment instruments with more promise than is likely to be achieved. Two examples deserve recognition. The first example is a Citigroup Global Markets 7 percent security called SEQUINS, an interesting acronym for something that’s all glitter but has little value. The acronym was concocted from the term “Select EQUity Indexed NoteS,” but a more appropriate concoction would be “Senseless EQuities for Unin-formed InvestorS.” The issue is rated investment grade and matures in two years, but is callable in one. Its redemption value is tied to the share price of Comcast Class A common stock. Well, yes, but not really. It’s tied to Comcast stock only to the extent that it drops in value. If it should rise, your redemption value is capped at a call price that limits your upside to a 13 percent return. Hence, if Comcast does well, even in just one year, the underwriter can call the security and pay you a total return of 13 percent. If Comcast does poorly, they can wait two years and hand you a fixed number of shares of stock guaranteed to be worth less than you paid for your SEQUINS. While the offering statement clearly discloses all the risks, it fails to explain why anyone interested in owning Comcast stock would seek out such a lose-lose way to buy them.

My second candidate for dubious investment honors is also a Citi-group product. Its called Citigroup Global Markets 11 percent 12/29/04 ELKS. These Equity LinKed Securities (ELKS) promise a bigger payoff by sporting an 11 percent coupon rate and an investment-grade rating, but that’s all show. The fun here is in speculating how much of your principal you can you expect back at maturity. This is based on a formula tied to the price of five high-visibility stocks in five different industries: high-tech, retail, pharmaceutical, banking, and beverage. Your principal recovery is the lesser of what you paid in or the value of the worst performing of the five stocks less the first 10 percent of price decline. What are the odds that all five of these industries, as well as all five of the players in these industries, will have a good year? It’s like putting five apples in a barrel and giving you the pick of the most rotten one after a year.

These securities are designed for hedge funds and others for whom they are just one card in a poker hand. Investors seeking high-yield short-term investments may see a virtue in the apparent high-yield from these securities, but in fact the risk here is much greater than the inflation risk they may be trying to avoid. In no way should they be considered as growth or income investments. The biggest redeeming quality of these securities is that they do not sully the term preferred stocks or bonds by using it in their name, although they are listed and trade in the preferred market. They are strictly equity hedge plays, much like selling puts or calls.


PARRS
Investors looking for protection against interest rate fluctuations may be tempted by a security called Putable Automatic Rate Reset Securities (PARRS) created by Morgan Stanley. The Tennessee Valley Authority (TVA), an AAA-rated government agency, put out such an issue in 1998 with a 6.75 percent interest rate that resets annually after the first five years at the index rate for 30-year Treasuries plus 98 basis points. If the reset is downward, you have the option of putting the issue back to the TVA at par. Sounds great until you read the fine print. Rates are reset only downward, hence you suffer every rate decline and never get back to your starting rate. Worse still, once a rate bottom is reached, all future resets would be at a higher rate, so they never reset, which means you can’t exercise your put option. The TVA issue reset to a low of 5.49 percent in 2005, after which rates rose. Hence, future downward resets are unlikely, which means invoking the put provision will not occur. For this reason, a security that should be trading near its $25 par is trading closer to $23. This security was put out at an attractive initial interest rate to suck in investors with an apparent promise of protection against rate fluctuations. In fact, however, the only fluctuations it “protects” against are rate declines, normally a positive event for investors. But couldn’t investors have put the issue back to the TVA in 2005, when the rate was reduced to 5.49 percent? Yes, and 19 percent of holders did. The rest were apparently asleep at the wheel or did not realize the long-term implications of a low reset price.


Hedge Funds
Over the past three years the media has developed an infatuation with hedge funds as if they were something new. What’s new is that some very smart people have figured out a way to siphon off even more fees from clueless investors by convincing them that an illiquid fund that does not have to meet SEC requirements or scrutiny must somehow be a better way to invest. What’s new is that some less smart people have also jumped on this same bandwagon for fundamentally the same reason. Hence we now have a whole new industry with thousands of funds and an estimated $1.5 trillion in resources. I am not exaggerating when I say that rarely has so much money been entrusted to so few people with such limited talent. Your typical hedge fund management has one or two name partners who, likely as not, made lots of money for themselves by various means and now tell you they can do the same thing for you, for a mere 1.5 percent a year plus 20 percent of any gains if you lock your money up with them for five years and promise to stay out of the way. With those kind of rewards, you can bet the risks they take with your money can’t stand up to close scrutiny.

The days of making 25 percent a year through traditional investing are over. Today’s hotshot managers play currency markets, derivatives, natural resources, option strategies, and lots of foreign markets where stock manipulation is still easy to do. Investing with these managers is an act of faith, since few of their investors do so with any degree of understanding.

Of more concern to me is that much of this vast pool of money will be going to help company managements take their companies private with a view to a relaunch in three to five years at a big profit. What’s wrong with that, you say? Company managements don’t just decide suddenly to take a company private; it’s something that takes lots of planning, planning that takes place while they are being paid to run the company in the best interest of shareholders. To take a company private, you have to line up a cooperative board; you have to line up the financing; but most of all, you have to run the company for a year or two in such a way that the stock price is cheap and shareholders are ready to throw in the towel. That means investing loads of money in development projects that won’t pay off in the short run; it means running down margins and running up expenses in areas that can be cut back in short order after privatization. In short, much of the value creation derived from taking a company private actually takes place before the company was privatized. If not, then there might actually be substantial risk for the buyout team, and who needs that?! Dishonest, yes; illegal, try to prove it; being done today, you bet.

Collateralized Debt
All the following securities are derivate securities created out of pools of mortgages, bonds, or other forms of debt.
Collateralized Mortgage Obligations (CMOs)
Collateralized Bond Obligations (CBOs)
Collateralized Debt Obligations (CDOs)
Collateralized Loan Obligations (CLOs)

What makes them dangerous is the fact that all participants are not treated equally. By way of an example, a pool of mortgages may be put together and then carved up into several distinct securities, called tranches. The first tranche may be entitled to, say, a 5 percent rate of return, be the first to receive the proceeds from early liquidations, and be the last to suffer any loss from defaults. The second tranche may get a 6 percent rate of return, receive all proceeds from early liquidations after the first tranche has been fully paid off, and have to absorb default losses only after they reach a defined level. A third tranche may specify an 8 percent rate of return, but be obligated to absorb all default losses and required to fund the interest payments to the first two tranches if the portfolio’s rate of return drops due to having adjustable rate mortgages.

For more Information:
Income Investment Guide, Business Investments

Share/Save/Bookmark

0 comments:

Post a Comment

Place Your Comments Here

Recent Posts

Make Money Profit

Smart Money Success. Financial Success. Business Success.

Online Success Center. Professional Resources for Online Success.

Yahoo MyWebLog Recent Viewers

Business & Life Success Resources Centre

Support Us

1. Rate Me 5 STARS-->

2. Favourite my Blog --> Add to 

Technorati Favorites
3. Vote me --> Top Blogs
4. Vote me -->Blogroll.net
5. Just Click this one only--> the best
6. Just Click this one only --> Blog Directory
7. Click "HOME" -->
8. Rate me --> blog search 

directory
9. Rate Me --> Rate My Blog

Verified Blog

Total Pageviews

 

Learning Corner.Engineering Books.Management EBooks.Business Books.Computer Book.Discount Bookstore. Copyright 2008 All Rights Reserved Revolution Two Church theme