No. of Recommendations: 0
I was doing a quick screen of bonds available for purchase through my Scottrade account. I was filtering through and Union Carbide caught my eye as it is yielding 12.93%. It is a wholly-owned subsidiary of Dow and when i cross checked it versus quantum online's list of related securities for Dow I found two structured assets KVT & DKM which are yielding 7.79% and 7.31%.

This strikes me as odd. I'm no expert on Dow, but a quick search shows that Union Carbide sells almost exclusively to Dow.

I can understand a slight premium to the Dow assets as they are tradeable in smaller blocks of value and they are directly linked to the parent company vs. a subsidiary.

My assumption is that the second piece of the puzzle => the parent company vs. subsidiary really only comes into play if Dow spins off Union Carbide. I am thinking that this assumption must be missing something. Is it a plausible risk that Dow would stop paying the union carbide bond significantly before they would stop paying on their dow debt ? As I type I realize that the other possible answer is that during a bankruptcy Union Carbide Debt may only have a claim to Union Carbide assets... But I would think that if bankruptcy were close enough to a real possibility, that the Dow debt wouldn't be trading at such a low yield.

Am I missing something? Looking forward to any insight whether specific to these issues or theories in general.

Scott
Print the post Back To Top
No. of Recommendations: 5
Union Carbide was once one of the five largest chemical companies in the US. It was bought by Dow about 10 years ago. FTC required the sale of some assets, but I think all operations are integrated under the Dow name at this time.

Usually when one company is acquired by another, the bond holders of the acquired company are contacted and details are negotiated. So if bonds still exist with the Union Carbide name on them, Dow is probably fully liable for them, but some selected assets may be associated with them in the case of a default. If you follow the link in QuantumOnLine.com to the prospectus for the issue, any details like that should be spelled out.

Dow has an active board in Fooldom. They are in the process of trying to buy Rohm & Haas, but the deal was to be financed in part by the partial sale of some plastics businesses to a Dow/Kuwait JV, usually called K-Dow. But Kuwait backed out. So now Dow is scrambling to come up with new financing. They have funds to close the deal, but rating agencies threaten to downgrade debt to junk status if they close without additional financing.

Meanwhile, they were supposed to close 4days after FTC approved the deal in January, but did not and now ROH is suing them for breech of contract.

I think Dow will survive, but it is a stressful time. Some are calling for CEO Liveris to resign. I think Dow is well managed and will work it out. But if share price gets too low, someone like BASF may bid for Dow.

Meanwhile, Dow has been a dividend stock, once paying as much as 9% and considered secure. But now they are threatening to cut dividend. So many investors are nervous.

The savy will probably be fine if they buy right and keep their cool. But panic selling is not surprising for those who wonder if the sky is falling.
Print the post Back To Top
No. of Recommendations: 0
I appreciate the response. Right now this bond doesn't fit simply because I don't have the free cash in my IRA to buy any... But I have added DOW's message board to my favorites and may very well pick some of these bonds up in the near future.

Scott
Print the post Back To Top
No. of Recommendations: 2
Scott,

Scottrade isn’t a good broker from whom to buy spec-grade bonds (IMHO, ‘natch), because of their 10-bond, minimum-purchase requirement. Unless, of course, 10 bonds is your customary, minimum position, which raises a further question of what constitutes, for you, proper diversification?

The stock guys argue that systemic-risk reduction (obtained by owing a diversified portfolio of companies/industries) plateaus around 20. If that assertion is correct, and if diversification concepts can be applied from one asset class to another, then a bond guy (or gal) would need to own the debt of 20 different companies. Par is $1,000. But bonds, once issued, quickly trade both above and below par as the interest-rate environment changes and as the market’s expectations change concerning the financial prospects of the company.

It’s not often that spec-grade bonds, especially “fallen angels”, trade at a premium in the secondary market. Therefore, if one is attempting to put together a properly-diversified portfolio of spec-grade bonds, and if 20 has been selected as the magic number to obtain proper diversification, then the would-be investor doesn’t need $200,000. Instead, she needs 20x her expected, average price. Let’s guess that price to be 70 in today’s market. (There’ve been times in the past when my average price for junk was 55. But today’s market is what has to be dealt with.) So, $140k funds her portfolio, and a 10-bond position in Union Carbide’s debt would be roughly 5% of working capital.

Frankly, those kinds of numbers scare me. Union Carbide’s debt is junk. That’s why it’s priced as it is. I’d argue (and feel a lot more comfortable) if the position were smaller than 5% of working capital. In fact, I’d argue that 2% should be the maximum-sized position, and that 0.25-0.50% is even more better. For a 10-bond position priced at 70 to be 0.50% of working capital requires $1.4 million of assets. But a 1-3 bond position drops the capital requirement hugely, bringing junk-bond investing within the means of the “average investor”. (For the record, I executed a trade this morning for 3 of Union Carbide Chem & Plast’s 7 7/8’s of ’23. So this discussion of risk isn’t merely academic.)

To the upside, a 10-bond lot is more marketable than a 1-3 bond lot, just as a 25-bond lot is more marketable, still. However, size is exposure, and exposure increases risk. So there are downsides, too, in taking large positions.

Now comes the question that initiated your post: “Though the yield on their debt seems too good to be true, why not buy it? What are the risks I might be overlooking?”

First, let’s consider yield. On the day you were scanning, the reported YTM was 12.93%. Today, the reported yield is different. But can either of those numbers be trusted? I’d argue not, because of hidden, questionable assumptions such as 360-day years and “interest on interest” (aka, the reinvestment of coupons done by MacCauley’s formula). I’d suggest that if you take a very simple-minded approach to calculating YTM (“What will be my income streams?”), the actual YLM is higher than the reported one, due to an inter-relationship between the coupon and the purchase price that goes like this:

YTM is [ (Par-Price) + Sum of Coupons]/ Holding Period

As a concrete example of this, Union Carbide Chem & Plast’s 7.875’s of ’23 are offered out just now at 59.870 for a reported YTM of 14.69. However, when I run those numbers though a simple Excel macro and add in commish, the YTM I come up with is 17.749. That’s a 3-point difference in yield. Who’s “right”; who’s “wrong”? I’d argue that both numbers are useful. The reported, “official” yield is a benchmark by which to gauge offered bonds, and one’s personally-calculated YTM is a benchmark of one’s portfolio performance.

OK, 17 ¾% is attractive. But is it attractive enough compared to a lot of obvious risks? To be candid, I did only the briefest of due diligence, and then I executed. Partly because that’s my style, and partly because “If you want to know how the ponies are going to run, then you gotta make your bet.” I’ve owned their debt before and made good money. Now isn’t then, but a junk-bond buyer has no choice but to keep taking positions in order to obtain sequential diversification. If he wants to walk away from everything that is the least bit questionable, he should walk away from it all, because he’s a lot less likely to also be surprised to the upside when a questionable position does work out.

That’s the risk in investing. The CAPM/MPT boys are idiots who think they can calculate risk and project portfolio returns. But nobody can predict the future, and when market gains and losses are examined over statistically-valid time frames, there is no telling before it happens what will happen. Therefore, as Talib and Mandelbrot argue, diversification many magnitudes greater than current thinking assumes is safe is the only defense the small investor has. My current exposure to the debt of chemical companies is 2 of Nova Chem’s bonds and 1 of Dow’s. Adding 3 of Union Carbide’s helped to round out to 6. As a fraction of working capital that exposure is way less than 2%. Therefore, I consider it a prudent and necessary risk.

Ques: What do I see as my risks?
Ans: Continuing financial distress for the company and probably a Chapter 11 filing.
Ques: How soon?
Ans: Hard to say. Meanwhile, my current yield is mitigating my potential losses, and my entry price might be 3x a workout, which acceptable. The stock is still above $5, and the shorts aren’t on top of it. The dividend is fat and can be cut.
Ques: Will the trade work?
Ans: Who knows?
Ques: Should the trade have been done?
Ans: I’d argue “yes”, though I’ll freely admit that, on its own merits, the evidence is weak. Union Carbide’s debt is a put. For 60 I purchased the right to “put” the bond at 100. My purchase price is my premium, mitigated by coupons, or a breakeven period of 7.6 years. That’s a bit far out in today’s market, but that’s also the market that has to be dealt with. Or as an old English proverb suggests:

” He that cannot abide a bad market deserves not a good one.”

One final comment about Scottrade and bonds. They act as principal, meaning they apply a markup that typically looks to be a point and half per bond, which isn’t outrageous. If you’re happy with them, stay. If not, look at Zions Direct, E*Trade, or Fidelity, though the latter typically shows less inventory than the other two and its scanner is more awkward to use.

Charlie
Print the post Back To Top
No. of Recommendations: 0
Charlie,

I appreciate the reply. I've just in the past year begun to focus on fixed income. I've looked at it and read a few primers on it years ago when i began investing, but it tends to be much harder to get your hands around than common stock investing, because I think fewer people do it.

But over the past 9 months, i've put a significant portion of my IRA into a selection of 10 or so Bonds, QUIBS, preferreds. Bonds "were" tougher for me, because I had assumed 10,000 was the minimum purchase assuming that was an industry standard and not in fact a quirk of Scottrade. At $1500 lots I could begin to acquire bonds and keep my risk distibuted fairly well, So I really appreciate that tidbit and will keep those places in mind.

The YTM comment is interesting too, I know I just picked the number off the scottrade screen, so It's interesting feedback to know thats it's materially different than what a simple excel sheet can calculate. Again, i assumed....


Scott
Print the post Back To Top
No. of Recommendations: 2
Scott,

I’m glad you found my comments helpful. But now that that you’ve responded, I see that further clarifications are necessary.

Scottrade’s 10-bond minimum (for corporates) isn’t a “quirk”. It’s their company policy, and it’s a common policy at many brokers. One second of reflection will suggest the reasons why: GREED and MONOPOLY. Only 2% of bond trades are done by small investors. (That used to be the reported figure. The number is probably bigger these days.) The broker isn’t going to make much vig for handling a 1-bond trade. But he knows (through industry-wide collusion) that nobody is going to change their policies and/or cut their commissions to accommodate small investors. Therefore, he knows he can screw you, coming and going, with spreads as wide as 10%, plus a commission, plus a minimum-sized order. Welcome to bond investing.

An aside. Munis almost always are offered out with a 10-bond minimum. A 5 minimum is rare, and I don’t recall ever seeing a smaller size. Ditto agencies for sizes, unless the whole lot is just a couple of bonds.

With bonds, a round lot is 100 units, just as it is with stocks. In fact, if you want to make a market in bonds –i.e., be “licensed” to operate a bond desk- you have to be willing/able to trade in round lots. That info is useful to a small investor shopping for bonds. When you see a round lot offered, you can assume it is just someone fulfilling his obligation to make a market, not necessarily someone who is really trying to sell those bonds. And often enough the price isn’t very attractive. What you want to see is someone willing to lower his price to move product. However -–and this is where things get tricky— the situation you don’t want to see is lots and lots of product of which he is willing to sell single units.

The thought behind that observation is this. If he is so anxious to unload product that he is willing to fuss with selling single bonds, why do you want to buy them? In fact, where you will most often see single shares being offered is with lower, credit-quality issues. The “good stuff” will only be sold 5 or 10 or 25 at a time, because the desk holding the inventory knows they can get the trade done in that size.


But the reality of being a small bond investor is that you’re going to be buying mostly just the crumbs the big boys let fall from the table. The really good stuff, e.g., converts, you’re going to be locked out of buying, because it all goes to the big boys, and almost none of it ever shows up in the secondary market. A corollary of that is this. If you ever just see a tiny amount of any issuer offered, do your due diligence as fast as you can with the idea of grabbing those bonds before they're gone. A typical bond issue is millions of dollars, maybe a billion. Par is a thousand bucks. Divide the issue-size by par and you know the “float”. If the float is 50,000, but you only seeing 7 bonds, who owns the other 49,993? Obviously, the big boys, and they’re sitting on that issue, because its risks are minimal, its yield it fat, etc.

Some of my best positions have come from such situations where I was buying all of the national offer, because a couple of bonds was all there were to buy, or half or a quarter of the total offer. When is the last time you bought all shares offered of any stock? Bonds are a crazy market.

Back to my “crumbs” remark. Why is a stock investor willing to sell shares to an investor who is willing to buy them? And why is a stock investor willing to buy shares from an investor who is willing to sell them? Obviously, both of them think they are right. One of them thinks the stock price is going to go down, so he’s happy to dump. One of them thinks the price is going up, so he happy to buy. The same is true with bonds (or any asset). It’s differences of opinion that make markets, not agreements about price. (If both sides thought the same, there’d be no trade.

Now comes the tough part. How do you beat the big boys? They have research and trading advantages the small investor can’t match. Therefore, you need some kind of an edge in order to overcome those disadvantages. Someone like Marty Whitman, a value investor I really respect, argues in his books and quarterly reports to his shareholders, that it can be done, and he outlines methods of doing so. Other people, like me, who are actually very crappy credit analysts, have found other methods, namely game theory, aka, money management. So it is possible for a small investor to elbow his way into the institutionally-dominated market that bonds and survive.

An aside: the commonly used format to indicate the size of the lot and the required minimum purchase is XX/X, such as 37/5, 340/1, 5000/100, etc. Often enough I have to back away from buying something because the minimum size across all maturities of the issuer is 10 bonds, and I don’t want that big a position. However, if you keep checking back every day with that broker’s offering list and you check inventory through other brokers, enough you can find someone willing to sell in the size you need.

In short, you need to find another broker, not that Scottrade isn’t excellent for some purposes. (Disclaimer: I’ve got two accounts there, just as I've got accounts anywhere I have to, in order to my investing done.)

Charlie
Print the post Back To Top
No. of Recommendations: 1
Scott,

Just a quick, further comment before I meet my daughter's flight (and then put myself incommunicado for a while).

RE: YTM. There seems to be a standard method of calculating YTM that all brokers use. Some of them also provide "bond calculators", some of whose parameters can be tweaked. I'm the sort of person who questions anything and everything. So I figured out a way of calculating YTM that made better sense to me. (I'll write it up as a tutorial sometime and post it, but not today.)

Sometimes my results are materially different than the brokers. Sometimes they are congruent. That's way I say that everyone has to run their own numbers, and those are the only ones that can be trusted.

That isn't to say that their numbers aren't useful. They are. They're a benchmark. I'd argue that both numbers (theirs and your own) are needed, and both should be used as is appropriate.

Charlie
Print the post Back To Top