Tag Archives: investing

Pair Trading Opportunity – AGL Resources And Piedmont Natural Gas

Summary Two deals in the same sector with similar conditions and similar payment methods — the perfect situation for implementing a pair trading strategy. Because of regulation, this will be a very long process. So the pair trading strategy is more profitable than a classic merger arbitrage. In my opinion, if the authorities block one of the transactions the other merger will automatically have a lot problems. This risk should be hedged. I have to admit it: I hate mergers with a lot of regulatory conditions and economic intervention . I’m not a lawyer, so I’m not an expert in terms and conditions and I avoid these transactions. However, we can sometimes see very good opportunities in the M&A markets because of similar deals pursuant to the same antitrust approvals. On Aug. 24, 2015, Southern Company (NYSE: SO ) and AGL Resources (NYSE: GAS ) announced a merger agreement. Sometime later, on Oct. 26, 2015, Duke Energy (NYSE: DUK ) and Piedmont Natural Gas (NYSE: PNY ) approved another merger agreement with similar terms and conditions. Both transactions will be paid in cash, and their size is comparable: $12 billion and $6.7 billion, respectively. In this article, I will only assess the terms and conditions of both mergers. If you want to understand more about the financial performance of the companies, check our these articles: Buyers Duke is the largest electric utility in the United States. It serves 7.3 million customers, located in the Southeast and Midwest. It has an enterprise value of $88.01 billion and $1.38 billion cash on the balance sheet; its ROA is 2.83%. You can check some more numbers here. Source: I nvestor Presentation . It is a mature company, with an interesting dividend yield as well as a high payout ratio: Source: Investor Presentation. You can only see this type of payout ratio in mature industries. Merger arbitrage analysts might say that they like this transaction or not, but the fact is that the sector is in a phase of consolidation and mergers will occur. Southern serves more than 4.5 million customers, and it is the leader in the southeast portion of the United States. It has an enterprise value of $67.48 billion and $1.12 billion in cash; its ROA is 3.74%. You can check some more numbers here. Source: Investor Presentation . I would like to mention that the buyers are very big players. Their size is comparable, and the only difference is that they operate in different areas. The negotiation process with the authorities will be the same. Because of this fact, the merger spread should be similar. Targets and Transitions Benefits Piedmont has one million customers in portions of North Carolina, South Carolina, and Tennessee. It has a better ROA than its acquirer (3.54%), and it is also more than 10 times smaller than Duke. The transaction is an interesting move. Duke’s objective is to enhance its regulated business mix. What’s more, this merger creates a strong platform for future growth. AGL is based in Atlanta. It provides energy services to 5.5 million utility customers (including over one million retail customers served by the SouthStar Energy Services joint venture). Its ROA is 3.84%, which is better than that of the buyer. This transaction is a little better than the other one. It is accretive to ongoing EPS in the first full year, and it will create a strong credit profile. Source: Investor Presentation . Overall, the targets are very similar. It looks like a copied transaction, both in size (“same customer base”) and in value. As mentioned earlier, because of this fact the merger spread should be approximately the same. Terms, Conditions and Timing If you are interested, you can read the merger agreement of Duke’s transaction here and that of Southern here . Both mergers are pursuant to the shareholders’ approval. I did not read about any shareholders complaining about the price paid. So, I’m not worried about these conditions. It is more important, in this case, to assess the regulatory conditions. Southern’s transaction is subject to the following regulatory conditions: – The receipt of antitrust clearance in the United States (Hart-Scott-Rodino Act) – The approval of the FCC – The approval of the California Public Utilities Commission, Georgia Public Service Commission, Illinois Commerce Commission, Maryland Public Service Commission, New Jersey Board of Public Utilities and Virginia State Corporation Commission and other approvals required under applicable state laws. Source: Merger Agreement. Duke’s transaction is subject to the following antitrust conditions: – The receipt of antitrust clearance in the United States (Hart-Scott-Rodino Act) – “The merger is subject to the approval of the NCUC. The Company and Duke Energy expect to file in or around January 2016 a joint application for approval by the NCUC of the merger. Section 62-111(a) of the North Carolina General Statutes provides that no merger or combination affecting a public utility may be made through acquisition or control by stock purchase or otherwise without written approval from the NCUC. Under this statute, such approval shall be given if justified by the public convenience and necessity. The Company is a public utility under North Carolina law and two of Duke Energy’s subsidiaries are also public utilities under North Carolina law. Source: Merger Agreement. I do not think that any merger arbitrageur will tell you the outcome of these mergers. It is a very technical question that you might only be able to answer if you have worked approving mergers for a while. So I would not implement a classic merger arbitrage strategy here. I do not like gambling. The pair trading strategy that I will explain below reduces the exposure to these regulatory risks. Overall, the mergers will take a long time because of these regulatory conditions. Both transactions are said to close in the second quarter of 2016. Pair Trading Strategy and Conclusion Duke will pay $60 per share in cash, so the merger arbitrage spread is 5.24% ($60/$57.01 (close on Dec. 11, 2015) – 1). What’s more, we have to include four quarterly dividends paid by Piedmont (0.33 per share; I included the fourth quarterly dividend of 2015 but not that of 2016). So, the merger contribution is $61.32, and the calculated spread is 7.56% ($61.32/$57.01 – 1). Southern will pay an amount of $66.00 per share in cash, so the merger arbitrage spread is 5.21% ($66/$62.73 (close on Dec. 11, 2015) – 1). However, if we include the four quarterly dividends that AGL distributes (0.51 per shares), the merger contribution becomes $68.04, and the calculated spread is 8.46%($68.04/$62.73 – 1). The most recent evolution of the calculated spread can be seen in the following figure: Source: Maudes Capital. I would like to mention that the spread of both companies is somewhat correlated. It makes sense because of the facts explained above. In the future, the evolution will be similar so that you can perfectly implement a pair trading strategy. Today, I would buy PNY shares, and use the same amount of money to short sell GAS. You can make more than 1% return in a short period of time. The best thing in this idea is that you eliminate the regulatory risk included in both transactions. If one merger does not close, the other merger will have a lot of issues as well, and the spread will be enlarged. This means that you hedge the loss in one merger with the gains in the other transaction. To make a long story short, these transactions have a lot of regulatory conditions, and the classic merger arbitrage strategy is not a good idea. The pair trading strategy provides a better risk/return ratio. What’s more, both mergers are necessary moves in the same sector, and therefore good M&A ideas. I believe that both transactions will close, but I do not like playing with regulatory conditions. So, I prefer to hedge the risk. Note: At the moment there are some other merger arbitrage and pair trading investments like this one — you can read about them here , here , and here .

The Fed And SLV – What’s Ahead?

Summary The FOMC is expected to raise rates this week. How will this decision impact SLV? Whether the Fed raises rates or not, isn’t the only issue to consider. The FOMC is expected to convene this week and decide whether it’s time to hit lift off and raise rates. While rates are still expected to remain low, even a modest hike of 0.25 basis points could be enough to send down the iShares Silver Trust ETF (NYSEARCA: SLV ). But the direction of the silver market won’t only rely on the whether the Fed raises rates or not. Other considerations also matter including what’s the trajectory of the future rate hikes, the wording of the statement, the revised outlook for next year, and Chair Yellen’s press conference just to name a few. How will the Fed expected hike move the price of SLV? Let’s breakdown what’s up ahead for SLV. Based on the implied probabilities , the market expects three rate hikes in 2015-2016 with a very likely hike in December – a little over 80% chance, the highest level in months. But with an 80% chance this still gives some room for uncertainty in the markets. (click to enlarge) Source: Fed-watch If the Fed does move along with the hike, it’s likely to bring down the price of SLV as it did back in the last FOMC meeting when the Fed stated it’s ready to raise rates in December. Is the market ready for a hike? When it comes to the reasoning for raising rates the Fed sees that the U.S. labor market is on course to full employment with unemployment rate at 5%, an average of over 200,000 jobs were added a monthly basis in 2015 and wage growth at 2.3%. Also, U.S. core CPI is at 1.9%, which isn’t far off the Fed’s 2% target . And the Case-Shiller home price index showed that prices have been steadily climbing in the past three years; while prices aren’t at record high levels of mid-2006, they are still high enough to sustain a rise in mortgage rates and weed out any possible bubbles that may be forming in the real estate market. The same could be said about the stock market. The flip side for keeping rates unchanged is that the labor market may not be in a good enough shape to sustain higher rates with “real unemployment rate” or U6 rate is close to 10% and participation rate remains low. Moreover, the expected rising cash rates will make it even harder for the Fed to reach its 2% inflation goal. And low commodities prices aren’t helping. Having said that, the Fed is still expected to raise rates this meeting. And higher rates won’t do any good for SLV. From the perceptive of the stronger U.S. dollar, a stronger dollar could push down SLV. After all, the rally of the U.S. dollar in recent weeks, up to the last couple of weeks, seemed to have contributed to the weakness of SLV, as indicated in the chart below. (click to enlarge) Source: FRED and Google finance Bear in mind, however, that the correlation between the two isn’t too strong at -0.26 during 2015. But the correlation has intensified lately: Over the past couple of months it reached -0.4. So keep an eye out for the direction of U.S. dollar, which is likely to keep rising if the Fed moves on with normalization. Beyond this time’s rate hike Looking beyond the expected rate hike, the Fed is likely to issue a statement with a dovish tone reiterating that future hikes won’t be every other meeting and will spread apart in 2016 – something that will be backed by the dot plot. Chair Yellen will also try to calm the markets by assuring the strength and stability of the U.S. economy and how another hike won’t be decided any time soon (the term “data dependent” will be thrown a lot – as it always is). The FOMC will also release its dot plot about the cash rate. Back in September, the FOMC anticipated rates will rise to 1.4% by the end of next year and 2.6% by the end of 2017. The trajectory of the cash rate could also have an impact on the direction of the price of SLV. On this issue, if the FOMC were to revise down its outlook about the cash rates, and it’s a very likely scenario, this could partly offset the adverse impact the rate hike in the upcoming meeting will have on precious metals prices. This could translate to keeping SLV from tumbling down in the coming months. Unless the Fed surprises the market, the short term outlook of SLV is still likely to be downward. The expected rise in the U.S. dollar could keep driving down SLV. On the other hand, if the Fed cuts down again its outlook for the cash rate in 2016 and beyond, this could, down the line, keep the price of SLV from further plunging in the medium term. For more please see: Will Higher Physical Demand for Silver Drive Up SLV?

High Yield Carnage And Closed End Funds

Summary High yield bonds are suffering a liquidity crisis that is causing NAVs to fall. Due to their nature, CEFs are less susceptible to a liquidity crisis than bond mutual funds, but they are impacted by the high redemptions elsewhere in the bond market. When the time is right, there will be wonderful buying opportunities in the high yield CEF universe, but that time is not quite yet. With Carl Icahn warning about a “keg of dynamite” in the high yield market and Third Avenue liquidating a high yield bond fund, the so-called “junk bond” market is living up to its name. While markets are victim to volatility every once in a while, the problems in high yield are worrisome for a couple of reasons. Firstly, the high yield market never really recovered from the taper tantrum of 2013, meaning the bad run for high yield has now lasted almost three years: (click to enlarge) Secondly, with a ZIRP environment where retirees are desperate for income, many have been fooled into buying into the high yield market at the wrong time. Many fears around high yield bonds focus on the impact of a rising interest rate environment, but a much greater threat is behind Icahn’s red flag: liquidity. A Quick Introduction to Bond Trading With so much media focus on the stock market, many people translate what they know and learn about equities to the credit markets. This is a huge mistake for several reasons, but right now the mistake revolves around trading. Common stocks trade trillions of times in a day, but bonds do not. In fact, many bonds will not be traded for days, or even months . This is especially true for the high yield market, where investors often hold to maturity to collect the yield. The implications of this are significant. Without frequent trading, a fund that needs to sell its holdings to fulfill redemption demands could suddenly be faced with the worst dilemma you can have in any business: needing to sell immediately with no buyers in sight. When this happens, prices crater. Without the liquidity of stocks or even U.S. Treasuries, high yield bonds are susceptible to a massive decline in values, which is why we have seen the decline in value for these funds accelerate recently. Part of this is because more people are selling out of high yield mutual funds, which is requiring the funds to sell to give investors back their cash. In doing so, they are driving prices down, and the trend is likely to continue. Why CEFs are a Good Thing The timing to buy into high yield is not good; as Icahn rightly says, the devastation is likely to continue. There is still money in high yield funds that is likely to come out, and there are still continued fears about rising defaults in energy that are impacting the credit markets more broadly. But when the time to buy into high yield is right, CEFs may be a better alternative than mutual funds for yourself and the market as a whole. If well managed, CEFs do not face the redemption issue that mutual funds do. Because their total number of shares is fixed upon IPO, investors don’t “redeem” their holdings for cash-they sell their stake in the fund to someone else. This means that there can be a steep decline in the market price of CEFs that will not force the CEF to sell bonds. The only time the fund needs to sell bonds is to pay dividends (if its net investment income is less than its distributions) or to free up capital to lower leverage. A well-managed CEF can avoid both by cutting dividends (as we saw many high yield funds do in the last two years) and by lowering leverage (again, a tactic gaining popularity in these funds). This doesn’t mean CEFs are insulated from the bond market carnage; since they are trading in the same market, they are suffering alongside everyone else. But this suffering can take many forms: it can mean that the NAV of its holdings declines, but if the fund holds the bond to maturity, it will get its already invested capital. If the fund doesn’t need to sell the bond prematurely to pay dividends or lower leverage, it can weather the storm of a collapsing high yield market. I believe this is partly why the Pimco High Income Fund (NYSE: PHK ) made its unprecedented dividend cut a few months ago. Predicting a need for cash on hand and a need to stay as far out of the high yield market as the fund’s mandate will allow, it has lowered leverage and lowered distributions to effectively lower its liabilities and liquidity needs. This is prudent, and affirms my confidence in management if not in the wisdom of buying PHK right now. Other funds have made similarly wise decisions, as I discuss below. Picking through the Carnage So where does that leave us now? Several high income CEFs are down massively and will be well positioned to buy when the liquidity crisis in the market is over. But which to choose? (click to enlarge) A comparison of eight funds with relatively similar mandates and investment strategies reveals a lot of similarities and some telling differences. Most significantly, the Deutsche High Income Opportunities Fund (NYSE: DHG ) and the Deutsche High Income Trust (NYSE: KHI ) have the best performance of the group-ironic, since DeutscheBank (NYSE: DB ) has had an awful year. But “best” in this case means a negative total return YTD including dividends and an erosion of 10% of capital on average. The worst performer, the Pioneer High Income Trust (NYSE: PHT ), is down over 46% YTD and is at its lowest point in the last year. A dividend cut in February, which now seems like an extremely prudent decision given the liquidity needs of the high yield market throughout the year, is mostly to blame, and has resulted in the stock trading at a discount to NAV consistently throughout the year. In contrast to this is PHK, which is down 32% YTD but is the only fund to trade at a premium. Just a few weeks ago, however, that premium was as high as 30% just a few weeks ago, which is what caused me to sell the fund . A Group of Peers Looking at the others, we see comparable discounts to NAV among the Invesco High Income Trust II (NYSE: VLT ), the Dreyfus High Yield Strategies Fund (NYSE: DHF ), and the Credit Suisse High Yield Bond Fund (NASDAQ: CHY ). Worse than these is the First Trust Strategic High Income Fund II (NYSE: FHY ), a thinly traded fund that has also performed worse than the others. In addition to a reverse split in 2011, FHY cut its dividend earlier this year. Even more distressingly, the fund failed to see its NAV recover after 2008, although many other funds were able to recover against their lowest point in the dark days of 2009: Combined with First Trust’s small size and thus relatively limited buying power in bond markets, these distressing signals indicate this is not a fund to buy on the dip. The Standout Of the rest, DHF is one of the strongest contenders for a variety of reasons. For one, its dividend cut came in the middle of February and it has not cut in 2015. I interpret this as an indication of the managers’ prescience; simply put, they saw the liquidity crisis before others. Additionally, the fund’s effective duration of 3.72 years is extremely short for the high yield CEF universe and only 5.67% of its portfolio is in energy: (click to enlarge) Finally, to cover dividends, DHF will need to earn a 10.88% yield on its portfolio since it is trading at a discount. This is easy to do even in a ZIRP environment, and is getting easier now that junk bond yields are rising: (click to enlarge) A high yield fund starting today could get that yield with only 20% leverage–much lower than the level many bond CEFs maintain. Leverage is my main concern with DHF, however; at over 30%, it is excessive in this cratering high yield market, which is why I am not buying DHF now and will not for a while. However, when the time is right this fund may be one of the best options in the high yield market, although if the premiums shrink and discounts grow for other historical strong performers like PHK and PHT, they may become attractive too. For now, however, I am fully out of the high yield market and will likely remain so for several months.