The latest in bond market madness...

The latest in bond market madness... 'Coco' bonds... Elliot Management targets EMC... New high for Steel Dynamics...
 

 Companies can't issue debt fast enough...

 

As we've noted many times – and as you've no doubt experienced – investors are desperate for yield.

 

Highly rated companies issued a record $642 billion of debt in the first half of this year, according to data provider Dealogic. That tops the previous high of $612 billion in the first half of 2009. And they could have sold more...

 

 In September 2013, telecom provider Verizon announced it would offer $49 billion of corporate debt. It was the largest corporate offering in history... It was oversubscribed by a factor of two.

 

In April, tech giant Apple announced it would issue $12 billion of debt... Before Apple even priced its bonds, it had attracted more than $40 billion in orders.

 

 And it's not just investment-grade companies... Companies issued a record $29.7 billion of high-yield, or "junk," bonds in June... And the average yield on junk bonds hit a low of 4.77%.

 

 Wall Street, noticing the supply gap, stepped in with some creative financing options – like "payment in kind" (PIK) bonds.

 

PIK bonds give the issuer the right to pay back the debt by issuing more debt. In other words, these bonds are designed for companies that may have trouble meeting payments in the future... They can just pile on more debt instead of making the minimum payment.

 

 We featured the below quote on PIKs in the June 4 Digest...

 

"We call it the yield-hunger games," Matt Toms, head of U.S. public fixed income for Voya Investment Management, told the Financial Times. "In this environment of very low yields and very low volatility, any extra yield that products such as these may offer already helps."

 

 Companies issued $1.89 billion in PIKs in June, up from $115 million in May. Through the first week of July, year-to-date PIK issuance was $7.48 billion – more than the $6.7 billion issued in all of 2012 and on pace to surpass the $12 billion issued last year.

 

 Today, we introduce you to another insane, fixed-income product – the contingent-convertible (or "coco") bond.

 

Before explaining coco bonds, you first need to understand what a regular convertible bond is... When a company issues convertible debt, it typically gives the investor the option to convert that debt to equity after three to five years at a premium to the issuer's current share price. Essentially, in exchange for lending the company money today, you can convert that debt into equity at a significant premium in the future.

 

 Cocos are issued by banks. And the bonds can be converted into equity or written down when the issuing bank's equity falls below a certain threshold. Think about that for a minute...

 

One benefit to investing in a typical corporate bond rather than equity is that bondholders have a claim on the company's assets in terms of bankruptcy... when shareholders can be wiped out. And investors also experience less volatility with bonds.

 

But with cocos, you're agreeing to loan a bank money for record-low yields. In return, when times are tough (and its capital is depleted), the bank can force you to convert your debt into equity – cushioning its balance sheet with extra capital.

 

 Cocos weren't created on Wall Street... European policymakers invented these bonds in 2009, in the depths of the financial crisis, as a way to shore up banks' balance sheets.

 

 Current average yields for coco bonds are 5.6%, according to Bank of America Merrill Lynch – about 150 basis points (1.5%) more than other comparable corporate debt. Cocos hit a record low of 5.54% in mid-May (down from 6.36% at the beginning of the year).

 

 In good times, cocos behave like a high-yield bond. But when the market falls, investors are exposed to equity risks and volatility. Still, cocos are flying off the shelves...

 

In 2013, companies issued $14.2 billion in cocos, according to Dealogic.

 

As of last month, banks issued about $39 billion in cocos year-to-date, according to Bloomberg. Royal Bank of Scotland thinks issuance could hit $100 billion this year.

 

 Investors are buying as many cocos as possible for the extra yield.

 

In May, Deutsche Bank said it received €25 billion of orders for its maiden €1.5 billion coco issuance.

 

 "Since the beginning of this year, there has been a complete change in the investor base – guys who previously wouldn't touch them are now fighting for allocations," PIMCO managing director Philippe Bodereau told the Financial Times. "Cocos are rallying because the fundamental credit story is getting better. Banks have been doing a lot of capital-raising, which provides comfort to coco investors."

 

Richard Thomas, head of European credit research at Bank of America, told the Financial Times that cocos are among the highest-yielding instruments on the market and one of the most actively traded. "We see the collapse in yields with a degree of caution," he said. "We've come a long way very fast."

 

 At the same time that investors are rushing for this risky asset... European regulators have made them even riskier. They ruled that the coupons paid by cocos are discretionary and can be canceled by either regulators or the bank's management... even if the issuer continues paying a dividend to shareholders.

 

 In addition to giving investors extra yield, cocos also give banks a cheap way to boost regulatory capital. Banks are required to hold at least 6% of their risk-weighted assets in "Tier 1" capital (that's "high-quality" core capital that includes equity and disclosed reserves). Of that, up to 1.5% can be in the form of so-called "Additional Tier 1 Capital," which includes cocos.

 

So when the banks take a hit, they can boost their Tier 1 capital by converting the cocos... That will come in handy when European banks have to pass stress tests later this year.

 

As with most short-term fixes devised in the midst of a crisis, cocos threaten to exacerbate a future crisis. From a statement publicly released by Royal Bank of Scotland...

 

[B]oth banks and regulators are smiling at the success of bail-in bonds [cocos]. For regulators, cocos help to plug the capital gap of European banks. When Lloyds Group bankers issued the first bail-in bond in 2009, they did not expect it to turn into the new hottest area of bond markets. But without a swift effort to standardize and regulate the market, coco bonds threaten to make a future bank crisis worse, rather than being part of the solution.

 

 Shares of Stansberry's Investment Advisory recommendation network storage giant EMC Corp. hit a new high yesterday on news activist hedge-fund Elliot Management built a $1 billion stake in the firm.

 

EMC is a play on "Big Data" – companies that allow companies to store and analyze massive amounts of data.

 

From the January 2013 newsletter...

 

As organizations move to cloud computing, a key to operations success will be managing the information. EMC Information Infrastructure provides the backbone and infrastructure for organizations to store, manage, and protect the data.   The idea of storage as mere "preservation" and "recall" is obsolete. Dynamically analyzing stored data is where the money is. And the firm that invests the most in analysis will win.   This is where EMC has the edge. EMC offer the best products and services by investing heavily in R&D. EMC spends an average of $1.4 billion per year on R&D. We believe EMC is the world leader in its category.   EMC is building new tools (or buying up smaller rivals that have the tools) to analyze data with "lateral thinking" to better serve ... and profit from... its customer base.

 

 Elliot, one of the best-performing and most aggressive hedge funds around, is urging EMC to spin off software company VMware.

 

EMC bought VMware in 2004... then sold a chunk of the firm in an initial public offering in 2007. EMC still owns 80% of VMware.

 

 Shares of EMC jumped 5% on news of Elliot's involvement yesterday. They're up another 1% today.

 

EMC is up 21% since Porter first recommended it to subscribers.

 

 Steel maker Steel Dynamics (STLD) – a holding in the Small Stock Specialist model portfolio – jumped nearly 12% yesterday on news it will buy a U.S. steel plant from Russian steel manufacturer Severstal.

 

Severstal said it has been looking to sell its North American assets since last year. And while it's not a target of sanctions surrounding the Ukrainian crisis, the timing indicates the company worries about future sanctions.

 

STLD will pay $1.63 billion for Severstal Columbus, located in northeast Mississippi. The new plant will increase Steel Dynamic's annual steel shipping capacity by about 40% to 11 million tons. STLD expects the deal to add to its earnings immediately.

 

Small Stock Specialist editor Frank Curzio recommended STLD in September 2011. The company was trading at book value. Frank wrote:

 

Steel Dynamics is one of the most diversified steel companies in the market, with less exposure to the struggling construction industry. It's also one of the lowest-cost producers since most of its facilities are among the newest in the industry.

 

Small Stock Specialist readers are up 87% on the recommendation.

 

 

 New 52-week highs (as of 7/21/14): Alcoa (AA), Dorchester Minerals (DMLP), ProShares Ultra MSCI Emerging Markets Fund (EET), EMC (EMC), Kinder Morgan Management (KMR), Eli Lilly (LLY), Microsoft (MSFT), Panhandle Oil and Gas (PHX), Steel Dynamics (STLD), Skyworks Solutions (SWKS), ProShares Ultra 20+ Year Treasury Fund (UBT), and Vanguard Natural Resources (VNR).

 

 People are still fawning over Porter's nine-day Digest series... It's a slow mailbag day, so we'll run it. What's on your mind? Do we need to write about George Soros or Monsanto to rile you up? Send your feedback to feedback@stansberryresearch.com.

 

 "I have just finished reading again the 9 days of Digests by Porter which by now are probably almost world renowned. I must say that I have never nor will I ever see such wise and useful advice from any financial advisor. One of these essays, given on Monday the 23 is of particular interest to me and perhaps many others. In this Digest Porter discusses timing the market and quotes Richard Russell regarding how to invest as a rich man and why a poor man will lose in the market.

 

The advantage that the wealthy investor (rich man) enjoys is that he doesn't need the markets because he already has all the income he needs. But what about the little guy, the poor man... This fellow always feels pressured to "make money" and probably invests in the wrong things at the wrong time.

 

"If we define a rich man as one who lives on say $150,000 annually but has an income of say $200,000 or $250,000 for example (obviously these numbers can vary widely but you get the point), I submit that there are many 'rich men' out there who desire to time the market but do not have the proper guidance or advice. I believe that you Porter should consider starting a newsletter specifically for the 'rich men' out there that are yearning for sage investment timing advice. Your organization has many newsletters that mostly provide monthly equity analysis and purchase recommendations and not much on investment timing. The rich men out here need something better.

 

"Thanks again for the nine days of priceless advice that you've given us." – Paid-up subscriber Richard Kumpfbeck

 

Regards,

 

Sean Goldsmith

July 22, 2014

 

Dan Ferris: This is one of my favorite resource stocks today...

 

In today's Digest Premium, Extreme Value editor Dan Ferris reveals the name of one of his favorite resource investments today...

 

To subscribe to Digest Premium and receive a free hardback copy of Jim Rogers' latest book, click here.

Dan Ferris: This is one of my favorite resource stocks today...
 

Editor's note: Today's Digest Premium was adapted from episode 166 of Stansberry Radio Premium. In it, Extreme Value editor Dan Ferris revealed the name of one of his favorite resource investments today...

 

 

 Sprott Resource Corp (TSX: SCP, OTC: SCPZF) is an interesting little company. We recommended it once before in Extreme Value and it went up a good bit. When it was still up about 50% and pulled back off its highs, I (Dan) felt that management kind of lost the script a little bit. So we sold it. Since then, management has changed and it's singing the right tune again. So I think it's time to get back into it, and it's really cheap again, too... cheaper than the first time we found it.

 

Sprott is like a publicly traded private-equity fund. It invests almost exclusively in private companies and it starts up private companies. And it does things behind the scenes that 90% of us just can't do.

 

We'd never see these private deals. Even if we could, we probably wouldn't have the tens of millions of dollars it would take to get into them in the first place. So it's different than just buying small mining stocks.

 

 One of Sprott's biggest investments is a company called Long Run Exploration, a Canadian oil and gas exploration firm. This is a combination of two previous companies that Sprott invested in – WestFire and Guide Exploration. Sprott took this combined company public and now owns about 15%.

 

Long Run Exploration now pays a dividend close to $10 million (in Canadian dollars) a year, and that just about covers its operating expenses, which is pretty incredible.

 

So Sprott has this one investment it made and took public that's worth around C$120 million on its balance sheet. And then on top of that, it's paying Sprott income that's covering its expenses. So Sprott is just sitting there watching this thing bring cash in. Meanwhile, it can turn around and take the rest of its cash and invest it in other places.

 

 Sprott was not in this position the first time around. That was one of the reasons we sold it. The company didn't have a source of cash flow and started paying out a dividend in 2012. And we tried to understand this. We stuck around for a few months and then said, "We can't understand paying out cash when you don't have a source of cash flow and the market for these natural resources companies is falling apart. You're supposed to be retaining cash."

 

 The situation has completely turned around. And that's just one of the situations that Sprott owns right now. Sprott also has around C$80 million in cash on the balance sheet with zero debt to invest. It recently invested about C$19.5 million in a new oil and gas venture.

 

Another thing is that Sprott is taking another oil and gas company public. Right now, it just sits on Sprott's balance sheet, valued at around C$58 million. That's just the company's internal, private valuation of this company. Private valuations are often lower than public valuations.

 

That's one of the beauties of Sprott. It buys at private valuations and then takes them public, which ramps up its net asset value. And over time, we expect that to have a really good effect on the stock price. The company recently announced that it's going to take another one of these companies public. It's called Independence Contract Drilling (ICD). It's a vertically integrated company in the contract oil and gas drilling business. ICD doesn't just operate the oil and gas drilling rigs... It builds them, too. Tomorrow, I'll explain more...

 

– Dan Ferris

 

 

Editor's note: While Dan thinks Sprott is a great investment today, he recently told Extreme Value subscribers he found "one of the best opportunities in the natural resource sector I've seen in my entire career."

 

This tiny company just closed a deal that will increase its cash flow by a factor of 10. Dan thinks the stock could easily double or triple from here. And he says the company will soon start paying a double-digit dividend for investors who buy in at today's levels. For more details, click here...

Dan Ferris: This is one of my favorite resource stocks today...

 

In today's Digest Premium, Extreme Value editor Dan Ferris reveals the name of one of his favorite resource investments today...

 

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