Investment idea re: deflation -- Fairfax 7.75% Senior Notes due 2037

[bluedevil]

Guys,

 

Here is an investment idea for those that buy into HWIC's thesis that the US/Europe will soon face deflationary pressures:  Fairfax's bonds that mature in 2037.  Currently, you can buy these bonds for a yield of 7.7%. Critically, they are non-callable.

 

Suppose the US faces a period of deflationary pressure.  The value of ultra long-term, non-callable debt should skyrocket.  Moreover, as Fairfax is well-positioned for deflation, it should profit handsomely, accelerating the slow but steady increase in Fairfax's debt ratings to the targeted A-level.  If Fairfax's thesis plays out, you could profit handsomely in a few years when you cash in your A-rated, 7.75% coupon bonds into a market where long-term treasuries yield, say, 2.5%.  In the interim, you have collected your coupons.

 

Suppose the US does not suffer from deflation.  A long-term security from a high-quality, well-managed company focused on increasing its ratings that pays you 7.7% seems pretty good relative to the potential risks.

 

Thoughts?

[Grenville]

Nice idea!

 

A couple of questions:

1. Are these bonds available to retail investors?

2. Have you tried to buy any of these? Where do you have to go to buy them? ie. IB, Scottrade, or a big Broker...?

[bluedevil]

They are available to retail investors from I think just about any brokerage like Fidelity or Etrade.  But the float is pretty small, so sometimes you have to wait for batches to go on sale.

[smo001]

Grenville,

 

I just checked my etrade account and you can buy them there. Go to the link below and type in "fairfax" under "Corporate Price Data." It'll pop open another window and show the outstanding issues for Fairfax. If you're using a discount broker run the search with the cusip rather than the name to ensure you will get the exact issue you want. Happy shopping!

 

http://www.investinginbonds.com/marketataglance.asp?catid=34

 

 

 

 

[Grenville]

Thank you for the responses. I'll have to look into the indenture and read all the details. I'll post any thoughts after I examine...I'm busy for the next month, but I've been wanting to buy some bonds and this might be a good opportunity.

[Grenville]

Another more liquid way to bet on deflation is zero coupon bonds. Jeast posted an ETF from PIMCO, again I haven't looked into what exactly it holds but here's the ticker: zroz

 

Nice bond site, I like the history of trades they have.

 

Thanks!

[Myth465]

I feel like a bet on deflation should be cheap, and have massive upside. Similar to FFH's position. If you are right here you make 7% - 15% or so. Decent, but no tremendous upside.

[ERICOPOLY]

For me,  it's 5% compounding after taxes if no bond price increase.  I would rather go with the FFH stock -- 5% is low hurdle rate.

 

However, it might be a safe way to play the market right now since volatility is cheap -- buy near the money calls, to be paid for with the earnings from the bonds.  If market crashes in deflation, you likely make a gain on the bonds price.  If no deflation, you could do well on the calls.

 

[Myth465]

Eric would you take a 10% taxable yield. I guess I am asking is what would make you look at bonds / FI vs. equity?

[ERICOPOLY]

Eric would you take a 10% taxable yield. I guess I am asking is what would make you look at bonds / FI vs. equity?

 

It just looks better than it really is.  They could very easily put my tax rate up to 40% in their soak the rich campaign because the voters don't want to pay their own way.

 

Wow!  6% compounding.  I'll pass.

 

Just too much opportunity cost.

 

So I would either use the income to cover the cost of call options, or would be happy to buy 10% bonds in a non-taxable account (where I would use the proceeds once again for call options).

 

This way at least you can have equity upside with bond downside.

[bluedevil]

I feel like a bet on deflation should be cheap, and have massive upside. Similar to FFH's position. If you are right here you make 7% - 15% or so. Decent, but no tremendous upside.

 

Myth,

 

Why do you think the returns would be so meager?

 

If long-term treasury yields fell to 2.5% due to deflation, wouldn't you expect people to buy long-term Fairfax debt with a yield of 5%?  If that happens, you will net around, say, a 50% return, plus the 7.7% coupons you collected along the way.  Not crazy, but this is a *relatively* low risk investment.

 

I agree that the ideal way to play deflation would be a cheap bet with big upside, but part of my problem is the difficulty of finding vehicles to do that as a retail investor without access to derivatives.  The only retail vehicle I've really heard about (and which Greenville noted) are zero coupon long-term treasury bonds (or just straight long-term treasurys), but the returns there would be pretty disappointing if we don't experience deflation or stock market turbulence.  I've been trying to wrack my brain.  If you have any ideas, let me know!

[Myth465]

The returns are nice, but if you are wrong you get crushed in a situation with high inflation. I like what FFH did because they bet $1 to make $10 on a situation that is either unlikely or has a low probability of working out. They were able to protect the portfolio with relatively few dollars. I think they are right about the historic case for deflation, but the Fed has drawn a line in the sand saying it wont allow deflation. As a guy with a few dollars to his name, I make it a point not to fight with the Fed or its massive balance sheet / bully pulpit.

 

The upside to downside inmo would need to be higher. Ideally you want an inflation bet with a 5 to 1 (upside to downside) and a deflation bet with 5 to 1 or 10 to 1 (upside to downside). You could cover your portfolio or a good chunk of it. You pretty much would only lose in a normal market (or stagflation or some other deal), but would be fully hedged. If you are good at picking stocks the rest of the port would do quite well.

 

Also the fact that FFH sold the bond means to me that they expect higher inflation at some point or they think they can do better than 8%. Probably both given FFH. 25 years feels like forever. I am looking forward to buying 30 year government bonds at 15%. That would set someone up for 2 decades of out-performance if the cycle repeats.

 

The only decent option I have come across in the retail space is ROIC warrants. They may be chopped off at the knees though. If long term rates trade down to 2.5% then reits will be doing quite well due to yield bigs. If Management performs, rates stay low, and things workout you would get 8.5x return. Management though said they will do something about the warrants in a few quarters so I am not sure what will happen to my hedge. Lets hope for a quick return of capital and return of capital lol.

 

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ERICOPOLY, not sure what your fair share is - but I see a future where you will be paying more. Hopefully I have the networth / income to join you. I will probably be just as upset  :D. 10% just doesnt seem great to me. Calls can be addictive, I like the pair trade though.

[ERICOPOLY]

ERICOPOLY, not sure what your fair share is - but I see a future where you will be paying more.

 

I'm not a Johnson&Johnson heir.  Given the station in life I was born into, I think my fair federal tax burden is right where it would be if I were still employed at Microsoft.  I took a huge risk and I feel strongly that the reward is mine.  Nobody would have shared in my losses.

 

I may need to start employing games like purchasing deep in the money calls for leverage in my RothIRA and an offsetting amount of deep-in-the-money puts in my taxable account -- so that on the whole I'm not leveraged, and over time the gains flow disproportionately to the tax-free account.  Could be done with safe things like BRK-B to ensure the gains don't flow to the taxable account.

 

[gaf63]

smo001, thanks for the bond site,

Anyone

Is the interest on bonds subject to the same Canadian 15% withholding tax as  dividends for foreign holders??

TIA, Gary

 

[nodnub]

ERICOPOLY, not sure what your fair share is - but I see a future where you will be paying more.

 

I'm not a Johnson&Johnson heir.  Given the station in life I was born into, I think my fair federal tax burden is right where it would be if I were still employed at Microsoft.  I took a huge risk and I feel strongly that the reward is mine.  Nobody would have shared in my losses.

ericopoly,

I can't figure out what you mean here.  The reward is yours, but so are the tax liabilities.  How else should it be?   

 

Are you just making a statement that you would prefer a flat tax system?

[ERICOPOLY]

ERICOPOLY, not sure what your fair share is - but I see a future where you will be paying more.

 

I'm not a Johnson&Johnson heir.  Given the station in life I was born into, I think my fair federal tax burden is right where it would be if I were still employed at Microsoft.  I took a huge risk and I feel strongly that the reward is mine.  Nobody would have shared in my losses.

ericopoly,

I can't figure out what you mean here.  The reward is yours, but so are the tax liabilities.  How else should it be?    

 

Are you just making a statement that you would prefer a flat tax system?

 

The system I want is one where I can make unlimited contributions to a tax-deferred account, and can withdraw money at any time without early-withdrawal penalties.  This way, I pay income tax in line with the income I consume, just like most everyone else.

 

So it's sort of similar to variable annuity, except it eliminates the early withdrawal penalty and is more cost efficient (variable annuities carry heavy fees) -- plus I can select the investments, rather than be stuck only with funds.

 

I don't think Americans are first in line for taking my money -- I would rather help people elsewhere in the world first where the money goes farther and the problems are deeper.  I would also like to make the money compound for a while before giving a large part away.  So I follow in the tradition of Gates and Buffett somewhat in this thinking (the former wants to help people outside the US, the latter wanted to compound it tax-deferred before giving it).  And neither believes the US Treasury should be the beneficiary of their gifts! 

 

[finetrader]

I may need to start employing games like purchasing deep in the money calls for leverage in my RothIRA and an offsetting amount of deep-in-the-money puts in my taxable account -- so that on the whole I'm not leveraged, and over time the gains flow disproportionately to the tax-free account.

 

Do you think there is an inverse way to do with options so you can take money out of tax-deferred account and not be taxed on it?  (could be useful when close to retirement when you have to start taking money off the tax-deferred account)

[ERICOPOLY]

I may need to start employing games like purchasing deep in the money calls for leverage in my RothIRA and an offsetting amount of deep-in-the-money puts in my taxable account -- so that on the whole I'm not leveraged, and over time the gains flow disproportionately to the tax-free account.

 

Do you think there is an inverse way to do with options so you can take money out of tax-deferred account and not be taxed on it?  (could be useful when close to retirement when you have to start taking money off the tax-deferred account)

 

You could probably buy long term at-the-money calls in your taxable account and write them covered (same strike, same price) in your IRA.  This way you don't ever lose money on the whole (in terms of net worth), but you "withdraw" gains at the long term capital gains tax rate instead of paying the regular income tax rate that IRA gains are taxed on.  Could be useful today, with 15% LT gains rate vs potentially 35% income tax rate on IRA withdrawal.

 

Not sure if that's even legal by the way, but I don't see why not.

 

I don't have a regular IRA anymore though -- 100% RothIRA at this point.

[jegenolf]

I don't have a regular IRA anymore though -- 100% RothIRA at this point.

 

Ah the benefits of not having a job. You got to convert to Roth and shield some income in those low tax brackets didn't you...

 

The non-capped Roth conversion is a pretty nice disincentive to work, at least for a year or two.

[Uccmal]

I still hold roughly a 20% position in FFH common.  At this time it is acting as a pretty good, anecdotally, market hedge.  I have noticed that it has gone up during the little correction we have had in recent weeks.

 

I dont think that FFH will follow all boats in either a market crash or a deflation this time around.  Enough people are aware of the style of FFH now that a market crash and or sustained deflation should actually bouy the company. 

 

So, wouldn't FFH common without all the tax implications make a better inflation hedge than 7.75% pre-tax interest?

 

In a down market any of us can easily beat the 5% after tax bogey just by buying depressed dividend payers.

[Myth465]

I dont think that FFH will follow all boats in either a market crash or a deflation this time around.  Enough people are aware of the style of FFH now that a market crash and or sustained deflation should actually bouy the company. 

 

I agree, my thesis on FFH is falling apart. Now that its off the NYSE it seems to trade more rationally. Even after the losses in Q1, it regained its footing pretty quickly. Prem has proved that removing it from the US exchange was a step in the right direction.

[bluedevil]

I still hold roughly a 20% position in FFH common.  At this time it is acting as a pretty good, anecdotally, market hedge.  I have noticed that it has gone up during the little correction we have had in recent weeks.

 

I dont think that FFH will follow all boats in either a market crash or a deflation this time around.  Enough people are aware of the style of FFH now that a market crash and or sustained deflation should actually bouy the company. 

 

So, wouldn't FFH common without all the tax implications make a better inflation hedge than 7.75% pre-tax interest?

 

In a down market any of us can easily beat the 5% after tax bogey just by buying depressed dividend payers.

 

I don't disagree with any of that (I own FFH stock myself not bonds), but I recommended this security for a retiring relative who was looking for a safe, income producing investment in a Roth-IRA account, and it makes a lot of sense to me there.