Tuesday, February 19, 2019

Curious case of leveraging Astrea IV bonds.

Sometimes I make mistakes when I teach a class. Fortunately, the smart folks who attend the session call me out very quickly and I can adjust my position rapidly on the spot.

In this case, I made a glaring mistake projecting the yield of Astrea IV bonds, taking the coupons and dividing it by market price to get more than 4% yields. One of my students is a brilliant CFA III candidate and he pointed out my mistake immediately after punching numbers into his Texas BA II calculator.

I have overestimated the yield to maturity of the bond.

The tragedy is that Astrea IV is that it has a provision that allows it to be called or cancelled in June 2023. This means that in June 2023, I will get back to $1000 of my money and 6 months worth of coupon payments even though the market price right now is a $1,080 high. Reading some other blogs, I came to the opinion that the odds of this bond being called is very high.

A more accurate estimate of the yield would therefore require using the IRR() command in Excel. I produce my cashflow projection assuming that the call will occur here :

  2019 2020 2021 2022 2023
Coupons  $43.50  $43.50  $43.50  $43.50  $1,021.75
Outflow -$1,080.00  $-    $-    $-    $-  
Net Pay Out -$1,036.50  $43.50  $43.50  $43.50  $1,021.75
IRR 2.85%        

Having this kind of IRR of 2.85% makes it a difficult candidate for leverage as my financing cost is current at 3.28%. This is sad because I typically pad a REIT portfolio with bonds to reduce overall volatility so investors can sleep well at night over the one year.

Interestingly, the Astrea IV bond also has an extra feature. If the underlying funds perform well a 0.5% bonus will be issued and if this turns out to be true, the cashflow diagram will be as follows :

  2019 2020 2021 2022 2023
Coupons  $43.50  $43.50  $43.50  $43.50  $1,071.75
Outflow -$1,080.00  $-    $-    $-    $-  
Net Pay Out -$1,036.50  $43.50  $43.50  $43.50  $1,071.75
IRR 4.01%        

If investors believe that the 0.5% bonus will be given out, then leverage becomes feasible.

I was fortunately enough to get into Astrea IV at a lower price in December so I do not need to correct my error in my leveraged portfolio, but investors may wish to instead employ a safe business trust like Netlink Trust or bank preference shares to lower the volatility of their leveraged portfolio.

Of course, I reversed my recommendation to my students immediately on Monday morning.

If you see any further errors, in my brief calculation do let me know.

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