Source: Bank of America
The combination of lower
equity to value ratios for homeowners with mortgages and a large number of ARM
interest rate resets on subprime loans does not bode well for the default rate.
In his latest commentary, Bill Gross of PIMCO wrote that the place to look for
financial contagion was in the “subprime resets to come and the ultimate effect
they will have on the prices of homes – the collateral that’s so critical in
this asset-backed , and therefore interest-sensitive financed-based economy of
2007 and beyond.”
Two hedge funds sponsored
by Bear Stearns have demonstrated the potential problems of thinly traded
securities combined with leverage. The Bear Stearns High-Grade Structured
Credit Strategies Enhanced Leverage Fund reported that its net asset value had
declined by 18% for the month of April and redemptions by investors were
temporarily suspended by the fund. The fund manager sold $4 billion of
securities to reduce leverage and avoid a cash shortage but Merrill Lynch
nevertheless seized $850 million of collateral and attempted to sell the
securities. Bear Stearns eventually loaned $1.6 billion to avoid liquidation of
the funds as other lenders reduced their credit exposure by calling their
loans. The situation now appears to have stabilized after leverage within the
funds was substantially reduced.
According to data compiled
by Bloomberg L.P., almost 65% of the bonds in indexes that track subprime
mortgage debt don’t meet the ratings criteria in place when the bonds were
sold. The credit rating companies (Standard & Poor’s, Moody’s Investor Services
and Fitch Ratings), however, have failed to cut the credit ratings on about $200
billion of bonds backed by subprime mortgages in spite of declines in market
prices. Estimates of losses on CDOs, which include subprime mortgage and
corporate debt, now range from $125 billion to $250 billion.
Since CDOs are not traded
actively, valuations are usually based upon mark to valuation models which
incorporate credit ratings rather than market prices. Many institutional
investors and lenders may now be wondering if the valuations of hedge fund
assets reflect realizable prices and if it is best to reduce their exposure
before others decide to do so. While the likelihood of some credit contraction
due to a loss of confidence is obvious, the timing and extent remains unclear.
Additions
The American Century
International Bond Fund (BEGBX) and some Canadian Government bonds were
purchased during the quarter for many accounts to maintain a foreign currency
position. The US dollar is expected to decline further relative to other
currencies based upon the magnitude of the US trade deficit and reliance upon
foreign investment.
The MFS Intermediate Income
Trust (MIN) was purchased for some accounts. At the time of purchase, MIN was
trading at a discount to net asset value which exceeded 10%. The MIN portfolio
holds about one-third of its portfolio in foreign holdings, with an average AAA
credit rating and relatively short maturities.
Chunghwa Telecom Co., Ltd.
(CHT) is the leading telecommunications service provider in Taiwan. It provides
fixed-line, mobile, internet and data services to residential and business
customers in Taiwan. CHT has a strong balance sheet with no long-term debt.
CHT currently sells for approximately 10.5X estimated 2007 free cash flow and
has an expected dividend yield of 5.8%.
Trina Solar Limited (TSL)
is a vertically integrated manufacturer of solar photovoltaic modules based in
China. Solar power industry demand has grown at an annualized rate of 43%
during the last five years and is expected to remain strong with the assistance
of government incentives. TSL has a competitive cost advantage due to its
proprietary process technology that allows a higher proportion of lower cost
reclaimable silicon raw materials to be used in the production of
monocrystalline silicon ingots. TSL expects to increase its production capacity
from 100 megawatts (MW) at the end of the first quarter to 150 MW by the end of
2007 and 350 MW by the end of 2008. Several new agreements were recently signed
with companies in Spain and Italy. Consensus earnings estimates for TSL are
$1.65 and $3.58 for 2007 and 2008, respectively.
U.S. Treasury bills were
purchased for selected accounts during the quarter. Inflation expectations
appear to be rising and I would prefer to maintain a concentration in shorter
maturities for the fixed income portion of the portfolios.
Deletions
Profits were taken on
Aluminum Corp. of China (ACH), Devon Energy Corp. (DVN) and Petrobras (PBR)
during the quarter. My projected return model indicated that the potential
upside for their stock prices was more limited than in the past.
The Van Kampen Trust for
Investment Grade Municipals (VGM) and MFS Government Markets Income Trust (MGF)
were sold during the quarter. The discounts to net asset value had declined to
6-7% of net asset value. VGM is also leveraged with preferred stock equal to
33% of assets. The proceeds will be used to purchase other closed-end funds
that sell at a larger discount.
The Putnam Tax-Free Health
Care Fund (PMH) was sold at a discount to net asset value of 1%. The Trustees
of PMH approved a plan to merge the fund into a Putnam tax-exempt open-end fund
at net asset value. Consequently, the discount to net asset value narrowed
substantially. The merger plan must be approved by shareholders and a temporary
redemption fee is expected to be imposed after the merger.
A SLM Corporation bond that
was held in some retirement accounts was sold. SLM received a leveraged buyout
offer which was expected to increase its debt level and lower its credit rating.
The Argentina Government
peso-denominated bond and GDP-linked security were sold, primarily because of
persistent pricing problems at TD Ameritrade.
Updates
ConocoPhillips (COP)
announced that it was unable to reach an agreement with Venezuela concerning
appropriate compensation for the company’s interests in three joint venture
projects. COP expects to record a complete impairment of its entire interests
in the three projects of approximately $4.5 billion in its second quarter
results. COP remains hopeful that negotiations will eventually result in at
least a partial recovery. The news appears to have been already discounted and
it did not have much impact on the stock price.
If you have any questions
regarding your accounts, please contact me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.