Sunday, 16 July 2017

Interest Rate Hedging Smoke Screen

After US Federal Reserve increased interest rates in Dec, Mar and Jun, and after Yellen's congressional speech last Wed, interest rates are confirmed on the way up. This will impact companies with large debts, especially REITs, as higher interest expense would mean lower distribution for shareholders. The usual response that companies give to questions of rising interest rates is that they have hedged the majority of their loans by swapping floating loan rates for fixed loan rates. However, are such measures adequate to mitigate the impact of rising interest rates?

If you ask any person who took up a fixed-rate mortgage loan to finance his housing purchase, he will tell you that even though it is a fixed-rate loan, the interest rate is only fixed for 2-3 years. After that, the interest rate will revert to a floating rate. Although he can refinance to a new fixed-rate loan after 2-3 years, the new fixed interest rate will be based on the prevailing interest rates then, not the interest rates now. Currently, a 2-year fixed-rate loan is available at 1.6%. But if interest rates were to rise to say, 2.6%, 2 years later, the new fixed-rate loan after refinancing would be at 2.6%. So, fixing the loan interest rate does not eliminate the effect of rising interest rates. It only postpones the impact to 2-3 years later when the loan or interest rate swap expires.

Moreover, unlike mortgage loans in which you pay down the loan principal over time, company loans are usually bullet loans, in which repayment of the loan principal is only required when the loan matures. Furthermore, these bullet loans are usually refinanced and rolled over to a new bullet loan. In other words, the loan principal is not paid down over time. When you fix the interest rate and pay down the loan over the period of the fixed interest rate, you reduce the increase in interest expense when the rate is reset after refinancing. But when companies do not pay down the loan when the interest rate is fixed, the increase in interest expense 2-3 years down the road is the same as if the interest rate fix does not exist! The only benefit is that companies save some interest expense during the 2-3 years when interest rate is fixed. But it does not eliminate the impact of rising interest rates altogether.

So, when companies say they hedge interest rates, please be aware that it only postpones the impact to 2-3 years down the road.


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Monday, 10 July 2017

Which KrisEnergy Should I Buy?

If you read my earlier post on My Oil & Gas Fightback, you would know that one of the stocks I am interested in is KrisEnergy. The main reason for my interest in this stock is because it can potentially turn around quickly when oil price recovers and become a multi-bagger. However, there are 3 KrisEnergy counters listed on SGX, namely, 
  • the KrisEnergy stock itself;
  • a warrant named KrisEnergy W240131, which is convertible to the stock and will expire on 31 Jan 2024; and 
  • a zero-coupon bond named KrisEnergy z240131, which will also mature on 31 Jan 2024.
Which KrisEnergy should I buy for maximum capital gain?

KrisEnergy the stock is the simplest. If oil price goes up, it will make money. Conversely, if oil price stays down, it will lose money. There is no expiry date to the stock, unless the company goes bankrupt.

KrisEnergy the warrant is also easy to understand. It can be converted into the stock at an exercise price of $0.11. Because of the exercise price, it trades at a much lower price compared to the stock. Thus, the potential for a price increase is many folds that of the stock. However, it has an expiry date of 31 Jan 2024, after which it will become worthless. Thus, for  speculators who believe oil price will go up at least once in the 6.5 years before it expire can consider the warrant.

For me, there is another consideration in choosing between the stock and the warrant. I treat KrisEnergy as a minion, meaning it is a small speculative position which is mentally written off the moment it is purchased (see Meet The Minions for more info). Since the money will be written off,  it does not matter whether I buy the stock or the warrant. The stock and warrant currently trade at $0.12 and $0.038 respectively. For the same amount of money, I could buy 3.16 warrants for every 1 share of the stock. Coupled with the fact that if oil price were to recover, the rise in the warrant is many folds that of the stock. Thus, between the 2, the minion strategy always prefer the warrant.

KrisEnergy the bond is an interesting one. It is a bond, which means that it will be redeemed at face value when it matures. Furthermore, in the event of bankruptcy, the bond ranks higher than the stock and warrant and might be able to recover some money back for its holders. Thus, it has less risks compared to the stock and the warrant.

Moreover, it is not a plain vanilla bond that pays regular coupons (i.e. interest) to bondholders at regular intervals and does not move much in price. It is a zero-coupon bond. Zero-coupon bonds are bonds that do not pay any coupons. Instead, zero-coupon bonds are sold at a discount but redeemed at face value when they mature. Thus, investors who buy the bonds make money by gaining capital appreciation instead of regular coupons. For KrisEnergy's zero-coupon bonds, the last traded price is $0.44. When the bond matures on 31 Jan 2024, it will be redeemed in full at $1 (assuming KrisEnergy does not default). Hence, bondholders would gain $0.56 over a period of 6.5 years. This is equivalent to a coupon rate of 13.5%. Of course, the caveat here is that KrisEnergy does not default or restructure the bonds. 

Not only that, it is also a junk bond. Junk bonds are bonds whose issuer's ability and willingness to meet the bond obligations are uncertain. Their prospects are closely linked to the issuer's ability to pay dividends on the stock. Thus, both junk bonds and stock will rise and fall along with economic developments affecting the company. In other words, junk bonds can be as volatile as equities.

Thus, to gain capital appreciation, either the stock, warrant or bond are feasible options. The best instrument to speculate in will depend on your outlook for oil price. If you are bullish about oil price in the next 6.5 years, warrant will give the best capital appreciation. If you are neutral about oil price, bond will provide the best capital gain. If you are bearish about oil price, all instruments will be bad, with bond being less worse off. An estimation of each instrument's performance under the various scenarios on oil price is as follows.

Outlook Bond Stock Warrant
Bullish Good Good Best
Neutral Good Neutral Bad
Bearish Bad Worse Worst

P.S. I am vested in KrisEnergy stock but planning to switch to KrisEnergy warrant.


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Monday, 3 July 2017

Wills, Trusts, AMDs and LPAs

I just attended a 2-day estate planning talks on wills, trusts, Advanced Medical Directives (AMDs) and Lasting Powers of Attorney (LPAs) organised by RockWills Corp Pte Ltd. There are some interesting facts about them that I share below.

Wills 

Most people know what is a will, so I will skip the basic facts and mention what I learnt from the talk. As you may be aware, you need to identify who are the executor and trustee of the will. The executor is the person who will carry out all necessary actions to distribute the estate according to the wishes of the will, while the trustee is the person who will hold on to the estate until it is completely distributed to the beneficiaries of the will. Although you can nominate an executor and trustee to carry out the wishes of the will, they can actually renounce these roles! The beneficiaries will then have to appoint another executor and trustee to execute the will.

The other point highlighted is that while you can write a well-planned will, if the will cannot be found or is destroyed, it is useless as well. This may sound like common sense, but the safekeeping of the will is sometimes taken for granted. For example, I made my will approximately 10 years ago. It is sealed inside an envelope and placed in an easily accessible location as nobody knows the existence of this will. However, for these past 10 years, I never open up the envelope and check the content. Who knows, maybe the ink might have faded or the paper on which the will was written might have turned yellow such that the will is no longer legible? 

The other concern for leaving my will so easily accessible is if someone were to read it after I am gone and dislike its content, he could simply destroy it and there would not be a will left behind.

The reason for my complacency is because I believed a copy of the will is kept by the law firm who wrote my will and by the Wills Registry under the Ministry of Law. I was reminded at the talks that the Wills Registry does not keep a copy of my will; it only has a record of when and who drew up my will. Will the law firm still keep a copy of my will 10 years after making it? I believe so, but I better not count on it since it did not charge me any custody fee. I will have to seriously think through how should I keep my will securely while still keeping it accessible when needed. 

Trusts

This is the most interesting topic that I learnt from the talks. If you have read my blog post on There is Really a Regular-Payout Term Insurance, you would know that I have a preference for insurance policies that pay out regular sums of money over a period of time instead of a lump sum. This is because my dependents might not be financially savvy enough to handle a large sum of money suddenly and might unwittingly invest the money in some risky investment products. A regular payout provides greater certainty on the financial sustainability of my dependents.

Similarly, a will pays out the inheritance as a lump sum, which has the same disadvantages mentioned above. However, if you write a will to pay out the inheritance into a trust, you can provide instructions on how regularly a trust disburse the funds to the beneficiaries. You could also set certain milestones for your beneficiaries to achieve before they get further payouts, such as getting a degree, etc.

Advanced Medical Directives (AMDs) 

AMDs are instructions that you set in advance to inform doctors whether you wish to be kept on life-support in the event of a terminal illness and when death is imminent without life-support. You can refer to Ministry of Health's website on AMDs for more information.

The key thing to note is that the witnesses to the AMDs should not be beneficiaries of your will.

Lasting Powers of Attorney (LPAs)

LPAs are legal documents authorising a trusted person (known as a donee) to make decisions related to your personal welfare and financial matters in the event of mental incapacity such as dementia or stroke. This is a very powerful document as the donee(s) can make many decisions on your behalf. Thus, whom you appoint as donee(s) is very important. For the simple LPA, you can appoint 1 or 2 donees and specify whether the 2 donees need to act jointly or can act alone. You can also appoint a replacement donee should one of the originally appointed donees becomes unsuitable. You can refer to Office of the Public Guardian's website on LPAs for more information.

Some other practical considerations that the speaker mentioned at the talk are the donee should preferably not be of the same age, because both the donor and the donee might suffer from dementia when the LPA needs to take effect. Also, the donee should not be someone living overseas as he would have difficulties overseeing daily matters related to personal welfare and/or financial matters. 

That's all for the lessons I gathered from the talks. It is useful to attending such talks from time to time to clear up any misconceptions and understand the options available for estate planning.


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