On the 21st of May 2022, we posted our new portfolio to subscribers. The three Entergy Corporation (ETR) baby bonds EMP, ELC, and EAI were a significant portion of the portfolio (14%):
ETR A-rated BONDS
EMP. ELC and EAI have seen their yields fall lately to 5.65% They are OTC bonds from their comparable entities that have yields of 4.5%. The 3 comparable bonds mature in 30 years while the baby bonds mature in 44 years. There is no way that a 44 yr bond deserves a 1.1% YTM spread compared to the same company 30 yr bond, especially with such a high credit rating.
source: subscribers’ article posted on the 21st of May 2022.
Later on, we prepared the article to follow to explain the arbitrage in detail. Enjoy:
The recent selling of fixed income combined with a total lack of liquidity has made some products disconnected from reality. The heroes in this article seem to have quite deviated from their fair place on the yield curve. We will try to explain the value they have at current prices.
The 3 baby bonds by ETR are almost identical
At current prices, the 3 bonds have a YTM of around 5.4%. This, of course, is not that spectacular when you read the inflation news every day, but as far as financial analysis is concerned, these 3 bonds are quite mispriced. They carry a very high credit rating by S&P (A) and Moody’s (A2) and are 1st lien mortgage bonds. Based on credit risk, these are the safest private company corporate bonds that trade on the exchange. They were issued in 2016 with 50 years term to maturity at a spread to 30-year treasuries or around 2.65% at the time. Even though this spread has remained roughly the same, there are other comparisons that make these bonds a decent buy to our newly announced portfolio.
Comparison with bonds from the same entity
These are several bonds that are absolutely similar, with the only difference that they were once issued as 30-year bonds rather than 50-year ones:
These are First Lien Mortgage bonds with the same credit rating by both agencies. The YTM spread at the moment stands around 0.9%. It is very hard for us to measure the deviation in spreads because in the last few years the exchange-traded bonds have been trading as almost certain redemptions because of their higher coupon and their embedded call option, which is absent in the OTC traded ones. This is why we chose to look at their durations (EAI vs the 3,35% 2052 Entergy ARK bond):
A bond has two main risks. Credit risk is equal, and duration risk, which is a function of yield to maturity. This latter is at the moment higher for the 30-year bond. Let’s not forget the definition of arbitrage – taking less risk while generating a higher return. Basically, there is nothing more to say about this situation The calculations are identical for EMP and ELC vs their OTC brothers.
Comparison with same-sector bonds
In the pictures below, we can see all comparable sector bonds and their respective terms and yields:
There is only one bond comparable to our trio:
This one is probably a decent addition to our portfolio as well and it represents a decent opportunity. We can not claim that EMP, ELC, or EAI are superior to this particular bond. All other bonds in the pictures have significantly lower yields even though some of them have way lower credit ratings. This further proves the initial thesis that our exchange-traded ETR baby bonds are mispriced.
Fair value estimate
Trying to be as conservative as possible, we are choosing a YTM of the 3 ETR bonds that makes their duration slightly higher than that of the comparable OTC bonds. At a YTM of around 5.10%, we have a duration of around 17.62 for the three baby bonds compared to 17.20 for the OTC bonds trading at around 4.5%. The extra 0.6% yield premium is compensating for the “enormous” duration spread of 0.42. We could have gone way crazier in our fair value estimate by posting this chart:
As you can see, there is almost no spread between 30-year and 40-year or 50-year bonds. Also, keep in mind that when a buyer shows up in the exchange-traded bonds, it usually bids them to a point where they become overvalued. One can always expect some “Alpha” based on liquidity issues. It is not very easy to buy a decent amount in these bonds, and this is why they are not constantly arbitrated the way OTC bonds are.
Why double-digit returns?
If our fair value estimate is reached within six months’ time, for example, we would have a large capital gain (for an “A” rated bond) that adds to the current yield of the bond. The bonds were added to our portfolio for subscribers at these yields and prices:
A bond bought at $22.70 with a fair value estimate above $24 gives its holder around 5% capital appreciation potential based on pure relative analysis. If one finds the logic to be correct, he can surely expect double-digit returns.
EMP, ELC, and EAI are a proud addition to our recently announced portfolio. Being the safest private company debt trading on the exchange, it is surprising to see them being undervalued on a relative basis and giving us a simple Alpha to gather. The fixed income trader and/or investor can not pass on such opportunities because they are rare. Hopefully, all fixed income market panic is behind us and we can happily collect our yield + Alpha.
How the trade has developed
For less than 2 weeks, ELC, as an example, has risen from 22.70 to 24.20 and it has paid 1 interest distribution of 30 cents. The return is around 8% for such a short time. This would not be the case if there wasn’t some extreme rally in PFF, but the comparable OTC bonds used as a benchmark have not seen their yields moving that much:
This has been a pure narrowing of a spread that was not justified to start with, and these are the types of opportunities that illustrate what “Seeking Alpha” means.