For those investors who think bonds lack pizzazz, let me show you a game that is being played by a few stout-hearted investors.
First off, you must realize that this is a speculative venture. It deals with low-quality (B-rated or BB-rated issues), high-yielding (more than 16 percent) names that are purchased through a brokerage house on margin. Margin means that you put up 30 percent of the purchase price (your equity) and, with your bonds for collaterial, the brokerage house will lend you 70 percent of the purchase price (the margin) an interest cost. The current margin cost is 19 1/4 percent.
The purpose of this strategy is to leverage yourself for a capital gains play when interest rates fall and bond prices move up. It should be emphasized again that this is a speculative play for price move, and in no way should it be considered for an income play at this phase of the interest-rate cycle.
In our example, we will purchase $100,000 Zapata 10 7/8 due Sept. 1, 1998 at a 70 ($700 a bond). The company is rated B. The figures are on a yearly basis. (TABLE) Purchase price(COLUMN)$70,000 30% equity(COLUMN)22,500 Amount financed at 19 1/4%(COLUMN)$47,500 Coupon income(COLUMN)$10,875 19 1/4% margin cost(COLUMN)9,144 NET GAIN(COLUMN)$1,731 RETURN ON EQUITY(COLUMN)7.7%(END TABLE)
Should interest rates fall and the price of the Zaptas move up five points to be sold at 75 ($750), your total profit would be $6,731 ($5,000 plus $1,731). The return on your equity ($22,500) then would be 29.9 percent. Not bad, especially if that 5-point move should occur over a short period of time. Also, should interest rates delcine, your margin cost also will decline and increase your net gain.
This also can be done with higher-rated, lower-couponed, deeper-discount bonds. But the math does not favor this transaction in a period of high rates, although you do have the leverage for the potential appreciation and your equity will be significantly lower.
The following points must be stressed:
A bond to be purchased on margin must be listed on one of the national exchanges. Your broker would know this.
Bond prices also can fall. Most brokerage house require that your equity be maintained at 75 percent of its original value. Should the market decline to the point where the value of the equity falls below 75 percent, the broker will issue a margin call to restore the value to the 75 percent ratio.
Be prepared for a hidden cost -- the accured interest. You do receive all of the interest when the coupon is paid every 6 months. But when you purchase a bond, it could have 5 months of accrued interest which you must pay the seller. In the case of Zapata, 5 months' accrued interest would be $4,531.
Your margin cost, 19 1/4 percent ($9,144), is tax-deductable. You pay a capital gains tax (either short term or long term) on the price appreciation.
The markets on these low-rated bonds are extemely thin. They are scarce gyrate accordingly. Your best approach is to arrive at a price and enter your order with a definite price limit.
Finally, most of these low-rated bonds represent debt subordinated to other debt. But these bonds as debt securities are senior to any preferred or common stock of the company in the event the company does encounter any financial problems.
Some possible candidates are: Gulf Resources and Chemical 10 7/8s, Monogram 11s, Bangor Punta 11 1/2s, Texas International Airline 10 7/8s and Western Company 10.70s. A competent broker should be albe to answer your question.
The Treasury will offer a four-year note on Tuesday in minimum denominations of $1,000. A price guesstimate would be between 13 3/4 percent and 13 7/8 percent.