(LINE) Archives - Page 2 of 2 - Mad Hedge Fund Trader

Why I?m Hammering the Bond Market

Those lucky traders who have been following my Trade Alert service are well aware that I have been hamming the bond market for the past week. These new positions were a major factor in adding an impressive 5% to my model trading portfolio P&L during a week when there was very little happening in the real world.

There is a method to my madness.

This was supposed to be the year of the ?Great Reallocation,? whereby long-term investors bailed on their fixed income portfolios in favor of stocks. The only problem was that it just didn?t happen.

Bonds fell alright, taking the ten year Treasury yield up to 3.0% by August 20. But what selling did occur up until then saw the proceeds moved largely into cash instead of equities.

What happened next surprised many industry experts. Bonds rallied strongly going into a September meeting at the Federal Reserve where they were supposed to announce a taper of its $85 billion a month in bond buying. That was supposed to crash the bond market, and the street piled on massive shorts.

The meeting came and went without a taper announcement, catching many traders wrong footed. That forced them to chase the market to cover shorts, taking the yen year yield all the way down to 2.47% by last week.

Then the rally abruptly died.

When you see disparate markets confirming major reversals within an asset class all at once, it usually signifies that something big is happening. Starting on Wednesday, the Treasury market peaked and began a rapid descent, taking yields up 17 basis points in dramatic fashion.

Corporate bonds also took a dive, with the High Grade Investable Bond ETF (LQD) giving back a few points. Junk bonds took a hit, with the high yield ETF (HYG) taking it on the kisser. Even emerging market debt (ELD) and the municipal bond market (MUB) were thrown out with the bathwater.

Only master limited partnerships continued to hold up well, my favorite pick in the sector, Linn Energy (LINE), blasting ten points to the upside. This is one of the few areas in the fixed income space where a double-digit yield pays you for your principal risk.

That prompted me to rush followers out of a 100% cash position into seven new positions in very quick succession. I was writing Trade Alerts so fast that I was busier than the proverbial one-handed paperhanger. So I was a day early. Take it out of my next paycheck!

What is the big thing that the market is trying to tell us here? I may be going deaf and blind in my old age, but I can see this one coming a mile off.

The ?Great Reallocation? scheduled for 2013 is actually going to happen in 2014. The sell off in bonds that ran for the first eight months of the year put the fear of god into investors and managers alike. It?s not for nothing that bond giant PIMCO?s Bill Gross says that he expects to get ?ashes in my stocking for Christmas this year.?

Having been warned once on the risks entailed in a market that is coming off a 60 year high, bond owners don?t need to be told twice to sit down when the music stops playing. They have started to lighten up in a hurry.

December is turning into a ?Great Front Run of 2014.? To reallocate out of bonds into stocks in 2014, you have to start selling your bonds now. That means that bonds could remain weak for the rest of 2013, possibly even taking the ten year yield all the way back up to 3.0% again. Hence, my aggressive selling.

If I am right about this scenario, the flipside for stocks could be even more important. It augurs for a narrow, low volume, sideways correcting stock market for a few more weeks, then a blast to the upside into year-end. A Standard and Poor?s 500 of 1,800 becomes a chip shot, and with two months to run, it could even make it as high as 1,850. There is a global synchronized recovery on the table for 2014 and everyone and his brother wants to participate.

My only concern here is that we are pulling forward performance from 2014 into this year that will ultimately make next year harder to trade.

So Who?s Selling Their Bonds First?

MLP?s Are On Fire

Newsletter

Master Limited Partnerships have been on fire since the beginning of the year. Once the deal on the ?Fiscal Cliff? was done, and these instruments? special tax treatment protected, it was off to the races. These unique and versatile instruments combine the tax benefits of a limited partnership with the liquidity of publicly traded securities.

The explosion in demand has created a new issue boom. SunCoke Energy Partners (SXCP) makes coking coal used in the steel production process, came to market this week boasting an 8.25% yield. Then, CVR Refining (CVRR), which specializes in petroleum refining in Texas and Oklahoma, upped the ante with an eye popping 18.8% yield. These things can?t be that high risk!

Enbridge Energy Partners (EEP) is run by some of my former colleagues at Morgan Stanley and offers a 7% yield. Kinder Morgan Energy (KMP) posts a healthy 5.8% yield, while Trans Mountain (TLP) ups the ante with an 8% return. Linn Energy goes all the way up to a healthy 6.3% yield.

Why the enticing cash flow? The problem is that these partnerships suffer from their guilt by association with Texas Tea, which is notorious for its volatility. Although they have no direct exposure to the price of oil, investors tend to incorrectly classify them as energy stocks and dump them whenever oil falls. The great thing about these high yields is that you get paid to wait until crude makes a comeback, which it will always do, as long as there is a China. Not a bad game to play in a zero return world.

To qualify for MLP status, a partnership must generate at least 90 percent of its income from what the Internal Revenue Service deems ?qualifying? sources. For many MLPs, these include all manner of activities related to the production, processing or transportation of oil, natural gas and coal.

Energy MLPs are defined as owning energy infrastructure in the U.S., including pipelines, natural gas, gasoline, oil, storage, terminals, and processing plants. These are all special tax subsidies put into place when oil companies suffered from extremely low oil prices. Once on the books, they lived on forever.

In practice, MLPs pay their investors through quarterly distributions. Typically, the higher the quarterly distributions paid to LP unit holders, the higher the management fee paid to the general partner. The idea is that the GP has an incentive to try to boost distributions through pursuing income-accretive acquisitions and organic growth projects.

Because MLPs are partnerships, they avoid the corporate income tax, on both a state and federal basis. Instead of getting a form 1099-DIV and the end of the year, you receive a form K-1, which your accountant should know how to handle. The only problem with this set up is that the partnerships are required to send you a K-1 for every state in which they do business. Own enough of these, and your tax return will end up as thick as the Houston telephone book.

Additionally, the limited partner (investor) may also record a pro-rated share of the MLP?s depreciation on his or her own tax forms to reduce liability. This is the primary benefit of MLPs and gives MLPs relatively cheap funding costs.

The tax implications of MLPs for individual investors are complex. The distributions are taxed at the marginal rate of the partner, unlike dividends from qualified stock corporations. On the other hand, there is no advantage to claiming the pro-rated share of the MLP?s depreciation (see above) when held in a tax deferred account, like an IRA or 401k. To encourage tax-deferred investors, many MLP?s set up corporation holding companies of LP claims which can issue common equity.

Since 2003, MLPs as an asset class have grown astronomically, from $30 billion to over $250 billion, and have also been the best performing asset class in the world over the last 10, 5, and 3 year periods. The recent discovery of new, massive gas and oil fields in the US and the rapid expansion of shale fracking should auger well for the rising popularity of this instrument.

If you don?t want to bet the ranch putting all you money into a single issue, you might consider the JP Morgan Alerian MLP Index ETN (AMJ), with a 5.35% yield. You give up some yield here in exchange for a broader diversification of risk across many issues in this quasi index fund. For many, it will be worth it to just to sleep at night.

Nope, Don?t See Any Yield Yet

The Slippery Slope for Oil

Newsletter

If volatility and lack of direction in the equity market are driving you nuts these days, thank your lucky stars you?re not in the oil market. Only last night, a Japanese supertanker plowed into a US Navy destroyer, causing prices to spike. That?s assuming that you had time to notice while sifting through numerous, contradictory leaks from Israeli intelligence about whether they will, or will not, imminently attack Iran. Oh, and don?t forget, demand from Europe is disappearing up its own tailpipe.

My take is that the administration is pursuing the correct policy on Iran. With Europe joining the embargo on June 30, and its major means of trade financed with the dispatch of Standard Chartered, Iran?s economy is now caught in a vice. With minimal domestic refining capacity, the country is drowning in its own oil, but facing several gasoline shortages. Some essential foodstuffs have doubled in price. These are key ingredients needed for the Arab Spring to spill into Iran. Then the country falls into our lap like an overripe piece of fruit, without a shot fired.

It could well be that none of this makes any difference to the price of crude. Like every other asset class, it has become hostage to the likelihood of another round of quantitative easing from the Federal Reserve. West Texas Intermediate has moved an impressive $18 off of its $77 low on the prospect of QE3 alone. All that is left is for Ben Bernanke to pull the trigger.

Our first chance at a hint will be at the Jackson Hole confab of central bankers on August 26. After that, we have to wait until the September 18-19 Open Market Committee Meeting for relief. It is safe to say that if Ben delivers, oil could be trading at triple digits very quickly. If he doesn?t, then we could be plumbing new lows shortly.

That put us in the same risk/reward dilemma for oil as with the equity markets. Note the imbalance. If we get QE3, then we can entertain $6 of upside. If we don?t, you are looking at $25 of downside. Hint: strapping on risk/reward trades like this is not how hedge fund managers get rich.

That makes me a happier buyer on the next big dip than a chaser up here. Names to focus on? ExxonMobile (XOM), Occidental Petroleum (OXY), and Cabot Oil & Gas (COG), as well as the master limited partnerships like Kinder Morgan (KMP), Enbridge Energy Partners (EEP), Trans Montaigne Partners (TLP), Linn Energy (LINE).

That?s all for today. It is hard to write brilliant, seamless prose when you?re brain dead and mindless from nine hours of jet lag. Besides, the whales are still on vacation at Southampton and the South of France, so my traditional sources of hot tips will remain dry for another week or so. Damn! I should have taken an extra week off to investigate economic conditions in the Greek Islands. With a Depression on, I hear that hotels that normally go for $2,000 a day can be had for $2,000 a week.

Reach for Yield With Master Limited Partnerships

Newsletter

The dramatic collapse in the price of oil is creating a rare opportunity to get into some of the highest yielding paper in the financial markets, master limited partnerships (MLP)?s. These are LP?s that are publicly traded on a securities exchanges. These unique and versatile instruments combine the tax benefits of a limited partnership with the liquidity of publicly traded securities.

Enbridge Energy Partners (EEP) is run by some of my former colleagues at Morgan Stanley and offers a 7.5% yield. Kinder Morgan Energy (KMP) posts a healthy 5% yield, while Trans Mountain (TLP) ups the ante with an 8% return. Linn Energy goes all the way up to an eye popping 8.5% yield.

Why the enticing cash flow? The problem is that these partnerships suffer from their guilt by association with Texas Tea, which has plummeted by nearly 30% since March 1. Although they have no direct exposure to the price of oil, investors tend to incorrectly classify them as energy stocks and dump them whenever oil falls. The great thing about these high yields is that you get paid to wait until crude makes a comeback, which it always does. Not a bad game to play in a zero return world.

To qualify for MLP status, a partnership must generate at least 90 percent of its income from what the Internal Revenue Service deems "qualifying" sources. For many MLPs, these include all manner of activities related to the production, processing or transportation of oil, natural gas and coal. Energy MLPs are defined as owning energy infrastructure in the U.S., including pipelines, natural gas, gasoline, oil, storage, terminals, and processing plants. These are all special tax subsidies put into place when oil companies suffered from extremely low oil prices. Once on the books, they lived on forever.

In practice, MLPs pay their investors through quarterly distributions. Typically, the higher the quarterly distributions paid to LP unit holders, the higher the management fee paid to the general partner. The idea is that the GP has an incentive to try to boost distributions through pursuing income-accretive acquisitions and organic growth projects.

Because MLPs are partnerships, they avoid the corporate income tax, on both a state and federal basis. Instead of getting a form 1099-DIV and the end of the year, you receive a form K-1, which your accountant should know how to handle. Additionally, the limited partner (investor) may also record a pro-rated share of the MLP's depreciation on his or her own tax forms to reduce liability. This is the primary benefit of MLPs and gives MLPs relatively cheap funding costs.

The tax implications of MLPs for individual investors are complex. The distributions are taxed at the marginal rate of the partner, unlike dividends from qualified stock corporations. On the other hand, there is no advantage to claiming the pro-rated share of the MLP's depreciation (see above) when held in a tax deferred account, like a IRA or 401k. To encourage tax-deferred investors, many MLP?s set up corporation holding companies of LP claims which can issue common equity.

Since 2003, MLPs as an asset class have grown astronomically, from $30 billion to $250 billion , and have also been the best performing asset class in the world over the last 10, 5, and 3 year periods. The recent discovery of new, massive gas and oil fields in the US and the rapid expansion of shale fracking should auger well for the rising popularity of this instrument.

Nope, Don?t See Any Yield Yet

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