IEI - Treasuries Are Lagging The Market And There Is Something Even Better

2023-07-18 17:29:04 ET

Summary

• Tennessee Valley Authority PARRS D 2028 is undervalued to its corresponding benchmark treasuries.
• iShares 3-7 Year Treasury Bond ETF is the best security to serve as a benchmark for TVC.
• Writing a call option in IEI can boost the YTM of the AA+ security TVC to 6.70% for the next 5 years.

All option calculations are hypothetical and are used to determine fair value based on generally accepted standards.

Overview

The several increases in the Fed Funds Rate throughout the last year and a half created a lot of mispricing in the exchange-traded debt instruments, giving sophisticated investors attractive opportunities to profit from. Our investment group is on a constant watch for these chances, and we try our best to exploit them to our benefit. Should the investing ideas be really good ones in our opinion, we like to share them with you.

The mispriced investment vehicle we would like to turn your attention to with this short article is Tennessee Valley Authority PARRS D 2028 ( TVC ) - an exchange-traded baby bond (PARRS stands for "Putable Automatic Rate Reset Securities") issued by the federally-owned utility company Tennessee Valley Authority ("TVA"). It has once again widened its credit spread to its corresponding benchmark with no sound financial logic behind it. In our recent article "8 Income Picks For Any Taste With Yields From 5 To 10+%" we presented its brother Tennessee Valley Authority PARRS A 2029 ( TVE ) that was in a similar situation at the time.

This time, however, our idea is a little bit different. We would like to offer a covered call option strategy in the corresponding benchmark, iShares 3-7 Year Treasury Bond ETF ( IEI ), that will boost the yield of the security we already like. The article's focus will be set on the U.S. treasury yield curve in combination with a mispriced high-grade investment vehicle and how we can profit from it. So let's dive into the analysis.

Yield Curve

In the screenshot below is the US Treasuries Yield curve that is obviously inverted at the current moment.

Due to the several increases in the Fed Funds Rate in the last year and a half, the short-term treasury yields are higher than the ones for the longer time frames.

TVC

TVC and its brother TVE are among our favorite exchange-traded fixed-income products. The baby bonds have a credit rating of Aaa by Moody's and AA+ by S&P, so they carry the same credit risk as the USA itself.

We have made an in-depth analysis of the two very similar issues in our article , "TVE And TVC The Safest Part Of Our Portfolio" and anyone interested in the details should feel free to check it out. As of the moment of writing this one, TVC is trading at 5.16% YTM with a price of 21.88$. With 5 years to its maturity date and a duration of 4.5, TVC has very limited duration risk. When issued on 06/02/1998 it had initial distributions of 6.75% per annum and the corresponding at the time benchmark - the 30-year constant maturity treasuries had a yield of 5.8%.

However, as time has passed since the IPO, the corresponding ETF will not be iShares 20+ Year Treasury Bond ETF ( TLT ) since the duration of TVC at the moment has deviated significantly from the TLT one:

As TVC has 5 years left to maturity, its benchmark now is the 5-year treasuries. The corresponding ETF should be one that holds this type of government notes, with a duration as close as possible to the TVC's 4.5 one.

IEI

The perfect candidate, in our view, is the IEI - iShares 3-7 Year Treasury Bond ETF mentioned above.

Holding Treasuries with a maturity from 3 to 7 years and having a duration of 4.4, IEI is the best ETF we could find that represents a "benchmark" for TVC, as they are almost identical in metrics.

The trade

In order to evaluate the "fair value" of TVC's credit spread to its corresponding benchmark, we will use the last four mid-term debt issues TVA has placed. We will use two 5-year and two 10-year TVA bonds that are shown below.

The logic behind this is that every security should be fairly priced at its IPO. In the process of IPO, each security is evaluated thoroughly by top-tier professionals, and the credit spread it receives to its corresponding benchmark at that moment is of key importance for future evaluations. We, as self-respecting investors, of course, are highly interested in the debt IPO credit spread of the company, as it gives us the most accurate basis for evaluating securities pricing at the current moment.

The average credit spread to corresponding treasuries for the IPOs above is 0.31% and as they were the last TVA debt issues with durations similar to the TVC one, we should accept that this value is relevant for TVC's target credit spread. At the moment we have a 4.19% yield for the 5-year treasuries and TVC is trading at 5.15% YTM. With almost a 1% credit spread and 0.3% calculated for a "fair one," TVC is undervalued as it is. The thing is, that we believe it can be an even more appealing investing opportunity with a little bit more digging to be done. So it follows.

As explained above, IEI is the ETF that can most closely represent the treasuries that are a benchmark for TVC. The simplest way for an investor to take advantage of the TVC credit spread widening would be to go long the baby bond, short the same dollar value in IEI, and wait for the spread to narrow. As in every pair trade, there are some risks included: the spread can widen and the short holding cost can become too high, to name a few. In our opinion, there are no financial reasons for the spread to widen, but then again the market is not always moved by financial reasons. As for the short locate of IEI - at the moment it is around 1%, but over time it can change, and if the mispricing is not closed in a foreseeable time period, the costs can become considerable.

What we want to offer to your attention is an idea to boost the YTM of TVC by selling call options in IEI. The yield-boosting idea is similar to the one discussed in our recent article "The Smart Way To Invest In EPR Properties: The Preferred Shares." The risks of options and shorting should be fully understood before attempting any transactions using them.

If we sell a 5-year call option in IEI at a strike price of $117 USD and the price of the ETF ever reaches $117 USD within the 5-year time period, we will be short 100 shares or $11700 USD value in IEI. The same dollar value corresponds to 535 shares of TVC at its current price of 21.88 USD. So the profit of 10.51 USD from the call option can be used to boost the return of 535 shares of TVC over a 5-year time period.

Conclusion

IEI is the most suitable ETF to represent a benchmark for TVC, however, at this price level, we do not intend to take a direct short position in it. This, however, does not mean that we cannot use it. By selling a call option at a strike price we like, we can use the proceeds to boost the YTM of the baby bond that is already underpriced. If our calculations are correct, we managed to push the yield of the best credit-rated exchange-traded security to well above most of the puffed-up bank preferreds.

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