When Premiums Make Sense

In the car industry there are rare events where certain cars sell at a premiums to MSRP when the product is rare and not likely to ever be available again.

While it's useful to know fact from fiction, especially in something that's easy to mathematically quantify, it's also good to know free market prices that are out of line with traditional pricing models don't necessarily indicate irrational behavior. Context is always the most important thing. While "bubble" is one of the most popular words in the investment community today, not everything you see that you don't value highly is a bubble. Context is everything.

When context lines up with analysis, you have strong forces at play. Such was the case in the dot.com bubble and the more recent real-estate bubble. On the other side of such crisis, when context no longer lines up with analysis, you have to put aside computer models and add human insight. In the case of PHK, the context is a rare bond market dynamic unavailable to retail investors. So it's not irrational for buyers to pay a premium to get a piece of something that won't be available shortly, specifically because it has very, very strong fundamental market forces behind the assets, and many of those assets are still priced to account for the end of the American economy within thier lifetime.

If $1.3 trillion of newly created money weren't chasing the bond market; if the Federal Reserve wasn't the primary market maker in commercial paper; if MBS and CDO bonds were trading in a free market; then PHK would probably be the worst product on earth. But this is not a free market. The dynamics of a deep pocket buyer chasing what no one else wants is unlikely to ever occur in my lifetime. Owning anything that has that kind of demand behind it can't be evaluated by traditional methods.

When the Delorean sold over MSRP, it wasn't foolish for those who paid the premium to get it while they could, because those who knew the auto market knew the prices would never be that cheap again, and the opportunity was limited. Now in hindsight we can see Delorean motors collapsed. So if you think the bond market and Federal Reserve buying program is going to collapse, you should not be participating in these bonds. But if you think the market is normalizing like it did in the other crisis, then a little investigation of fundamental forces is in order.

For months I would read John Mualdin describe the valuation of collateralized debt and the out of proportion pricing relative to real risk during the worst of the credit crisis. Every time I would salivate over the chance to buy those out-of-favor bonds as the irrational fear that the world as we know it was going to end tomorrow drove prices of even well-structured bonds into the ground. Not having a Bloomberg terminal or a bond trader's account, there was a fundamental opportunity of a lifetime that I had no way on earth to participate in. Then I discovered PIMCO was chasing that market for the same reason and in the same way I wanted, and had a vehicle available for me to jump on.

I paid a premium to get a piece of it because a) there was no other way for a common citizen to sell junk to the Federal Government at top dollar, and b) there were no option contracts I could buy to lock in the inevitable rise in price for this class of bonds, and c) Ben Bernanke's actions made it undeniably clear there was nothing on earth in the financial market that he wasn't willing to buy - nothing, not even the worst junk imaginable.

Like an option, there's no guarantee the market moves in your favor. One has to know the deeper fundamentals behind the cash flows and demands for the assets of the entity in question. You can't just look at the balance sheet values of the Real Estate assets of Sears Holdings Corporation (SHLD) and know what it's really worth. You have to know the actual location of that real estate and whether the real estate market itself will sustain, threaten, or increase that value. If the market for those R/E assets is drying up, SHLD may be overpriced. If they have a large government revitalization program behind them, SHLD may be under-priced. The issue boils down to whether the retail market has realized those values yet, or not. Price to book value may grow far more quickly than book value, primarily because book value is constrained while human intellect is not, even if abstractions and market forces not quantifiable by GAAP make it clear where future book values are most likely to move.

If we revisit this CEF when the credit crisis of 2008 is a distant memory, after bond spreads have normalized, and it still trades at a high premium, then I will join the short-seller's camp. Until then, Uncle Ben and Tim are ensuring the bonds I own through PHK have a strong, liquid, demand-driven market. I don't know any other product on earth that has an avid open buyer standing in the wings with an unlimited supply of blank checks to buy product.

When that buyer departs, things will change. But at this point their interest is strong and reliable.