This Little-Known Bond Play Could Generate A 24.6% Return

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Assured Guaranty (NYSE: AGO ) is in the business of insuring bond offerings for corporations and municipalities. Not the most exciting stuff, but the bond insurance industry is relatively small with only a few key players. Essentially, these insurers put their stamp of approval on new bonds sold by companies or municipalities and agree to back the principle for creditors in the case of default.

For undertaking this risk, the insurance company is paid a premium (typically by the selling party), which represents a recurring income stream until the bond actually matures. Selling parties, such as corporations, cities or counties, are willing to pay this premium because they can typically sell the bonds with a lower rate of interest because investors know that they are much more likely to receive their principal back at a bare minimum.

In addition to the spread between premiums received and claims paid out, insurance companies typically have a second major source of income. This income comes from returns on the massive amounts of capital that the insurance companies are required to hold as protection in the event that they are required to meet claims.

Over the past several years, it has been difficult for bond insurers to generate profit from this area because of the historically low interest rates. Not only is it difficult for AGO to make money on conservative investments like Treasuries and mortgage-backed securities, the broad market reach for yield has made it difficult to find attractive dividend stocks that have decent yields without too much risk.

With interest rates poised to rise as the Federal Reserve completes its bond-buying program , Assured Guaranty may be in for some relief on the investment side. The company recently sold $500 million in senior notes, which gives it a capital boost and can be invested in more attractive securities over the next year. The company has stated that it will use the cash for general corporate purposes, which may include buying back shares of its stock (which currently pays a 1.7% dividend yield).

A stock repurchase appears to make a lot of sense given the company's current balance sheet and market value. As you can see below, at the end of 2013, the company claimed an adjusted book value of $49.58 per share, while the stock is currently trading just above $23. If the balance sheet valuation is accurate, Assured Guarantee can create a tremendous amount of value for shareholders simply by purchasing its own stock at a discount to book value. (My colleague David Sterman recently profiled the best bargains in a different class of investments that are trading at a discount to their intrinsic value.)


Source: Assured Guaranty

In addition to the successful bond offering and opportunity to repurchase shares at a discount, AGO should be helped by an improving economy. As unemployment falls, the stock market continues to hold up well, and corporate profits expand, AGO should face less risk of default from the bonds it underwrites. Based on a significant discount to book value, potential for increased investment gains and a strengthening economy, I expect shares to trade higher.

The stock recently pulled back with the broader market, and the added volatility and lower price point provide an excellent opportunity for selling puts. Today, I want to sell AGO Oct 23 puts with a limit order of $1.30.

By selling these puts, we are accepting an obligation to buy 100 shares of AGO per contract at the $23 strike price if the stock closes below this level when the puts expire on Oct. 17. Since we are receiving $1.30 in option premium from selling the puts, our net cost will be closer to $21.70. We will need to set aside $21.70 per share (or $2,170 per contract) of our own capital for use in the event that the puts are exercised.

If AGO remains above $23, the $130 in income will represent a gain of 6% over the $2,170 in capital set aside. Since this will be generated over the next 89 days, our per-year rate of return comes out to 24.6%.

Assured Guaranty is expected to report earnings in the first week in August. Analysts are currently predicting earnings per share ( EPS ) of $0.55, up from $0.52 in the same quarter last year. For 2014, AGO is expected to earn $2.53 per share, giving it a forward price-to-earnings (P/E) ratio is in the single digits.

Action to Take --> Selling puts gives us a chance to set up an attractive income. Of course, if the stock drops and we are assigned shares at a net cost of $21.70, I am happy to make that investment as AGO represents a compelling value.

This article was originally published at ProfitableTrading.com:
The 24.6% Yield Hiding Out in the Bond Insurance Market (It's Not Junk!)




The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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