The last several days, I’ve been analyzing and re-analyzing the credit default swap portfolio on the books at Primus Guaranty (PRS), as well as the capital cushion present in a run-off scenario - which the company is effectively in, given how little business is being written with the current environment.

This is prompted partly by the sell-off in the stock, which I recently bought, as well my interest in purchasing some of the preferred notes Primus offered. Those are currently trading at $10.50 against a par value of $25, with a yield of 16.5%.
One person suggested that I leverage up and start doing a borrow-short, buy-long and capture the fairly large differential between the two. As tempting as that sounds, it’s simply too much risk to do so and is almost Long-Term Capital-esque in its execution. The post-mortem on LTCM is essentially that they leveraged up into illiquid assets at the wrong time, and were margin called out of existence. Could the same thing happen here? Yes and no. Primus won’t run into liquidity issues because it doesn’t need to post collateral, but adding leverage personally would create that kind of risk… ah, the benefits of being an AAA/Aaa CDPC.
That, more than anything else, is why I would not leverage into PRD, regardless of my confidence in the capital cushion of Primus’ swap portfolio. Here are two rough estimates of capital cushion, both as run-off scenarios, but showing the different risk profile existing between preferred and common stock.

First, Primus has $871M in cash and investments, on which it should earn (present valued with a 3.35% discount rate) about $118M in interest or investment income over the 3.6 year average duration of the company’s swap portfolio. Future premium streams discounted at the same rate are worth another $355M, and this is relative to PV’d cash expenses over that time period totaling $192M - I think that number is on the high side, as I assume no curtailment of expenses as the swap book winds down, but I’ll leave some room to be conservative.

Additionally, there is $329M in outstanding senior debt, and the par value of the preferreds is another $99M. Netting those against the earlier figures yields a capital cushion of $720M, or just under 3% (298 bps) of the swap portfolio. Given that the average credit loss rates on all corporate debt (i.e. investment grade, as well as junk) has averaged 0.9% over the last 25 years according to Moody’s, and the loss rates for pure investment grade debt have never surpassed 0.5% in any one year, I think the preferreds are a great risk-reward play. While it isn’t time to overreach for yield in most places, the risk exposures underlying the safety of that big yield seem very clear to me in this case…

Moving to equity, the current market capitalization of $145M means that a $575M capital cushion exists before the equity base takes a real hit; this works out to 236 bps on the swap portfolio. Again, with the concentration limits in place and the underwriting discipline I’d like to think Primus exercised, even that amount seems on the high side. I simply don’t think that corporate defaults will be widespread enough to cause that kind of damage to Primus’ portfolio; $575M represents a complete wipeout (no recovery) on seven BBB-rated debts underwritten to maximum capacity. Because it’s doubtful that Primus is near maximum capacity on their names, it would seem to take a multiple of that number of defaults before we get even close to breaching the $500M loss mark.

In short, Primus is a bet that the company won’t get black-swanned out of existence by an unprecedented rate of corporate defaults. Unless we see an extremely deep recession reminiscent of the Great Depression, I think Primus - and now, more specifically the preferred notes - are a good yield play with great capital appreciation possibility as well.

See the Primus Guaranty (PRS) Stock Report.

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Disclosure: I own shares of PRS, and am considering a purchase of PRD.