As noted by the Globe & Mail, the CD Howe Institute has released a paper by Paul R. Masson titled The Dangers of an Extended Period of Low Interest Rates: Why the Bank of Canada Should Start Raising Them Now:
In this Commentary, I argue that short-term rates are therefore too low in Canada, a situation that is starting to build in pervasive problems for the economy. Below-equilibrium interest rates for an extended period distort investment decisions, leading to excessive risk taking and inefficient and ultimately unprofitable investments. They also encourage the formation of asset bubbles whose collapse could lead to a recurrence of the recent financial crisis.
Some of the symptoms of inefficient investment and asset price bubbles are already evident in Canada, in the housing sector for instance. The cumulative effect of artificially low interest rates also risks fuelling an underlying inflationary process. Therefore, I recommend that the Bank of Canada start now to reverse some of the monetary stimulus and begin raising interest rates.
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Raising interest rates is never popular, but keeping rates low for too long builds in pervasive problems for the economy. Interest rates in nominal terms are at record low levels and negative in real terms, even though Canada’s GDP is only slightly below capacity. At the same time, there are symptoms of distortions created by low interest rates in financial markets: unfunded pensions, losses by insurance companies, excessive household debt, high house prices, and a bias toward high-yielding equities. Extremely low interest rates mean that the Bank of Canada has a long way to go before they approach a neutral setting. The time has come for the Bank to start raising interest rates gradually to lessen the continued build-up of financial imbalances.
This is a timely report because Assiduous Reader AG has sent me a link to a alarmist report on client communications at UBS:
UBS is planning a mass mailing to many of its brokerage clients alerting them that they have been reclassified as “aggressive” investors following a recent change in its market outlook that some people inside the firm say reflects growing bearishness in the bond market, particularly over the long term, the FOX Business Network has learned.
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In late January, UBS (UBS) changed its “strategic asset allocation guidelines,” or the broad parameters used to classify its brokerage clients depending on their mix of stocks, bonds and other investments in their portfolio, people at the company tell FOX Business.According to brokers inside UBS, new guidelines will reflect a growing belief among the firm’s market strategists that the bull market in bonds has largely run its course, and that those investors who believed they had constructed a “conservative” portfolio by being heavily invested in bonds could be reclassified as “aggressive.” Some also believe the move may be an attempt by the firm to lessen its liability in the event clients who are holding large positions in bonds decide to take legal action against UBS.
Mike Ryan, the chief investment strategist for UBS, said so-called “non consent” letters will be sent out to investors in the coming weeks alerting them of their changed classification – but he says it has little to do with a firm-wide bias against bonds. Rather, UBS is changing “its long-term view” reflecting what it views as a “volatile market…not just in fixed income.”
The concerns regarding legal liability are dumbfounding, but seem reasonable enough. One ambulance-chaser writes:
On February 14, 2013, FINRA, the Financial Industry Regulatory Authority, sent a very sober Valentine’s Day card to bond investors in the form of an Investor Alert. The Alert probably should have been sent much earlier. It acknowledges what most brokerages already know: 1) that the bond bubble is about to burst; 2) that investors should beware of ever increasing risks in bond investing; and 3) that the life’s savings of bond investors is at risk of evaporating. Most bond investors are risk adverse, so this comes as very unwelcome news. Making matters even worse, most bond investors will never see this warning since most bond investors are also unsophisticated investors who are unaware of things like FINRA Investor Alerts.
Brokerage firms are taking very different approaches to pass this information along to investors. As reported in the Investment News on February 1, 2013, TD Ameritrade is sending a warning to its investors that the popping of the bond bubble is not a question of “if” but a question of “when”.
Fox Business reports UBS has taken the unprecedented step of changing the objectives of all of its bond investors from “conservative” to “aggressive.” www.foxbusiness.com/investing/2013/02/01/ubs-set-to-classify-bond-buyers-as-aggressive/ . This is akin to reclassifying Titanic passengers as Olympic swimmers in the hours prior to hitting the iceberg – you can call them what you want but it does not increase their chances of survival when the impending tragedy strikes.
Investors have rights to obtain recovery if the bond bubble bursts. They can seek recovery if their portfolios were over-concentrated in bonds prior to the bubble bursting. Additionally, bond investments will be seen as unsuitable since the investment would be for a much greater risk than most bond investors agreed to take. The bubble bursting will not be much of a Valentine’s Day present, but at least investors have recourse.
The handwringing over FINRA’s notice seems somewhat overwrought. As well as I can determine, the reference is to the Investor Alert Duration—What an Interest Rate Hike Could Do to Your Bond Portfolio:
Currently, interest rates are hovering near historic lows. Many economists believe that interest rates are not likely to get much lower and will eventually rise. If that is true, then outstanding bonds, particularly those with a low interest rate and high duration may experience significant price drops as interest rates rise along the way. If you have money in a bond fund that holds primarily long-term bonds, expect the value of that fund to decline, perhaps significantly, when interest rates rise.
So, taking these three straws in the wind in reverse order, the FINRA statement is nothing more than a well-timed reminder of the price volatility of long-dated instruments. It is not so long ago since the first quarter of 2007, when a huge number of Straight Perpetuals were sold to highly unsophisticated investors who were astonished when the price declines reached 40% at the nadir. In a recent speech reported on PrefBlog on May 10, Bernanke went so far as to say:
In light of the current low interest rate environment, we are watching particularly closely for instances of “reaching for yield” and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move. Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves.
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Also to be considered are factors such as the leverage and degree of maturity mismatch being used by the holders of the asset, the liquidity of the asset, and the sensitivity of the asset’s value to changes in broad financial conditions.
In other words, the Fed is perfectly well-aware that its policies encourage risk-taking – that is the whole point of monetary policy in the first place – but is desirous, insofar as possible, that this risk-taking take place within a rational framework; that the risk-takers understand that they are taking risks.
When one who has been oblivious to risk is suddenly confronted with the fact that risk not only exists but has worked significantly against him, panic ensues. We saw plenty of that in the crisis.
So I regard the FINRA statement as being nothing more than a reminder of the nature of risk: Don’t buy Fund A simply because the yield is reported as 3% as opposed to 2% on what you hold now! Be aware of interest rate risk, and how it is measured by duration, at the very least!
The ambulance-chaser’s assertions are ludicrous and simplistic, but probably a decent enough piece of marketing. I will fault it for its completely unwarranted inference that:
It acknowledges what most brokerages already know: 1) that the bond bubble is about to burst; 2) that investors should beware of ever increasing risks in bond investing; and 3) that the life’s savings of bond investors is at risk of evaporating.
The first is completely nuts. The brokerages know nothing. One of the great myths of finance is that brokerages have some kind of clue about what’s going to happen in the future and it continues to surprise me that this myth has survived the Credit Crunch.
Brokerages are trading operations. Their objective is to buy something from me for a nickel and sell it to you for a dime. They do not care, nor should they care, about which of us will be happier about the trade after a year has passed.
And the idea that the entire life’s savings of bond investors is at risk of evaporating is nonsensical. It will take a very severe bond market indeed to make even long-bond investors lose half their money. If we consider a current-coupon thirty-year Treasury at 3%, the price only breaches $50 at yields of 7%. Could it happen? Of course. Will it happen? That’s a much more difficult question; I suggest it’s unlikely as long as inflation expectations remain anchored at somewhere below 4%. If it does happen, can such a situation be described as the evaporation of life’s savings? Well, you tell me. Better yet, tell the judge.
However, I will reserve most of my ire for the UBS plans regarding bond investors – and I will take the time to note that I can find no commentary indicating that they actually followed through on these plans, nor any that would indicate the details of such plans. It seems reasonable to assume, for instance, an account holding solely short-term bonds would receive a different classification from one exclusively invested in long-term, but such refinements are not discussed in the stem article.
It seems likely that the plans, such as they were, were indeed “an attempt by the firm to lessen its liability in the event clients who are holding large positions in bonds decide to take legal action against UBS.”, which simply illustrates a prevalent attitude today that anybody who suffers the loss of so much as a nickel in the markets is obviously an innocent victim of cunning stockbrokers who knew precisely what was going to happen but didn’t care. I can only be grateful that there are still some vestiges of sanity left in the world:
Click for Big
But there are other problems, for instance:
new guidelines will reflect a growing belief among the firm’s market strategists that the bull market in bonds has largely run its course
This is nonsensical. This represents a market call by the firm’s “market strategists” and to reclassify investors on such a basis is saying that they represent the benchmark for prudent investment and that riskiness is measured by the degree of deviation from their recommendations. Not just nonsensical, but egomaniacal. Not just egomaniacal but narcissist.
UBS, in fact, is a poster-child for total cluelessness regarding market direction.
Particularly irritating is one of the other possible rationales for the putative decision:
Rather, UBS is changing “its long-term view” reflecting what it views as a “volatile market…not just in fixed income.”
Classifying investment risk as a function of volatility is a sign of ignorance whole-heartedly endorsed by regulators and incompetent investors because they read it in a book.
Investment risk is, as I have argued on many occasions, a function of the probability of meeting your investment goals.
Say your investment goal is to make $3,000 p.a. and you have $100,000. Then, I suggest, one of the least risky investments you can make is to plunk the whole damn thing into a thirty year treasury; nothing else is as likely to continue paying you the $3,000 p.a. for thirty years. Naturally, it would be better to plunk the money into a diversified portfolio with the same broad characteristics because, as is known to everybody except regulators and incompetent portfolio managers, risk is a vector. There are different kinds of risk, and to talk of risk as a scalar quantity is to destroy the point of the conversation.
I will go further. Even safer than the thirty year Treasury recommended for the purpose above would be a US Government perpetual bond, if any existed. This would be somewhat more volatile than the thirty-year bond in price terms, but would reduce the risk of the portfolio by addressing the question of ‘What happens after thirty years?’.
Naturally, different portfolio objectives will lead to different perspectives on the riskiness of various methods used to accomplish those goals. If I have $100,000 and my portfolio objective is to use the money to buy a house in one month’s time, then investing the whole thing in a government perpetual would be insanely risky. Far better would be a one-month treasury bill.
And if my portfolio objective is to make $3,000 p.a. AFTER INFLATION, then holy-smokes, the thirty-year treasury bond just got risky again. How about that?
And, in my favourite example ever, if you have $1 and your portfolio objective is to make $1-million before next Tuesday, then your least risky investment is a lottery ticket. The chances of success, while miniscule, are higher than with anything else – although a prudent person will be well-advised to redefine his portfolio objectives until a significant chance of success can be reasonably estimated.
To talk of “risk” in the absence of clearly defined desirable rewards is just craziness. I should work this up into a proper article some day.
Speaking of market forecasting, the Bank of Canada published a paper by Ian Christensen and Fuchun Li titled A Semiparametric Early Warning Model of Financial Stress Events:
The authors use the Financial Stress Index created by the International Monetary Fund to predict the likelihood of financial stress events for five developed countries: Canada, France, Germany, the United Kingdom and the United States. They use a semiparametric panel data model with nonparametric specification of the link functions and linear index function. The empirical results show that the semiparametric early warning model captures some well-known financial stress events. For Canada, Germany, the United Kingdom and the United States, the semiparametric model can provide much better out of-sample predicted probabilities than the logit model for the time period from 2007Q2 to 2010Q2, while for France, the logit model provides better performance for non-financial stress events than the semiparametric model.
Me, I just use a Magic 8-Ball: Reply Hazy. Try Again Later.
It was a modestly negative day for the Canadian preferred share market, with PerpetualPremiums off 11bp, FixedResets down 12bp and DeemedRetractibles flat. Volatility was minimal. Volume was a little below average.
PerpetualDiscounts now yield 4.89%, equivalent to 6.36% interest at the standard equivalency factor of 1.3x. Long Corporates now yield about 4.15%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 220bp, a slight – and perhaps spurious – narrowing from the 225bp reported May 8.
| HIMIPref™ Preferred Indices These values reflect the December 2008 revision of the HIMIPref™ Indices Values are provisional and are finalized monthly |
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| Index | Mean Current Yield (at bid) |
Median YTW |
Median Average Trading Value |
Median Mod Dur (YTW) |
Issues | Day’s Perf. | Index Value |
| Ratchet | 0.00 % | 0.00 % | 0 | 0.00 | 0 | 0.3899 % | 2,559.9 |
| FixedFloater | 3.85 % | 3.06 % | 32,010 | 18.91 | 1 | 0.7755 % | 4,270.0 |
| Floater | 2.72 % | 2.94 % | 82,509 | 19.85 | 4 | 0.3899 % | 2,764.0 |
| OpRet | 4.83 % | 2.35 % | 68,946 | 0.13 | 5 | 0.0054 % | 2,613.9 |
| SplitShare | 4.79 % | 4.09 % | 105,021 | 4.05 | 5 | -0.0627 % | 2,967.1 |
| Interest-Bearing | 0.00 % | 0.00 % | 0 | 0.00 | 0 | 0.0054 % | 2,390.2 |
| Perpetual-Premium | 5.20 % | 3.04 % | 91,044 | 0.79 | 32 | -0.1122 % | 2,377.6 |
| Perpetual-Discount | 4.85 % | 4.89 % | 193,673 | 15.62 | 4 | 0.1219 % | 2,684.8 |
| FixedReset | 4.88 % | 2.68 % | 253,218 | 3.35 | 81 | -0.1186 % | 2,518.2 |
| Deemed-Retractible | 4.87 % | 3.33 % | 133,098 | 0.92 | 44 | 0.0026 % | 2,460.5 |
| Performance Highlights | |||
| Issue | Index | Change | Notes |
| HSE.PR.A | FixedReset | -1.39 % | YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2043-05-15 Maturity Price : 23.57 Evaluated at bid price : 25.51 Bid-YTW : 3.01 % |
| Volume Highlights | |||
| Issue | Index | Shares Traded |
Notes |
| CU.PR.G | Perpetual-Premium | 1,121,508 | New issue settled today. YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2043-05-15 Maturity Price : 24.67 Evaluated at bid price : 25.07 Bid-YTW : 4.49 % |
| RY.PR.P | FixedReset | 126,907 | National crossed 49,500 at 25.74. RBC crossed 50,000 at the same price and bought 19,200 from Nesbitt at the same price again. YTW SCENARIO Maturity Type : Call Maturity Date : 2014-02-24 Maturity Price : 25.00 Evaluated at bid price : 25.69 Bid-YTW : 2.45 % |
| TRP.PR.A | FixedReset | 59,965 | Scotia crossed 50,000 at 25.50. YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2043-05-15 Maturity Price : 23.85 Evaluated at bid price : 25.47 Bid-YTW : 3.14 % |
| FTS.PR.G | FixedReset | 57,039 | Nesbitt crossed two blocks of 25,000 each, both at 25.12. YTW SCENARIO Maturity Type : Call Maturity Date : 2013-09-01 Maturity Price : 25.00 Evaluated at bid price : 25.11 Bid-YTW : 2.95 % |
| RY.PR.L | FixedReset | 55,186 | National crossed 50,000 at 25.62. YTW SCENARIO Maturity Type : Call Maturity Date : 2014-02-24 Maturity Price : 25.00 Evaluated at bid price : 25.63 Bid-YTW : 2.14 % |
| RY.PR.W | Perpetual-Premium | 49,020 | Desjardins crossed blocks of 14,500 and 24,000, both at 25.45. YTW SCENARIO Maturity Type : Call Maturity Date : 2013-06-14 Maturity Price : 25.25 Evaluated at bid price : 25.41 Bid-YTW : -4.25 % |
| There were 27 other index-included issues trading in excess of 10,000 shares. | |||
| Wide Spread Highlights | ||
| Issue | Index | Quote Data and Yield Notes |
| CU.PR.C | FixedReset | Quote: 26.40 – 26.65 Spot Rate : 0.2500 Average : 0.1661 YTW SCENARIO |
| TD.PR.O | Deemed-Retractible | Quote: 25.72 – 25.99 Spot Rate : 0.2700 Average : 0.1880 YTW SCENARIO |
| PWF.PR.R | Perpetual-Premium | Quote: 26.67 – 26.96 Spot Rate : 0.2900 Average : 0.2154 YTW SCENARIO |
| SLF.PR.D | Deemed-Retractible | Quote: 24.60 – 24.79 Spot Rate : 0.1900 Average : 0.1241 YTW SCENARIO |
| ENB.PR.F | FixedReset | Quote: 25.65 – 25.83 Spot Rate : 0.1800 Average : 0.1158 YTW SCENARIO |
| ENB.PR.B | FixedReset | Quote: 25.71 – 25.88 Spot Rate : 0.1700 Average : 0.1089 YTW SCENARIO |
I was wondering if you had any thoughts on the somewhat lackluster pricing action on CU.PR.G? Volume seemed decent but al least as of this morning prices have stayed below at least what I would have expected.
It’s trading pretty close to the virtually identical CU.PR.F. What price are you expecting, and why?
I missed CU.PR.F all together and was comparing it with an older rate reset I own CIU.PR.C of which this new one is superior. I guess I was thinking that it would open and stay at a price level closer to $25.40 or so. The longer people are starved for yield the better these investments look.
“a growing belief among the firm’s market strategists that the bull market in bonds has largely run its course”
Somebody should wind back the clock and see if this was ever said about Japan. How about the possibility that there is so much debt and need for deleveraging in developed countries that deflation might be more likely than inflation for quite a period? Gold might be telling that story.
I suppose there is a corresponding “growing belief” among brokers and strategists that a long term equity bull market is underway when profits are barely growing.
Shall we follow the herd or think for ourselves? With Canada poised for some grief around housing and a slowing economy, there may be a greater chance of a near term rate cut than increase.
I wish we knew. We don’t, so maybe it is a good idea to stay focused on income and consider two-sided potential moves.
[…] PerpetualDiscounts now yield 4.94%, equivalent to 6.42% interest at the standard equivalency factor of 1.3x. Long corporates now yield 4.16% so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 225bp, a slight increase from the 220bp reported May 15. […]