Category: Market Action

So it seems that money managers aren’t the only ones who appreciate the benefits of lying to their clients with the opacity of private equity valuations: large institutional investors want to get in on the action too:

Speaking at a panel discussion held by the Ontario Securities Commission debating the question “do public markets matter any more?” Mr. Flatt said public and private markets are symbiotic and that Brookfield operates in both. However, he also predicted that within the next 10 years, more than 30 institutional investors around the world – each with more than US$1-trillion in assets – will prefer private markets.

“They have to have things in the public markets, but the sums are so vast that they don’t want the distractions of the public markets on a day-to-day basis for all their capital, they just want to buy businesses,” Mr. Flatt said. “Public markets is just the ownership of a fractionalization of a business, but most people get confused because they think it is a casino.”

“That is why the private markets continue to grow, because these large funds have US$200-billion or US$500-billion or a trillion or two trillion, don’t want to have the distractions of the public markets for everything they own in their portfolio and be at the vagaries of the markets that go up and down on a daily basis,” he said.

Distractions? Distractions to whom? An actual investor will see opportunity in the chaos, distinguishing fundamental risk from emotion-driven price risk and profitting from the gaps.

By the size of the Assets Under Management that Mr. Flatt mentioned, it’s pretty clear that by “institutional investors” he means “Sovereign Wealth Funds”; and here I want to point out that there are two kinds of investment shops operating under the “single captive client” regime that I think is so superior (in general) to the alternatives.

The first kind does all their investment management in-house. The second kind farms out their investment management to third party firms. My admiration extends only to the former group; with the latter group, what you actually get is not performance driven management from people who know what they’re doing – the farming-out consists of one set of salesmen talking to another set of salesmen about things they don’t understand and writing each other cheques. There are a lot of firms who do some of both, of course; but Sovereign Wealth Funds, especially those who consider nepotism and cronyism as integral elements of Human Resource management, will not send their top guys to negotiate and monitor third party management.

[Law professor at Boston College Renee] Jones said public markets are shrinking and private markets are growing very rapidly, and the biggest concern that raises is about transparency.

“We are seeing more instances of mismanagement and misconduct and even fraud at these unicorns,” she said, using the term for private companies valued at more than US$1-billion. “That doesn’t just impact investors – it also impacts employees and even broader society.”

Indeed. I’m eagerly awaiting a massive report on the Thames Water fiasco and those of us with long memories will think back to the Alberta Heritage Fund, or whatever it was called, and its habit of recording spending on hospitals and their equipment as an investment and keeping it on the balance sheet. My God, imagine what they would have done with private equity!

PerpetualDiscounts now yield 6.55%, equivalent to 8.52% interest at the standard equivalency factor of 1.3x. Long corporates yielded 5.19% on 2024-5-10 and since then the closing price of ZLC has changed from 14.76 to 14.94, an increase of 122bp in price, implying a decrease of yields of 10bp (BMO reports a duration of 12.32, but don’t disclose whether this is Macaulay or Modified; I will assume Modified) to 5.09%. Therefore, the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has widened to 345bp from the 335bp reported May 15.

Sorry this is late – I went to the Blue Bovine Steakhouse last night and didn’t have time to pack up the day. It’s an OK place. One big problem is that the gross incompetence shown by the City of Toronto in projects of any size has manifested itself in a virtually total lack of signage in Union Station, where the restaurant is located. After arriving early, I wandered around the enormous structure for a good twenty minutes, looking for something that looked like it might be the place or at least a map of the facility before giving up and asking a security guard, who directed me. BB should include a map on its website! It’s located near the north-east corner of the ground floor, by the way – but is so high-end that it doesn’t have any signage to announce itself, so I was gazing in bafflement at only the second map (the first one didn’t show my destination) I had found during my ordeal when my guest came out of the restaurant to grab me and confessed that he’d gotten lost as well.

Anyway, the place follows the unfortunate trend of Toronto steakhouses (by which I mean Jacob’s) of adopting the “Industrial Cafeteria” style of seating plans, presumably on the grounds that the more people you can conceivably cram in per square foot, the better. I miss the Tom Jones and Carman’s more and more with every passing year.

It has also adopted Morton’s annoying habit in the greeting from the waiter: “We know you’re illiterate, so I’d like to show you the menu and explain how it works, and since you’re both obviously bumpkins who’ve never been to a restaurant before, I’d like to carefully explain what each item on the menu is.” I can’t stand it, but I pride myself on my placid and forgiving personality, so nobody was hospitalized.

The side-orders available were, we were assured, enormous and suitable for sharing. Well, perhaps, if you’re of extremely small stature. They were pretty skimpy for sharing – not much, if any, larger than a single serving. The mushrooms were good, but the onion rings could have been from any decent diner in Toronto.

The meat itself was excellent and well prepared. But I expect that.

The dessert menu appears to have been provided by Acme High-End Restaurant Dessert Menu Company: uninspiring. I am of the firm opinion that steakhouse dessert menus should be unusual and fun (I enjoy the banana splits at Barberians and had some great ‘bananas set on fire’ at Hy’s; I retain fond memories of the Apple Beignets at the Tom Jones), but this one just had about eight items from the “Things People Like When They’re Eating at Corporate Expense” column of Acme’s template. In partial mitigation, they offered Banana Crepes Flambee, but I wasn’t in the mood for crepes of any description.

All in all? Adequate. No more than that.

Canadian inflation ticked down a bit:

Canada’s annual inflation rate slowed to 2.7 per cent in April, matching analyst expectations and bolstering the case for the Bank of Canada to start cutting interest rates this summer.

Core measures of inflation, which strip out price movements, have also continued to trend lower.

Inflation has now fallen within the Bank of Canada’s target band of 1 per cent to 3 per cent for four consecutive months. The next interest rate announcement is on June 5.
…
For many renters, the cost-of-living emergency has already reached crisis point. Households without a mortgage have been falling behind on credit card and auto loan payments at increasing rates, according to the same report. That trend is likely driven by tenants struggling to keep up with rent, analysts say.

And soaring rents are rapidly spreading to the last few affordable areas of the country. Alberta recorded annual rent inflation of 16.2 per cent in April, nearly twice the national rent inflation of 8.2 per cent, according to the Statscan data.

And a different rental survey showed double-digit rent increases have also reached Saskatchewan. The province saw annual rental growth of 18 per cent in April, according to a report by real estate research firm Urbanation and rental platform Rentals.ca, which measures asking rents on vacant units.

But, as usual, the markets got excited anyway:

Swaps Market Before Announcement

Swaps Market After Announcement

So OMERS has written off Thames Water:

The Ontario Municipal Employees Retirement System (OMERS) has written off its entire investment in troubled British utility Thames Water, walking away from a stake once valued at well over $1-billion.

Thames Water has been struggling under the weight of more than £18-billion ($31-billion) of debt that has become more expensive with high interest rates. In late March, its shareholders – of which OMERS is the largest – refused to inject more money into the beleaguered company, casting doubt on its viability.
…
As of Dec. 31, 2021, OMERS had valued the part of its stake held through its Singapore subsidiary at £990-million ($1.7-billion).

The BBC adds:

When the company was privatised in 1989, it had no debt. But over the years it borrowed heavily and is currently £15.4bn in debt.

A large proportion of that was added when Macquarie, an Australian infrastructure bank, owned Thames Water, reaching over £10bn when the company was sold in 2017.

Macquarie said that it invested billions of pounds in upgrading Thames’s water and sewage infrastructure, but critics argue that it took billions of pounds out of the company in loans and dividends.
…
In March, Kemble shareholders halted a £500m down-payment on that promised cash injection when regulator Ofwat rejected plans to raise customer bills by 40% above inflation over the next five years.
…
Throughout this crisis, Ofwat has insisted that Thames Water – despite its huge debts – generates £2bn a year in inflation-linked income, which might be attractive to someone.
…
The challenges facing Thames Water are formidable. In Finsbury Park, north London, the company is replacing pipes laid when Queen Victoria was on the throne and the land above was fields. Today it is operating in – and under – built-up urban areas.

One certainty Thames customers can surely bet on is that bills are going to rise.

By way of history:

Macquarie and its co-investors made their position clear from the start, hiking dividends in the first year of their operations, 2007, to £656m when profits were a fraction of that at £241m.

Over their 11 years of control, Macquarie and its co-investors paid out £2.8bn to shareholders, which is two-fifths of the total £7bn in dividends that Thames Water has paid between 1990 and 2022. The average yearly dividends paid during the Macquarie period were five times higher than those paid after it sold its final stake in 2017. The consortium that took over ownership of Thames Water in 2017 has not taken a dividend since, but the company has paid internal dividends – including £37m in the year to 31 March 2022.

… and eventually I got to the good part:

The leakage rate from Thames Water pipes is the highest for five years and the company will not meet its target to plug them this year, according to information released under freedom of information laws.

The company, which serves 15 million customers across London and Thames Valley, has to have regular meetings with an environment minister because it is considered to be lagging in its performance.

Details of letters released under freedom of information laws between the chief executive, Sarah Bentley, and Rebecca Pow, an environment minister, reveal that Thames is not fixing its leaks as it has promised.

Bentley told Pow: “Right now, we have the highest leakage rate since 2018. Consequently, we have already signalled to Ofwat that we are behind on our 2022/23 leakage performance and our target this year will now be very challenging to achieve.

… and the company itself says:

Every day we supply 2.6 billion litres of water, but not all of that gets to our customers. At the moment, almost 24% of the water we supply is lost through leakage – which is a combination of water lost on our pipes, water lost on customers’ pipes and an element of unmeasured consumption (46% of billed customers are unmeasured with 17% of individual customers having smart meters).

In 2022/23 we reduced leakage by 10.7%, calculated using a three-year average from the 2019/20 baseline. Unfortunately, like many other water companies 2022/23 was an exceptional year for severe and unprecedented weather conditions. Despite delivering 25% more activity in 2022/23 we fell short of our performance commitment to achieve a 14.1% reduction in leakage.

24% leakage rate! It took Montreal thirty years of neglect to reach 40%!

About 30 per cent of the water that flows through Montreal’s crumbling water-main network is lost due to leaks [as of 2016], an improvement from the early 2000s, when 40 per cent was being wasted. Though the city is spending millions to replace 54 kilometres of water mains annually, the rate remains high.

That’s about on par with Johannesburg:

The City of Johannesburg is running its finances poorly. The maintenance bill for water infrastructure is R2-billion ($105-million) per year, but only R1-billion ($52-million) is allocated. Maintenance needs are spiralling out of control. The City bills residents for rates, water, electricity, sewage and other services. However, the funds received are not ring-fenced. Other projects are competing for the same pot of money.

Because the infrastructure is ageing (for example, in the suburb of Parkwood, the infrastructure is older than 70 years), the pipes rust and break. When they break, they leak, sometimes releasing very large quantities of water, before they are repaired. When the City responds to requests by residents for repairs, the response, if it comes, is often too little and the job is poorly done. There is little oversight or accountability by the City to ensure the contractors have done the job correctly and the repairs often do not last long.
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Of the non-revenue water, the leakage portion for Gauteng is half. In other words, for every four litres provided to Gauteng by Rand Water, one litre is wasted through leakage (the City’s fault) and one litre is either given away for free (public good), stolen (the public’s fault), or not accounted for (much harder to allocate blame). This means only half of what is provided can be charged for.

Toronto, by the way, does a little better:

A new study by the Residential and Civil Construction Association of Ontario (RCCAO) is highlighting just how much water goes to waste in Toronto every day.
The study, titled ‘Water Infrastructure in the 21st Century: Smart and Climate-Savvy Asset Management Policies,’ was completed by Tamer E. El-Diraby, a University of Toronto professor in the department of civil and mineral engineering.

While Toronto’s water distribution network services approximately 3.6 million people, the study claims that, due to “leaky and broken pipes,” 10 to 15 per cent of that water leaks from pipes daily.

This means that the city could be wasting 103 million litres of water per day — enough to fill more than 15,000 Olympic swimming pools a year, or just over 40 a day.

However, in some areas, the leakage rate could be far higher, says RCCAO.

“Reports by consultants who conducted actual assessments show that rates in Ontario could be as high as nearly 40 per cent. One analysis for the Town of Smiths Falls estimated that rates between 2003 and 2019 ranged between 41 per cent and 67 per cent,” said RCCAO.

One of the very few fiscally responsible things done in Toronto over the past quarter century was the price hike for water in the mid-2000s (?). This served to provide adequate funding for water services, while allowing those square-jawed defenders of fiscal conservatism to pretend that taxes hadn’t gone up.

But anyway, it seems like there’s a good chance that Thames Water will be nationalized, with massive losses to bondholders, price hikes for consumers and vast expense to taxpayers. I look forward to a public inquiry on this mess: financial porn on an epic scale! I am stocking up on popcorn already.

Here’s my hypothesis:

• All the various owners since privatization neglected capital maintenance, because that’s both expensive and boring.
• Macquarie stripped the company of every nickel that wasn’t nailed down and borrowed like crazy to pay out more
• OMERS et al. grossly overpaid for the company in the belief that the regulators would bail them out by allowing mind-boggling fee hikes
• They didn’t.
• This was all allowed to happen because Thames Water is owned by private equity; it didn’t have common equity prices approaching pennies (and giving unpleasant signals to the bond guys), it didn’t have an army of analysts poring over its books and reports trying to make themselves a nickel, all it had was private equity’s projections, full stop
• The purpose of private equity is to lie to your clients

As I say, it’s a hypothesis. Prove me wrong!

OMERS has a lot to answer for. OMERS is one of the investment outfits I admire: because they have a single captive client, they don’t need to have any salesmen on staff – this changes the culture; they can do their hiring and firing based solely on performance. But this certainly doesn’t make them perfect and I will be most interested in learning more details about how a 1.7-billion-dollars-odd got vaporized. In infrastructure. A water utility. In a mature OECD urban market, for God’s sake.

Update, 2024-5-18: This, from the Guardian:

The water company is now racing to avoid a multibillion-pound taxpayer-backed bailout after its parent company, Kemble, defaulted on its debt, raising fears that the company could face a significant restructure or even collapse.

Thames could be placed into special administration, which would result in the government stepping in and temporarily renationalising the company. This outcome would probably fuel critics of the Conservative government who argue the water company’s plight represents the failure of Margaret Thatcher’s privatisation agenda.

The Guardian revealed last month that under radical plans being drawn up in Whitehall, codenamed Project Timber, ministers would turn Britain’s biggest water company into a publicly owned arm’s-length body.

The plans, overseen by Defra and the Treasury, a new public corporation would be formed to hold the water monopoly, modelled on the company that built the £18.8bn Crossrail project, while Thames’s vast liabilities would be assumed into the government’s debt pile.

The water regulator, Ofwat, is reportedly working on rescue plans for Thames that could lead to the water company’s regional monopoly being dismantled and sold off to neighbouring rival suppliers under a scheme codenamed Project Telford.

Ofwat has tasked the former private equity banker Adrian Williams with overseeing the rescue bid, according to the Telegraph, in a last-ditch attempt to save the company from collapsing under the weight of a more than £15bn debt pile.

I don’t get it. What’s wrong with bankruptcy? Appoint a receiver, get some debtor-in-possession financing (possibly from the government), cancel all the outstanding equity and give debtholders all the new equity in the company while writing down the amount of debt they hold by some percentage that makes the restructured company viable. What’s the problem?

Inflation news from the US was positive:

The Consumer Price Index climbed 3.4 percent in April, down from 3.5 percent in March, the Labor Department said Wednesday. The “core” index — which strips out volatile food and fuel prices in order to give a sense of the underlying trend — rose 3.6 percent last month, down from 3.8 percent a month earlier. It was the lowest annual increase in core inflation since early 2021.
…
Had the data come in hotter than anticipated yet again, it could have led policymakers to conclude that high rates needed more time to bring inflation to heel. Speaking at an event in Amsterdam on Tuesday, Jerome H. Powell, the Fed chair, reiterated that recent inflation readings had made him more cautious about cutting rates.

“We did not expect this to be a smooth road, but these were higher than I think anybody expected,” he said. “What that has told us is that we will need to be patient and let restrictive policy do its work.”
…
Wednesday’s report showed improvement in some of the categories that had driven the recent uptick in inflation. Health insurance costs, which jumped in March, rose more slowly in April. Car insurance rates, too, rose more slowly, although still at an uncomfortably rapid clip.

But prices in one key part of the economy remained stubborn: housing. For more than a year, forecasters have been predicting that the government’s measure of housing inflation would ease, citing private-sector data showing rent increases slowing.

Instead, housing costs in the Consumer Price Index have continued to rise more quickly than before the pandemic, a pattern that continued in April.

The Five-year Canada yield dropped to 3.67%.

PerpetualDiscounts now yield 6.49%, equivalent to 8.44% interest at the standard equivalency factor of 1.3x. Long corporates yielded 5.19% on 2024-5-10 and since then the closing price of ZLC has changed from 14.76 to 14.98, an increase of 149bp in price, implying a decrease of yields of 12bp (BMO reports a duration of 12.32, but don’t disclose whether this is Macaulay or Modified; I will assume Modified) to 5.07%. Therefore, the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has narrowed slightly (and perhaps spuriously) to 335bp from the 340bp reported May 1.

Jobs, jobs, jobs!

he Canadian labour market rebounded in April by adding a substantial number of new positions, setting up a hotly debated decision from the Bank of Canada on whether to start lowering interest rates in June.

The economy added about 90,000 jobs in April after a slight decline in March, Statistics Canada said Friday in a report. It was the strongest month of job creation since January, 2023, and handily beat analyst expectations of 20,000 positions added last month.

Despite those gains, the unemployment rate held steady at 6.1 per cent, because the country’s population is growing at a feverish pace. The jobless rate has risen by more than a percentage point since the summer of 2022.
…
In April, employers mostly added part-time positions, which rose by about 50,000. The private sector accounted for most of the employment growth, although there were strong gains in the public sector as well.

The total number of hours worked jumped by 0.8 per cent in April, suggesting an upturn in economic growth to start the second quarter.
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Average hourly wages grew at an annual pace of 4.7 per cent in April, down from 5.1 per cent in March.

This had an immediate effect on bonds:

Implied probabilities in swaps markets now suggest less than a 50 per cent chance the Bank of Canada will cut its key lending rate at its next policy meeting June 5. Immediately prior to the data, those odds were pegged at about 58 per cent, and in recent days had risen to above 70 per cent, with traders bolstering their bets in particular after a surprisingly weak employment report last Friday in the U.S.

Swaps markets are now implying 70 per cent odds for a cut at the bank’s July meeting. And they are fully pricing in two rate cuts by the end of this year.
…
The Canadian dollar immediately spiked on the data, rising to 73.30 cents US, up from 73.10 cents, reflecting the lower probability of near-term cut rates. There was a sharp reaction in bond markets as well, with the Canadian government 2-year bond yield rising a further 5 basis points after the data. It’s up about 10 basis points in total for the day now, at 4.309 per cent, narrowing its spread to the U.S. equivalent bond.

Pre-Announcement

Post-Announcement

The BoC’s Financial Stability Report had some interesting things to say:

Hedge funds and pension funds have significantly increased their use of repo leverage

Leverage obtained by asset managers through borrowing in the repo market increased by around 30% in the past 12 months.25 This increase was driven largely by hedge funds and pension funds increasing their repo leverage by approximately 75% and 14%, respectively.26 Pension funds are the largest non-bank participants in Canadian repo markets, with over $90 billion in total borrowing outstanding. These pension funds face relatively less refinancing risk than hedge funds. About half of pension fund repo leverage has a maturity greater than one month, while about 70% of hedge fund repo exposure is under one week because hedge funds tend to rely more heavily on overnight and short-term repos. Some individual repo positions held by hedge funds are also very large and highly concentrated—for example, in a single Government of Canada bond.

The largest pension funds and insurance companies are typically sophisticated users of leverage that manage their liquidity risk and use liquidity coverage ratios to monitor planned and potential outflows.27 Nonetheless, even sophisticated users can run into difficulties during periods of market stress, as seen in the October 2022 UK pension fund experience and during the March 2020 “dash for cash.”28

Discussions with market participants and analysis of trading data indicate that one of the drivers behind the increase in hedge fund leverage is relative-value strategies. An example is the increasingly popular cash-futures basis trade in the Government of Canada bond market (see Box 3). These trades can provide market liquidity in both futures and bond markets. However, the large degree of leverage employed can leave hedge funds vulnerable to changes in the price difference between the underlying securities as well as to sudden changes in the availability and cost of repo financing.
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Box 3: Cash-futures basis trade

The basis trade, a relative-value strategy that has been a feature of the US Treasury market in recent years, is becoming more popular in Canada. This type of trading strategy uses a mix of long and short positions to capitalize on price differences between bonds and bond futures.

Market participants typically use a high degree of leverage—or borrowed funds—to increase profits for these trades. For example, when bond futures contracts are relatively more expensive than the underlying bond, an entity could profit from a cash-futures basis trade by selling bond futures, buying the underlying bond, and borrowing cash in repurchase agreement (repo) markets using the bond as collateral to finance the position.

Basis trades can improve market efficiency by reducing the cost of buying bond futures and supplying futures market liquidity to those who prefer holding long futures instead of bonds.31 These trades can also pose risk in times of stress—both to those making the trades and to financial markets more generally—due to many factors.

• The pricing discrepancies tend to be quite small, so to increase the profitability of the trades, financial firms (usually large, foreign-domiciled hedge funds) often use a large degree of leverage, which they typically obtain in the repo market. Indeed, the increase in the basis trade has been cited as one of the contributing factors for the surge in demand for repo funding seen earlier this year in Canada.32 High repo leverage, particularly when it is obtained through overnight or short-term repo maturities, can amplify sudden price movements in the underlying bond market.
• Maintaining these trades could become costly if repo rates were to spike suddenly, or if higher bond market volatility were to result in larger margin calls. The unwinding of these trades as a result of these shocks could lead to abrupt sales of fixed-income assets and, possibly, to strains on market liquidity. The more leveraged a hedge fund is, the more vulnerable it is to such shocks, and the greater the risk it poses to the overall system. This was evident in the US Treasury bond market in March 2020, when pandemic-related market stress caused many hedge funds to unwind their sizable cash-futures basis trade positions. This unwinding resulted in a large volume of US Treasury bonds being sold and contributed to the severe hampering of what is normally considered the most liquid bond market in the world. The one-way selling negatively affected market participants around the world that rely on the liquidity and stability of US Treasuries.33 As the International Monetary Fund recently noted, the aggressive use of repo leverage can also leave these trades vulnerable to other shocks, including upside inflationary surprises that could lower the value of bonds.34

The cash-futures basis trade is estimated to have grown steadily in Canada (Chart 3‑A), with exchange-for-physical transactions reaching $51 billion by the end of April 2024.35 This represents about 8% of the total trading volume of Government of Canada bonds (Chart 3‑B).36, 37 Of the total volume, 45% is in 2-year futures contracts, and the remainder is split somewhat evenly between the 5- and 10-year futures contracts.

All the above can be looked at as the back-up behind Bank of Canada Deputy Governor Toni Gravelle’s March 21 speech, which I reported 2024-3-22.

PerpetualDiscounts now yield 6.56%, equivalent to 8.53% interest at the standard equivalency factor of 1.3x. Long corporates yielded 5.34% on 2024-4-30 and since then the closing price of ZLC has changed from 14.50 to 14.83, an increase of 228bp in price, implying a decrease of yields of 19bp (BMO reports a duration of 12.23, but don’t disclose whether this is Macaulay or Modified; I will assume Modified) to 5.15%. Therefore, the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has narrowed slightly (and perhaps spuriously) to 340bp from the 345bp reported May 1.