PrefBlog

PrefInfo has been updated to 2011-12-17.

As always, finding an error will win you a PrefLetter … just let me know about it and if I agree it’s an error, you’ll get a free copy!

The House Financial Services Committee has approved draft Covered Bond legislation:

The committee voted 44-7 today to approve the bill, which would provide a regulatory framework for covered bonds by giving the Treasury Department oversight of the market and creating a separate resolution process in order to bolster investor interest.
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“The FDIC’s concerns, I believe, continue to be legitimate,” said Representative Barney Frank, the senior Democrat on the committee, who unsuccessfully offered two amendments drafted with the agency to change the measure. “The FDIC believes, I think correctly, there will be problems in some of these cases and the FDIC will not be fully protected.”

In an effort to alleviate some of the agency’s concerns, Representative Carolyn Maloney, a New York Democrat, offered a successful amendment that extended to one year, from 180 days, the amount of time the FDIC would have in event of a bank failure to hold the exclusive right to transfer the covered pool to another eligible issuer.

The panel also agreed, by voice vote, to a requirement that the Treasury write rules to cap the maximum amount outstanding, as a percentage of total assets, that any one issuer can hold.

Andrew Gray, the FDIC’s spokesman, said in an e-mailed statement that the bill would subsidize covered bond investors with the deposit insurance fund and “will add to the funding advantage” of large banks.

The FDIC’s Deputy Chairman, Michael H. Krimminger, testified in September 2010 regarding FDIC concerns regarding super-priority:

Unfortunately, H.R. 5823 would restrict the FDIC’s current receivership authorities used to maximize the value of the failed bank’s covered bonds. The bill leaves the FDIC with only two options: continue to perform until the covered bond program is transferred to another institution within a certain timeframe; or hand over the collateral to a separate trustee for the covered bond estate, in return for a residual certificate of questionable value. The FDIC would not have the authority – which it can use for any other asset class – to repudiate covered bonds, pay repudiation damages and take control of the collateral. This restriction would impair the FDIC’s ability to accomplish the “least costly” resolution and could increase losses to the DIF by providing covered bond investors with a super-priority that exceeds that provided to other secured creditors. These increased losses to the DIF would be borne by all of the more than 8,000 FDIC-insured institutions, whether or not they issued covered bonds.

Limiting the time in which the FDIC could market a covered bond program to other banks will constrain the FDIC’s ability to achieve maximum value for a program through such a transfer. Similarly, preventing the FDIC from using its normal repudiation power will prevent the FDIC from recapturing the over-collateralization in the covered bond program. The ‘residual certificate’ proposed in H.R. 5823 is likely to be virtually valueless. More importantly, the legislation would provide the investors with control over the collateral until the term of the program ends, even though the FDIC (and any party obligated on a secured debt) normally has the ability to recover over-collateralization by paying the amount of the claims and recovering the collateral free of all liens. Providing the FDIC a residual certificate instead of the ability to liquidate the collateral itself would reduce the value to the receivership estate and would not result in the least costly resolution.

So long as investors are paid the full principal amount of the covered bonds and interest to the date of payment, there is no policy reason to protect investment returns of covered bond investors through an indirect subsidy from the DIF

The FDIC issued a Covered Bond Policy Statement in 2008.

There is an excellent discussion of the legislation available by Barton Winokur, Chairman and Chief Executive Officer of Dechert LLP, and is based on a Dechert publication by Patrick D. Dolan, Robert H. Ledig, Gordon L. Miller and Kira N. Brereton, titled Reform for the Covered Bond Industry on the Horizon.

US Covered Bond legislation was last mentioned on PrefBlog when it passed the Capital Markets Subcommittee. Consultations in Canada are taking place behind closed doors, as is only right and decent.

Update, 2011-6-24: I note from Chart 3.15 of the BoE June 2011 Financial Stability Report that covered bonds comprise 5% of 2011-13 maturities, but 16% of planned 2011-13 issuance in the UK.

Ogilvy Renault has reported Canadian Covered Bond Legislation Consultation Paper Released:

Following the Canadian Government’s announcement in its 2010 budget of its intention to introduce a legislative framework for covered bonds, the Department of Finance yesterday released its much anticipated consultation paper on the proposed framework.

In the consultation paper, the Government reiterates its objective of ensuring financial institutions have access to covered bonds as a funding source. It also acknowledges the increased importance of covered bonds to Canadian banks in recent years with issuances by Canadian financial institutions having increased to over $30 billion since the first covered bonds were issued by a Canadian bank in 2007. Further, the Government recognizes that the stability of financial institutions and the financial sector can be enhanced by providing funding options that are robust under stress and that a legislative framework for covered bonds will benefit Canadians.

It this wasn’t a PrefLetter Weekend, I’d be spending a lot more time on this … but I’ll have to leave that until later. From a quick glance, it does not appear as if Bankers’ Acceptances are intended to be covered by the legislation – they should be!

Covered Bonds were last discussed in the post US Covered Bond Legislation Moving Forward. A previous article discussed the question of BAs or BDNs: What’s the Difference?.

Hat tip to Assiduous Reader GA, who brought the Ogilvy Renault article to my attention.

Update, 2011-5-25: The consultation period ends 2011-6-10.

Boyd Erman of the Globe & Mail reports in a piece titled Bank of America shocks Maple market:

Bank of America (BAC-N12.680.342.76%) has broken an unwritten rule and shocked the Canadian bond market by deciding not to redeem a $500-million bond issue.
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But the unwritten, wink-and-nod agreement with the investors who bought them was that the bonds would be called at the end of five years so that investors would never have to face the lower rates.

Bank of America has decided not to call the bonds and will take advantage of the lower rates. For investors in the bonds, it means lower prices and lower interest income, and a tough decision about what to do next.

My suggestion is that they make a note to read the terms of the issue next time, but what do I know?

The bonds were originally sold with a coupon of 4.81 per cent. Now, under the floating structure, they will pay interest rate at a short-term benchmark plus a fraction of a percentage point. At the moment, that works out to about 1.8 per cent.
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The bonds are now being quoted at about 96 to 97 cents on the dollar by some desks after being marked at par in the days before this on expectations that they would be called at 100 cents on the dollar, market sources said.

The comments on the Globe site are a hoot.

There’s not much information available on this issue, but it’s mentioned briefly in the RBC-CM Maple Guide of 2H08 – with all the pseudo-analysis based on a certainty of call, of course, as is usual with subordinated debt.

I last reviewed this topic in the post Bank Sub-Debt Redemptions.

Readers will remember that quotes provided by the TMX at the “end of the day” are not closing quotes: they are “last” quotes, measured at 4:30. They will differ from the Closing Quotes measured at 4:00 because orders may be cancelled, but not added, during the extended trading session – the one exception being that you can add as many orders as you like at the Closing Price.

I brought this to the attention of the TMX (I don’t think they’d ever really thought about it; my suspicion is that the code that worked perfectly well when there was not extended trading session simply got overlooked when the ETS was invented … put that is pure speculation on my part). The TMX took a survey of their customers and:

While we are not in a position to disclose survey results, we can tell you that there was limited interest from our clients with respect to the 4:00 PM closing bid/ask information. We are following up on adding 4:00 PM close bid/ask data to our end-of-day Trading Summary products and Market Data Web – Custom Query product. However, due to other development commitments and priorities, we can not say when this will be implemented.

I’m rather surprised and can only assume that the surveys were completed by database dorks rather than end users, because the Last Quote is only useful insofar as it reflects the Closing Quote – it has absolutely zero independent value.

I’m also surprised that there will be a potentially significant delay in giving users the option. I’ve never had the chance to examine the TMX code, so obviously I’m speculating again … but retrieval, storage and dissemination of Closing Quotes seems like a fairly trivial database operation. I don’t understand how implementation could possibly take more than a day.

I will, on occasion, spend some actual money to buy the “Trades and Quotes” output from the TMX – but not very often, because there is a charge for each quote and there can, conceivably, be several thousand quotes per minute. However, this will rarely be reported on PrefBlog in a timely manner, because I am separately advised that my problems nailing down IAG.PR.C on March 25 and CM.PR.K on March 28 were due to uploading schedules – detailed quote data is only put on DataLinx overnight, not within a few hours of the close.

The La Presse article mentioned on January 24 and in the comments to January 21 may have been identified!

Wind of change for equities (translation courtesy of Google):

Under the Basel III, the Bank for International Settlements, which monitors the financial stability around the world confirmed that the preferred shares that do not meet the new requirements will be phased out between 2013 and 2023.

To replace the existing preferred shares, banks will now issue the contingent capital. These titles are automatically converted into common shares if the bank becomes insolvent. Thus, holders of these securities pay the price, just as ordinary shareholders, should the unlikely situation where the government is forced to inject money to save the institution.

While this change was already planned, the news had a slight positive impact on the existing preferred shares: as they do not meet future requirements, banks will be more motivated to buy them. The preferred shares of banks that are trading at a discount currently should perform well in this context.

But it will take the next step is the confirmation by the Office of the Superintendent of Financial Institutions of Canada, for treatment of these instruments in the Canadian context.

… which isn’t quite the ringing endorsement I had been led to expect, but it is an endorsement and it was published in La Presse, so it’s the best suggestion so far.

I have previously published a review of Basel III effects on PrefBlog, with more depth in the January, 2011, edition of PrefLetter. Note that the La Presse article was published on January 15, after the awesome events of January 13 and January 14, but presumably the interview was conducted prior to this.

Mr. Tremblay, the PM for Omega Preferred Equity Fund, had some very sensible things to say about junk FixedResets:

I suggest to be careful with certain adjustable rate preferred shares that were issued in recent years. Their dividend adjusted every five years, depending on interest rates, which protects investors against the risk of rising interest rates which would lose value in preferred shares.

But shareholders are not protected against credit risk. These securities houses of perpetual preferred shares (no redemption at the option of the holder). We must carefully analyze the credit risk of the issuer if you do not want to be stuck with a bad credit forever!

Ask your advisor if he has done his homework, particularly for preferred shares with a credit valued at P3. On a scale from P1 to P5, titles that get a rating of P1 and P2 are the strongest. At P3, some issuers are good, others less. It must be very selective, buying preferred shares that are trading at a discount and that offer acceptable credit risk.

In the post TMX “Last” != “Close” I pointed out that the data published all over the web overnight does not actually represent closing quotations: it represents “Last” quotations, which differ mainly in that cancellations during the extended trading session can make the quote worse than it really was. In some (rare) cases, they can shift dramatically, if the closing bid (ask) is also the Last Sale Price and it is hit (lifted) by orders exceeding those available to fill it during the extended session (e.g., 25.00-10, 5×5 “Close”, with Last Sale = 25.10, could turn into 25.10-20, 10×5 “Last” if a bid for 1500 at 25.10 came in during the extended session and nothing else happened.

Anyway, as explained, this is important not just for quantitative back-test purposes, but for accounting reasons, as many funds use the “Last” quote thinking it is the same as the “Close” quote, and in any case are required to reconcile to the most recent active market quote for financial statement purposes.

So I asked an accountant – what would be the reconciliation bid for GWO.PR.J on December 2 – And I got this:

Click for big

So Bloomberg is clearly reporting the “Last” – not the “Close” – which is hilarious, as the extreme laziness of most portfolio managers has rendered them helpless and confused without a Bloomberg terminal. As previously explained:

A closing quote is considered to be the quote at the close of the regular trading session at 4pm. Market Maker responsibilities end at 4pm. The actual closing quote at 4pm on Dec.2 for this issue was 27.04 – 27.54.

So are these reconciliations what they purport to be? Does anybody care? Stay tuned!

Update, 2014-5-30: For more, see TMX to Report Closing Quotes … Someday.

Assiduous Readers will recall that MAPF’s reported performance for December was measurably impacted by a bad closing quote on SLF.PR.E: the quote was 19.91-60, 2×27.

I noted that I had sent an email of inquiry to the TMX regarding this quote; they have finally answered (it only took ten days and one follow-up!). My eMail is in reguar font; the TMX’s responses are in italics:

i) Who is the market-maker for this security?

W.D. Latimer Co. Ltd.

Not the world’s most plugged-in dealer.

ii) Will the TMX be investigating the circumstances that led to the wide spread on this closing quotation?

The Quote widened due to a couple of bids being cancelled for a mere 7 seconds prior to the close.

So here the TMX is saying there is nothing wrong or unusual with a latency of 7,000 milliseconds, As long ago as 2007, Reuters reported:

“The standard now is sub-one millisecond,” said Philadelphia Stock Exchange CEO Sandy Frucher. “If you get faster than sub-one millisecond you are trading ahead.”

About eighteen months ago, the standard for executing a trade was around five milliseconds, he said. A millisecond is one-thousandth of a second.

I think we can conclude that there was plenty of time for WDLatimer to respond to the market, if they had felt like it.

iii) Will the TMX be announcing the results of such an investigation?

See ii)

What a great investigation that was.

iv) Will the TMX be implementing any sanctions against the market makerfor this security?

No. TSX Market Making Rules require Market Makers to monitor spreads and react in a reasonable time frame when a spread increases beyond an agreed upon spread goal. A 7 second time frame particularily right at the close would not warrant any sanctions. Market Makers are monitored for performance on a monthly basis in terms of Average Time Weighted Spread as compared to an agreed upon Spread Goal, and also for number of Spread Goal violations per month and average time of those violations. A habit of violating this performance parameters would certainly be caught and addressed.

‘Trust us! We’re the Exchange!’

In response, I have sent the following eMail to the TSX:

Thank you for your reply. It raises the following further questions:

i) You refer to the the time span of the closing quote for this issue as being “a mere seven seconds”, and claim that Market Makers are required to react in a “reasonable time frame when a spread increases beyond an agreed upon spread goal”. It is my understanding that seven seconds is sufficient time for an algorithm to analyze and react to thousands of such situations.

a) What is the current TSX standard for “reasonable” in this context?

b) When was the TSX Standard for “reasonable” last reviewed?

c) What is the “spread goal” for SLF.PR.E

ii) You deprecate the importance of closing quotations with your statement “A 7 second time frame particularily right at the close would not warrant any sanctions.”

a) Which times during the trading day are considered most important by the TSX in assessing Market Maker performance, and how does the importance of these times compare to the importance of the close?

b) As you may be aware, the CICA requires reporting in financial statements of the valuation of Funds according to the closing quote. Does the TSX take a view on the appropriateness of using the close, given its apparent deprecation when monitoring Market Maker performance?

iii) You claim that “Market Makers are monitored for performance on a monthly basis in terms of Average Time Weighted Spread as compared to an agreed upon Spread Goal, and also for number of Spread Goal violations per month and average time of those violations. A habit of violating this performance parameters would certainly be caught and addressed.”

a) Where are the results of the monitoring process published?

b) How does the Average Time Weighted Spread take account of the reduced importance of quotations near the close?

c) How many violations of the Market Maker performance parameters were caught and addressed in calendar 2010?

Thank you for your attention to this matter.

The TMX has announced:

Horizons AlphaPro Preferred Share ETF (the “ETF”) – An application has been granted for the original listing in the Industrial category of 1,015,000 Class E units (the “Units”) of the ETF, all of which will be issued and outstanding, and none will be reserved for issuance upon completion of an initial public offering.

Listing of the Units will become effective at 5:01 p.m. on Monday, November 22, 2010 in anticipation of the offering closing prior to the opening on Tuesday, November 23, 2010. The Units will be posted for trading at the opening on November 23, 2010.

Horizons AlphaPro has announced:

AlphaPro Management Inc. (“AlphaPro”), manager of the Horizons AlphaPro exchange traded funds (“ETFs”), has launched Canada’s first actively managed preferred share ETF, the Horizons AlphaPro Preferred Share ETF (the “Preferred Share ETF”).

The Preferred Share ETF will begin trading today on the Toronto Stock Exchange under the symbol HPR. The sub-advisor to the Preferred Share ETF is Natcan Investment Management Inc. (“Natcan”), which currently manages more than $1 billion dollars in preferred share assets.

“We’re very happy to be working with Natcan once again. Their fixed income team has done a great job in managing the recently launched Horizons AlphaPro Corporate Bond ETF, Canada’s largest actively managed ETF. We expect more of the same with the Preferred Share ETF based on our belief that an active strategy can overcome many of the limitations found in trying to replicate a preferred share index,” said Ken McCord, President of AlphaPro.

The investment objective of the Preferred Share ETF is to provide dividend income while preserving capital by investing primarily in preferred shares of Canadian companies. The Preferred Share ETF may also invest in preferred shares of companies located in the United States, fixed income securities of Canadian and U.S. issuers, including other income generating securities, as well as Canadian equity securities and exchange traded funds that issue index participation units. The Preferred Share ETF will, to the best of its ability, seek to hedge its non-Canadian dollar currency exposure to the Canadian dollar at all times.

Natcan anticipates yields on investment grade preferred shares will stay strong over the next two years and that the asset class will likely continue to see a growth in interest from income seeking retail investors, many of whom are looking to increase their income in retirement. This process could be accelerated by the phase-out of many income trusts in 2011 and beyond.

“Preferred shares really hit a sweet spot for many Canadian investors,” Mr. McCord said. “They offer attractive, tax-efficient yields and are generally less volatile than common shares. For investors with a need for income and an appropriate risk tolerance, preferred shares can be a very effective investment solution.”

The Preferred Share ETF has closed the offering of its initial units and will begin trading on the Toronto Stock Exchange when the market opens this morning.

The prospectus, on SEDAR under Investment Funs, dated 2010-11-19, states:

The investment objective of the AlphaPro Preferred Share ETF is to provide dividend income while preserving capital by investing primarily in preferred shares of Canadian companies. The AlphaPro Preferred Share ETF may also invest in preferred shares of companies located in the United States, fixed income securities of Canadian and U.S. issuers, including other income generating securities, as well as Canadian equity securities and exchange traded funds that issue index participation units. The AlphaPro Preferred Share ETF will, to the best of its ability, seek to hedge its non-Canadian dollar currency exposure to the Canadian dollar at all times.
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To achieve AlphaPro Preferred Share ETF’s investment objectives, the ETF’s Sub-Advisor will use fundamental research to select companies that, based on the Sub-Advisor’s view on the company’s industry and growth prospects should be included in the ETF’s investment portfolio. An extensive credit analysis for each security as well as an assessment of each company’s risk profile is completed in order to confirm the selection and relative weight of each security held by the ETF. The AlphaPro Preferred Share ETF will primarily invest in the preferred securities of Canadian issuers whose debt, generally, at a minimum, have an investment grade rating at the time of purchase.
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The AlphaPro Preferred Share ETF may also invest in Canadian equity securities that have attractive dividend yields and Listed Funds that pay dividend income. In anticipation of or in response to adverse conditions or for defensive purposes the AlphaPro Preferred Share ETF may temporarily hold a portion of its assets in cash, money market instruments, bonds or other debt securities generally not to exceed 20% of the ETFs net assets.
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[Management Fee] 0.55% of the net asset value of the AlphaPro Preferred Share ETF
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Natcan, the Sub-Advisor of the AlphaPro Corporate Bond ETF, the AlphaPro Preferred Share ETF and the AlphaPro Floating Rate Bond ETF is an affiliate of NBF and NBF holds an indirect minority interest in the Manager. As a result, Natcan may be considered to be an associate of the Manager.
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Since 2009, Marc-André Gaudreau, has been Senior Vice-President of Natcan. Mr. Gaudreau, has more than 12 years of investment management and credit markets experience and has been with Natcan since 2004. From 2005 to 2009 Mr. Gaudreau was Vice-President, Corporate Bonds and Income Funds of Natcan.

Roger Rouleau, Vice President, Fixed Income of Natcan, has more than 4 years of fixed income research and investment management experience. Mr. Rouleau has been with Natcan since 2007 and from 2005 to 2007 was a Research Associate with RBC Capital Markets.

Mathieu Lachance, Vice President, Fixed Income of Natcan, has more than 7 years of experience in the financial markets industry. Before joining Natcan in 2009, he worked in the fixed income arbitrage sector of the Ministère des finances du Québec and as assistant index portfolio manager and derivatives trader at PSP Investments. Mathieu also has extensive experience with derivative products.

Regretably, the prospectus does not specify the track records of these individuals or their firms, despite the fact that Natcan “currently manages more than $1 billion dollars in preferred share assets.”

Unfortunately:

Mutual fund regulations restrict the presentation of performance figures until a fund reaches its one-year anniversary.

… but I will report performance once it becomes available.

Update: Jonathan Chevreau reports:

Natcan will also hold some floating rate preferred shares to protect against rising interest rates: Floating rate preferreds are not included in the S&P/TSX Preferred Share Index tracked by the passive rivals.

DPS.UN has lots of floaters; so I suppose it must be classified as active.

The management fee is 0.55%. Estimated weighted average yield of the securities at inception are 5.5%, with minimum credit quality of P-3/BBB.

Current Yield, obviously.