PrefBlog

Michael Lewis – whose book, Flash Boys, is a favourite target for mockery on PrefBlog – had some sharp observations:

Technology entrepreneurship will never have the power to displace big Wall Street banks in the central nervous system of America’s youth, in part because tech entrepreneurship requires the practitioner to have an original idea, or at least to know something about computers, but also because entrepreneurship doesn’t offer the sort of people who wind up at elite universities what a lot of them obviously crave: status certainty.

“I’m going to Goldman,” is still about as close as it gets in the real world to “I’m going to Harvard,” at least for the fiercely ambitious young person who is ambitious to do nothing in particular.

I don’t agree with many of his other assertions in the piece, but I liked that bit!

Eddy Elfenbein of the blog Crossing Wall Street reminds us that a house is just an asset:

Some trader right now is investing in, say, copper. I wish them well. But remember that copper has no independent value. By itself, it’s just an element. Not to get too philosophical, but copper’s entire value is based on what it can do for us. What are the goods and services it can enhance? For that to happen, copper needs to pass though the hands of a business.

This is why long-term studies of what’s been the best investment usually have stocks at the top, followed by bonds and real estate followed by commodities. When you’re investing in a company, you’re really investing in human ingenuity—the way that people can come together and figure out how to make something useful from those assets.

Real estate, for example, is a nice investment. I hope everyone owns their own home. But in the long run, real estate will never, ever, ever, ever outpace stocks. Never. This isn’t just my opinion, it’s reality. It won’t happen because it can’t happen.

A house is simply an asset. No matter how hard it tries, it will never be anything more than an asset. A house does its job by just sitting there. But a stock is different. A stock is part ownership in a corporation. A corporation is people using assets to create wealth. This ain’t just a matter of definitions.

A house’s return cannot exceed inflation over the long term – who would be able to buy it? However, things over the short term can be different, and the short-term can quite possibly exceed one’s lifespan. At present, Canadian house prices are rocketing upwards and have done so for a very long time; part of the recent rise has been interest rates; longer term it has been both a revaluation (in real terms, not just nominal) of the value of having a place to live in the city, whether the city is Toronto, Vancouver or Calgary; and part of it, I think, is due to income inequality. House prices are based not on the average wage of all Canadians, but on the average wage of those Canadians who can afford to buy houses.

My personal view is that a house is just a place to live. But I do know quite a few people who consider them to be investments and buy extra ones for rental purposes. Part of this is risk-aversion; while house prices can and do decline, they rarely decline by as much as equities did during the Credit Crunch. Part of this is wilful blindness; you don’t get a monthly statement from your real-estate broker giving you a solid idea of what you could get for your house if you sold it that day. Part of this is a question of control: renting out houses or speculating on them is something that you can do yourself, without any of the agency problems involved in giving your broker some money to invest on your behalf in companies run by other people, which will be valued by a third set of people. And part of it is … what if I’m wrong?

US public pensions are going to cost a lot:

The 25 largest U.S. public pensions face about $2 trillion in unfunded liabilities, showing that investment returns can’t keep up with ballooning obligations, according to Moody’s Investors Service.

The 25 biggest systems by assets averaged a 7.45 percent return from 2004 to 2013, close to the expected 7.65 percent rate, Moody’s said in a report released today. Yet the New York-based credit rater’s calculation of liabilities tripled in the eight years through 2012, according to the report.

“Despite the robust investment returns since 2004, annual growth in unfunded pension liabilities has outstripped these returns,” Moody’s said. “This growth is due to inadequate pension contributions, stemming from a variety of actuarial and funding practices, as well as the sheer growth of pension liabilities as benefit accruals accelerate with the passage of time, salary increases and additional years of service.”

Here’s a milestone: Government Motors is investment grade:

General Motors Co. (GM), five years after emerging from a government-backed bankruptcy, was returned to investment grade by Standard & Poor’s Ratings Services.

S&P upgraded the biggest U.S. automaker to BBB- from BB+ today, citing progress in Europe, healthy cash flow and limited reputational and market share damage as a result of the company’s record recalls. The ratings outlook is stable.

It was a poor day for the Canadian preferred share market, with PerpetualDiscounts losing 32bp, FixedResets off 8bp and DeemedRetractibles down 10bp. Volatility was low. Volume was low.

PIMCO’s in some kind of trouble with the SEC:

Pacific Investment Management Co. said it’s cooperating with regulators examining how the firm assigned asset prices at Bill Gross’s Pimco Total Return ETF.

“Pimco has been cooperating with the SEC in this non-public matter, and we take our regulatory obligations and responsibilities to our clients very seriously,” Mark Porterfield, a spokesman for Newport Beach, California-based Pimco, said in an e-mailed statement. “We believe our pricing procedures are entirely appropriate and in keeping with industry best-practices.”
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“What they’re being accused of is in fact the industry standard accounting process,” Dave Nadig, the chief investment officer at ETF.com, a San Francisco-based ETF research and analysis firm, said in a telephone interview.

By law, fund managers have to come up with a price, either by asking dealers for quotes or by extrapolating from data points such as credit rating, size, structure, and comparable securities, Nadig said.

“Because Pimco is an 800-pound gorilla, they negotiate a really good price,” he said. “If the SEC wants to change how bonds are priced, then they can do that, but that’s going to change everybody.”

The ETF attributed some of its outperformance against its benchmark to “an allocation to non-Agency mortgages which benefited from limited supply and a recovery in the housing sector,” according to the latest quarterly report on its website.

Kirsten Grind, Gregory Zuckerman and Jean Eaglesham of the Wall Street Journal explain:

The investments believed to be in question, such as small amounts of mortgage securities—or "odd lots" in the terminology of the financial markets—tend to receive lower prices because of their small sizes or because they are backed by smaller institutions, among other factors.

After the launch of the ETF, Wall Street traders were encouraged by Pimco to offer these small securities to the Pimco ETF, according to some of the people familiar with the matter. Mortgage bonds with a relatively small $500,000 face amount, for example, might have sold for only $480,000, because few investors wanted them, due to the small size.

But when Pimco, shortly after purchasing the bonds, placed a value on them, it typically used outside pricing companies that often assigned higher valuations because they used a similar, but much larger, pool of mortgage bonds to compare them with, according to people close to the firm. Placing a $500,000 valuation on a bond purchased for $480,000, for example, would have allowed Pimco to claim a quick 4% gain on the $500,000 bond, or $20,000.

If that maneuver happened with enough bonds, early results of the ETF could have been aided, these people say.

Traders say buying discounted bonds, then using an outside ratings company to place a higher valuation on those bonds, is akin to buying a used car on the cheap because it is in poor shape but having a lender rely on the list price when making a loan.

Matt Levine of Bloomberg points out:

The point of a bond ETF is, in large part, to make the illiquid liquid: to make it easy for small investors to buy and sell diversified bond portfolios in small sizes. The point of the ETF structure, on the other hand, is to use the market to prevent mispricing: The market in the underlying acts as a check on the valuation of the fund. And the point of the bond market sometimes seems to be to slice credit into tiny weird units that trade in idiosyncratic ways and reward cleverness. Those three things don’t really go together. It sounds like the SEC’s worry is that Pimco’s ETF made the illiquid liquid, but at the cost of losing the check on its valuation. Which then provided idiosyncratic opportunities to reward cleverness.

It’s a complex story, and not completely apparent that anything wrong is happening. It is quite well known that investors (even retail investors!) can make very good returns simply by asking their salesman to alert them to any strange odd-lots the brokerage might have hanging around. Brokerages will often provide liquidity for transferable GICs, for instance, by offering a really, really crumby price – like 150bp over market yield. They’ll then sell it for 100bp over market yield, recouping their costs while giving the ultimate buyer a great deal on his GIC … provided he doesn’t mind buying some weird dollar value of GIC with a basically random maturity date. But when you do that as part of an ETF … complications ensue.

But I will point out that a large fund (such as anything run by PIMCO!) might quite rationally take a long view … buy enough discounted small lots of the same issue and eventually that discount is no longer applicable.

But perhaps a new way of potentially scoring excess returns is coming!

With interest rates barely above zero, the typical U.S. savings account has all the excitement of, well, waiting in line at the bank. But what if instead of marketing yet another CD or credit card, banks held raffles and gave millions away each month to savers? The local bank might feel less like the villain behind those big overdraft fees and more like a casino on the Vegas strip.

A bank in South Africa tried this in 2005. The First National Bank’s Million-a-Month Account promised savers a chance to win 113 prizes a month, including a grand prize of 1 million South African rand (about U.S.$150,000 at the time). Within 18 months, the bank had more prize-eligible accounts than regular ones. These new customers, many of them poor, saved an extra 1 percent of their incomes, a recent study found, and boosted their overall saving 38 percent.

The only thing preventing a big bank from doing this in the U.S.: It’s completely illegal. A bill in Congress — which passed the U.S. House of Representatives on Sept. 16 — would change the law. If it’s passed by the U.S. Senate in the next few months and signed by President Barack Obama, banks of all sizes could start tempting savers with “savings promotion raffles.”
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In the U.S., federal law already lets credit unions offer prizes to savers, as long as states are okay with it. The Save-To-Win game, started in Michigan in 2009, is available at credit unions in four states. In Michigan, every $25 saved increases the chance that a customer could win dozens of monthly prizes worth up to $3,750, or six $10,000 grand prizes each year. So far, more than 50,000 people have saved more than $94 million through the game.

The fun of competing for prizes does get more people saving, the studies of the South African and Save-To-Win experiments suggest. And low-income people especially benefit from this extra cushion of cash. A quarter of Americans tell researcher they’re certain they’d have no way to come up with $2,000 in the next month.

In a paper titled International Transmission Channels of U.S. Quantitative Easing: Evidence from Canada, Tatjana Dahlhaus, Kristina Hess and Abeer Reza claim:

The U.S. Federal Reserve responded to the great recession by reducing policy rates to the effective lower bound. In order to provide further monetary stimulus, they subsequently conducted large-scale asset purchases, quadrupling their balance sheet in the process. We assess the international spillover effects of this quantitative easing program on the Canadian economy in a factor-augmented vector autoregression (FAVAR) framework, by considering a counterfactual scenario in which the Federal Reserve’s long-term asset holdings do not rise in response to the recession. We find that U.S. quantitative easing boosted Canadian output, mainly through the financial channel.
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Standard economic theory, however, provides ambiguous implications for the international spillover of monetary easing (Rogoff [2002]). Through the expenditure-switchingeffect, a monetary expansion in the United States would depreciate the home currency and deteriorate its terms of trade, making home goods cheaper for foreigners. The resulting increase in home country net exports would then detract from the real output of the foreign economy. The income-absorption effect, on the other hand, implies that as long as expansionary monetary policy in the home country drives up domestic income, home demand for imports would rise, boosting the economy of foreign exporters. Finally, in the presence of globalfinancial market integration, any increase in asset prices and reductions in yields in the domestic financial market resulting from QE may be reflected by similar movements in corresponding foreign financial market variables,2 which in turn would boost foreign consumption and investment through the same mechanism as it does in the domestic case. Therefore, whether Canada benefits from the U.S. expansion through QE depends on which of these effects dominate, and is an empirical question that we attempt to answer here.

R Split III Corp., proud issuer of RBS.PR.B was confirmed by DBRS at Pfd-2:

On September 24, 2013, DBRS upgraded the ratings on the Preferred Shares to Pfd-2 from Pfd-2 (low) based on the increased downside protection levels available to holders of the Preferred Shares over the prior year, as well as the increase in distribution coverage ratio. Since the rating was upgraded, the net asset value of the Company has generally been increasing steadily, rising from $43.55 on September 12, 2013, to $54.22 on September 11, 2014. Downside protection available to holders of the Preferred Shares increased to 74.9% as of September 11, 2014, compared to 68.8% on September 12, 2013. In addition, RBC raised its dividends twice this year, on February 26, 2014, and most recently on August 22, 2014, increasing quarterly distributions to 75 cents per share from 67 cents per share. This dividend boost increases the Preferred Share distribution coverage ratio to 2.9 times (up from 2.6 times in September 2013). The confirmation of the rating of the Preferred Shares is based primarily on the current level of downside protection available and the current distribution coverage ratio.

With a market capitalization of less than $10MM, RBS.PR.B is not tracked by HIMIPref™.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts rocketing up 34bp (more than half of this was due to strength in three BAM issues), FixedResets off 1bp and DeemedRetractibles down 4bp. Volatility was good, highlighted by winning BAM PerpetualDiscounts. Volume was below average.

RBC issued sub-debt at 3.45%+112:

Royal Bank of Canada (RY on TSX and NYSE) today announced an offering of $1 billion of subordinated debentures (“the Notes”) through its Canadian Medium Term Note Program.

The Notes bear interest at a fixed rate of 3.45 per cent per annum (paid semi-annually) until September 29, 2021, and at the three-month Banker’s Acceptance Rate plus 1.12 per cent thereafter until their maturity on September 29, 2026 (paid quarterly). The expected closing date is September 29, 2014. RBC Capital Markets is acting as lead agent on the issue.

The bank may, at its option, with the prior approval of the Office of the Superintendent of Financial Institutions Canada, redeem the Notes on or after September 29, 2021 at par, in whole at any time or in part from time to time, on not less than 30 days and not more than 60 days notice to registered holders.

Net proceeds from this transaction will be used for general business purposes.

Rumblings about corporate bond liquidity are getting more frequent:

Index fund managers are finding it hard to secure the bonds they need at the prices they want, forcing them to make trade-offs that can hurt investors and leave managers vulnerable in a market downturn.

Bond liquidity has all but dried up for corporate issues after new regulations and capital requirements forced Wall Street banks to slash their inventories of fixed-income products following the financial crisis. That’s especially challenging for index fund managers who must acquire certain bonds to be able to track specific benchmarks.

The lack of liquidity also means funds may have trouble selling bonds in the event interest rates rise and the investors who have sunk about $1.2-trillion (U.S.) in net deposits into long-term bond funds since the end of 2004 head for the exits.

The Financial Stability Board (FSB) is examining whether exchange-traded funds pose a risk to the global financial system for precisely that reason, according to the Bank of Canada’s representative to the committee at the Bank for International Settlements.

“There’s been investments and positions taken that may not have the liquidity there that people expect, especially as interest rates start to normalize,” Carolyn Wilkins, senior deputy governor at Canada’s central bank, told Bloomberg News in an interview. “So the liquidity illusion, if you want to put it that way, is something that we’re worried about.”

I certainly hope she was misquoted in the Bloomberg story regarding that interview:

The efforts of the Basel Committee are helping to restore faith in the financial system, Wilkins said.

“People are going to have the knowledge that the banks not only in Canada, but globally are safer,” she said. “That means that the probability of something going wrong that they’ll be on the hook for later as taxpayers will be lower.”

While additional regulatory requirements may translate into extra transaction costs for the banks and businesses and customers they deal with, “those costs should be worth it because they’re reducing the chances that something goes pear shaped,” she said.

Well, of course there are benefits to increased capital levels, although I don’t have quite the same certainty with respect to some regulatory requirements. And anybody will agree there are costs. The hard part is – and what has been consistently ignored by OSFI, the Bank of Canada, and every apparatchik in the apparatus – is balancing the two. We have a very safe banking system in Canada – and it has come at the expense of innovation and economic growth.

What job do you look for when you’re an unemployed Master of the Universe?

As trading in dollar-denominated bonds declined 22 percent in the past five years to an average daily $809 billion, so have the jobs, leaving even some of the most senior traders and salesmen moving from firm to firm. Dozens of journeymen are populating an industry that used to attract the young in throngs, lured by money and prestige, according to Michael Maloney, president of fixed-income recruiting firm Michael P. Maloney Inc.

“The business model is broken and 50 percent of the people in our world who are in trading are stuck right now,” Maloney said in an interview in his New York office.
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While the size of the U.S. bond market ballooned by more than $5 trillion since 2008 to $37.8 trillion at year-end, trading in the debt has slumped, according to data from the Securities Industry & Financial Markets Association. Average daily turnover fell to $809 billion last year from $1.04 trillion in 2008.

That’s partly because banks have pulled back from making markets in bonds as higher capital requirements make it less profitable. The business — where buyers and sellers are primarily matched over the telephone or through e-mails — has also suffered shrinking margins because of regulator-mandated price transparency and the rise of electronic trading.
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Transaction costs declined after the Financial Industry Regulatory Authority introduced its bond-price reporting system, called Trace, in 2002. Wall Street bond traders lost about $1 billion in fees in the next year, or about $2,000 a trade, according to a study in the Journal of Financial Economics. The system is intended to provide transparency in an opaque market, and help prevent investors from being fleeced.
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The number of credit traders working for the firms plunged 30 percent to about 300 over the same period, even as companies issued record amounts of bonds in the U.S. to take advantage of historically low interest rates, according to Options Group and data compiled by Bloomberg.

The ‘broken’ corporate bond market was also discussed yesterday.

Now, never let it be thought that I consider secondary market trading to be an important thing in and of itself. Secondary market trading is important only insofar as it affects the issuance market, because the purpose of the corporate bond market is exactly the same as that of the equities market: to transfer money from sources of capital to sinks, to be returned (with luck!) as an income stream from the real-world investment that’s done with the money. And issuance in recent years has been monstrous in the past few years so, we might rashly conclude – no problem!

However, as has been pointed out by Ron Mendel of Hartford Investment Management in his admirable essay Private Placement Debt: Diversification, yield potential in a complementary IG asset:

Private placement investors require additional yield relative to comparable public bond issues, as lenders demand greater yield to compensate for increased liquidity risk as well as the underwriting and monitoring costs. This premium is variable over time and is a function of technical, supply and demand characteristics, credit fundamentals and insurance liability requirements. The typical liquidity premium historically ranges between 25 – 45 basis points.

That’s a hell of a spread, although not as much as we get in the Canadian preferred share market! It will also be noted that this is the rate in an environment comprised largely of insurance companies; other investment entities, including individuals, are probably going to want a bigger premium for giving up liquidity. Additionally, the ability to issue corporate debt has not yet been tested in an environment of increasing policy rates or general doom and gloom (after the extraordinary gloom and doom of the credit crunch, anyway).

A lack of secondary market liquidity will ultimately increase spreads at issuance and will therefore harm the economy, hurting workers; in addition, the economic harm will be mitigated to some extent by lower policy rates, hurting savers. This is just a mess all ’round.

On a brighter note, King Timmy is unconcerned about the inversion clampdown:

Scott Bonikowsky, a Tim Hortons spokesman, said the deal is “moving forward as planned” and is driven by long-term growth and not tax benefits. The actions to curb inversions announced yesterday by Treasury Secretary Jacob J. Lew are getting an immediate test as eight U.S. companies with pending deals decide whether to move forward.

It was a modestly negative day for the Canadian preferred share market, with PerpetualDiscounts down 13bp, FixedResets off 10bp and DeemedRetractibles flat. Volatility was low. Volume was slightly below average.