PrefBlog

There was rather an alarming headline, but a story in the Globe made some important points about junk:

Still, demand for these [junk bond] deals has quickly escalated after a decade of inactivity, and 13 new Canadian offerings worth over $3-billion ultimately hit the market in 2010.
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In theory, [Barry Allan, who runs Marret Asset Management] said, 100 per cent of the volatility in the price of a government bond stems from interest rate movements. (Though, sovereign risk is now toying with that assumption.) Investment-grade bonds fluctuate in a similar fashion, with 80 per cent of price movements related to interest rates.

In contrast, only 20 per cent of movements in the prices of high-yield debt are tied to interest rates.
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The sector is hot in Canada because income trusts have all but disappeared, said Greg Woynarski, co-head of fixed income at Scotia Capital, which now has five people dedicated to high-yield products. “Debt is becoming the new equity.”

Back when trusts yielded 5 to 8 per cent in annual distributions, they effectively served the same function for income-seeking investors that high-yield debt does today.

It was a day of average volume on the Canadian preferred share market, with PerpetualDiscounts gaining 14bp and FixedResets won 6bp. As a result the Bozo Spread (Current Yield PerpetualDiscounts less Current Yield FixedResets) has gone negative – not necessarily a death knell for my conjecture that retail evaluates the relative attractiveness of these classes by comparing Current Yields, but it does make it more complex: the indices will have to be disaggregated to make it work (i.e., compare RY-RY, or TD-TD, not index-index).

In law school, you learn that a contract is holy. On the street, you learn that a contract is where you start:

New Jersey Governor Chris Christie said he doesn’t mind breaking promises to pensioners to close a $10.5 billion budget deficit — even if they sue.

“I have bigger issues than who sues me,” said Christie, 48, a Republican and former federal prosecutor who wants to end cost-of-living increases for retirees. “Get in line.”

Public workers in Colorado, South Dakota and Minnesota are already suing their states, which are among 18 that want to pare pension costs by increasing employee contributions, raising the retirement age or curbing cost-of-living increases.

“We believe it’s unconstitutional,” said Gary Justus, 63, a retired mathematics teacher in the Denver public schools who’s a plaintiff in the Colorado suit. “These are contracts that I and 100,000 other retirees worked for.”

BIS has released a working paper titled Messages from the academic literature on risk measurement for the trading book which I find very disappointing:

The artificial distinction between a “trading book” and a “banking book” refers to positions, but these positions need not be exposed to different sets of risk. If the risks associated with these books are distinct, even if they are not independent, then adding the VaR measures of these books will be conservative. If the risks associated with the two books are not distinct, (eg if the separation is due only to accounting rules), then adding compartmentalised VaR risk measures is guaranteed to be conservative only if all risks relevant to each book are accounted for. If not, the sum of compartmentalised risk measures may understate the risk of the combined portfolio risk.
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The last two sections 5 and 6 include management aspects, such as inter-risk aggregation and the borderline between the banking and trading books (which is discussed only briefly).

This ignores the very essence of the trading book, namely that it is used for trading. There is an army of prop traders (EVIL prop traders!) on the Street who could have explained this to the committee, but it would appear that the committee would prefer to ignore them.

The epitome of a prop trader is a high-frequency trader; a high-frequency trader is nothing more than a guy who has examined the “gut reactions” of prop traders, systemized them and created an expert system with a fast reaction time.

Now, let us assume that you’re a high frequency trader and you’re designing an algorithm to trade British Petroleum. Here’s my question: how much time do you spend worrying about peak oil, the growing influence of the Russion state, and the potential for increased regulation in the US? How much of your algorithm execution time considers such matters?

None. You couldn’t care less. The only reason your algorithm buys at a nickel is because there is good reason to believe that you can sell at a dime within, say, ten minutes. All that peak oil garbage is for investors, not traders. It’s a whole different time scale, with a completely different set of problems – an obvious fact which the committee chooses to ignore:

The accuracy of square-root of time scaling depends on the statistical properties of the data generating process of the risk factors. Diebold et al (1998) show that, if risk factors follow a GARCH(1,1) process, scaling by the square-root of time over-estimates long horizon volatility and consequently VaR is over-estimated. Similar conclusions are drawn by Provizionatou, Markose and Menkens (2005). In contrast to the results that assume that risk factors exhibit time-varying volatility, Danielsson and Zigrand (2006) find that, when the underlying risk factor follows a jump diffusion process, scaling by the square root of time systematically under-estimates risk and the downward bias tends to increase with the time horizon. While these results argue against square-root of time scaling, it is important to acknowledge that we were not able to find immediate alternatives to square-root of time scaling in the literature. Therefore, the practical usefulness of square-root of time scaling should be recognised.

As I have stated often before, the most important element of risk control for banks is to ensure that positions held in the trading book are, in fact, traded. Aged inventory should be encouraged to move to the banking book by steadily more punitive capital charges with the passage of time. This is, in fact, how smart trading houses keep their traders honest – the amount they’re charged for their use of capital, which affects their P&L, which affects their bonuses (EVIL bonuses!), progressively increases.

S&P cut Ireland again:

We are lowering our ratings on the Republic of Ireland to ‘A-/A-2’ from ‘A/A-1’ following our revision of the Irish Banking Industry Country Risk Assessment to Group ‘6’ from ‘4’.

We are keeping the ratings on CreditWatch with negative implications, reflecting our view of the uncertainties surrounding the size of Ireland’s additional capital needs for its largely state-owned financial sector.

We expect to resolve the CreditWatch placement by April, when we should be in a position to assess the impact of additional capital injections on the government’s debt dynamics.

Speaking of Europe, one of my favourite topics of reflection is the Law of Unintended Consequences:

Century-old controls on rents and evictions are stifling investment in Portuguese real estate and leaving the country with crumbling city centers as rental income fails to keep pace with maintenance costs, according to landlords and property industry groups. The government has pledged to introduce measures in March to streamline rules on rental properties as it seeks to jumpstart an economy that’s had one of Europe’s weakest growth rates over the last decade.

While legislation in 1981 lifted rent controls on new contracts and a 1990 law allowed landlords to set expiry dates on leases, more than half of Portugal’s rentals are subject to the older restrictions. That means most owners are still coping with contracts that never expire and rates that are frozen or limited to inflation adjustments, said Miguel Marques dos Santos, an attorney specializing in real estate at the Lisbon office of Garrigues. Even death isn’t always enough to break a lease because tenants can pass on a contract to their children, spouses or parents.
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The country had the third-most restrictive laws on eviction in 2009 among the 30 countries in the Organization for Economic Cooperation and Development, trailing only Sweden and Greece, the OECD said in a report published this year. It had the ninth- toughest rent-control restrictions.
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New development still attracts the vast majority of construction investment in Portugal, with only 6.2 percent going to renovation in 2009, according to Aecops. Only Romania spends less on renovations among the 14 European countries for which data was available, the European Construction Industry Federation said. The average is 23 percent.

Owners of rent-controlled properties don’t get enough income to support their upkeep, leaving Lisbon and other cities pockmarked with crumbling structures, Aecops said. It estimates that about 36 percent of the country’s residential buildings are in need of repair.

“Some of these contracts date back to the 60s and pay as little as 5 euros per month for a four-bedroom apartment in the capital,” Luis Menezes Leitao, president of Portugal’s Association of Landlords, said in an interview.

The lack of incentives to invest in renovation has caused a chronic shortage of rental accommodation, which now represents less than 20 percent of Portugal’s total housing stock, Menezes Leitao said. That has forced people to buy property instead, boosting debt and pushing up home prices.

“They couldn’t rent, so they bought and borrowed too much money,” he said. “It’s a contributing factor in the current crisis.”

Volume was surpisingly good today, considering the number of little girls who took a snow-day off work, but price action was restrained. PerpetualDiscounts were up 1bp, while FixedResets were down 4bp, as the Bozo Spread (Current Yield PerpetualDiscounts less Current Yield FixedResets) remained at zero.

PerpetualDiscounts now yield 5.26%, equivalent to 7.36% interest at the standard equivalency factor of 1.4x. Long Corporates have popped up to 5.6%, so the pre-tax interest-equivalent spread (also called the Seniority Spread) is now about 175bp, a significant narrowing from the 190bp reported at month-end.

Mr Joseph S Tracy, Executive Vice President of the Federal Reserve Bank of New York, gave a speech titled A strategy for the 2011 economic recovery:

The Great Recession distinguished itself from earlier recessions in terms of its severity rather than its length. There was a decline in real output relative to trend of $1.1 trillion or 8 percent (Chart 1). This contraction brought the level of real output back to its level in 2006. In most recessions, consumption growth slows but remains positive. In this recession, there was an actual decline in consumption rather than just a slowdown (Chart 2). When households need to cut back on their consumption, they typically do so first with durable goods – for example, by delaying the decision to replace a car or to trade up to a nicer house. It is no surprise then that auto sales dropped significantly (Chart 3). Housing starts had been declining since late 2005, and the decline continued during the recession (Chart 4). Producers reacted quickly to the sharp decline in consumer demand, but inventories still rose sharply relative to sales (Chart 5).

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How many more stories like the following must we read before the current craze for paid government informants dies down?

An immigration officer tried to rid himself of his wife by adding her name to a list of terrorist suspects.

He used his access to security databases to include his wife on a watch list of people banned from boarding flights into Britain because their presence in the country is ‘not conducive to the public good’.

As a result the woman was unable for three years to return from Pakistan after travelling to the county to visit family.

The tampering went undetected until the immigration officer was selected for promotion and his wife name was found on the suspects’ list during a vetting inquiry.

Interesting opinion on the Canadian bond market:

In order to maximize value in their bond portfolios, investors should limit exposure to Canada’s corporate bond market, one of the most expensive and least diversified of its kind in the world, says Ed Devlin, executive vice president and portfolio manager at PIMCO Canada Corp.

“The fundamental problem with the Canadian corporate bond market is that there is are too many investors chasing too few issuers,” Mr. Devlin said in a recent note to clients.

He noted that 59% of Canada’s main corporate bond benchmark is concentrated in just 10 issuers. By comparison the percentage of the index concentrated in 10 issuers is 20% in the U.S., 26% in Great Britain and 35% in the Eurozone.

Just another reason to start marketting Maple bonds to Canadians … it will never happen. Maple issuers don’t make a point of hiring Canadian ex-regulators.

It was a good day on the Canadian preferred share market as PerpetualDiscounts were up 18bp while FixedResets gained 4bp. The Bozo Spread (Current Yield PerpetualDiscounts less Current Yield FixedResets) is now zero!

The market was well-behaved, with no entries at all in the Performance Highlights.