PrefBlog

Accrued Interest compares a list of the top ten corporate bond issuers (by weight) with the top ten components of the S&P 500 (by weight) and speculates that the apparent divergence between the stock and bond markets (referred to yesterday) is not so strange after all … or, at least, has something to tell us in and of itself:

Perhaps the kinds of companies who are large bond issuers are struggling in the stock market as well. Perhaps the kinds of companies which are keeping the stock averages afloat are not big bond issuers: XOM, MSFT, PG, etc.

We may be looking at a sort of weird recession coming up. One where layoffs aren’t as bad as some past recessions, but consumer spending drops substantially anyway, because of credit availability. I could see such a recession not being terribly bad for stocks. But financials are right on the forefront of these problems. If that’s how it plays out, then the financial-laden corporate bond indices will at best stay wide for a while, even if the stock market improves.

There are reports that Citigroup and Merrill are going cap in hand to foreigners, begging for equity infusions – which could run afoul of protectionists in Congress (and, depending on what happens, perhaps the White House). It will be fascinating to watch this play out over the next few years … we are seeing an increase in Canadian rhetoric over the matter, despite the fact that Canadian investment in the US is booming.

Brad Setser discusses the matter and comes up with a rather startling statistic:

The most money the IMF ever lent to the emerging world in a quarter?

$13.7b – in the third quarter of 2001 (Turkey and Argentina … )
…
Capital infusions from emerging market governments to US and European banks smarting from losses on US mortgages in q4? $28.4b, by my count.

Years of fiscal profligacy in the US are now having their effect. And the mutterings of further fiscal profligacy from the White House are forecast to have negligible effect anyway:

If stimulus is required, better policy instruments are available — foremost monetary policy. Tweaking tax policy is also a distraction from the serious long-term fiscal issues facing the nation: a persistent budget deficit of 1-1/2% of GDP, the expiration of the Bush tax cuts, and a long-term fix to the Alternative Minimum Tax, plus the looming cost of the retirement of the baby boom generation.

My obsession with preferred shares makes me a rather biased observer … but I think that the US has to decide on a long term tax policy with respect to dividends. I reported the discussion of taxes in the WaMu preferred issue on December 13 … it is a mystery to me how the US, the country whose business is business, have ended up having such a basic investment consideration as the tax treatment of dividends as a polarizing political issue.

We’re not talking a piddly little difference like ‘either a rate of 17% or a rate of 20%’ here … we’re talking 35% (Democrats) and 15% (Republicans). This is sheer craziness, but I’m not holding my breath for rationality in an election year.

Some degree of normalcy is returning to the credit markets – as indicated by the amount of US commercial paper outstanding, anyway! ABCP outstanding is up $5-billion, while foreign financial is up $16-billion.

Bernanke gave a speech today and had a few interesting things to say:

One of the many unfortunate consequences of these events, which may be with us for some time, is on the availability of credit for nonprime borrowers. Ample evidence suggests that responsible nonprime lending can be beneficial and safe for the borrower as well as profitable for the lender. For example, even as delinquencies on subprime ARMs have soared, loss rates on subprime mortgages with fixed interest rates, though somewhat higher recently, remain in their historical range. Some lenders, including some who have worked closely with nonprofit groups with strong roots in low-to-moderate-income communities, have been able to foster homeownership in those communities while experiencing exceptionally low rates of default. Unfortunately, at this point, the market is not discriminating to any significant degree between good and bad nonprime loans, and few new loans are being made.

… however, one sentence of his six page speech attracted a lot of attention:

Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.

That, together with reports that Bank of America might buy Countrywide outright, lit a fire under the markets:

Countrywide climbed the most in at least 25 years after the Wall Street Journal reported Bank of America Corp. is in advanced talks to acquire the biggest U.S. mortgage company. JPMorgan Chase & Co., Wells Fargo & Co. and Citigroup Inc. led financial firms to the biggest rally in a month as traders increased bets that the Fed will reduce its benchmark lending rate by a half point this month.

Fed Fund futures were up slightly on the day, with the February contract implying 3.775% and the June contract implying 3.195% (derived from mid-afternoon prices). Note that the current rate is 4.25% and the next FOMC meeting is scheduled for Jan 29/30.

Not a bad day in the preferred market! PerpetualDiscounts continued their winning streak and there was a return good volume. Perhaps all the cowboys have come back from branding their funds, or whatever it is they do when not trading.

There were twenty-six other index-included $25.00-equivalent issues trading over 10,000 shares today.

Update: Current Senate Majority Leader Harry Reid: The Bush Tax Plan Leaves the Middle Class Behind:

FICTION: Bush Says Uncertainty Over the Extension of His Tax Cuts Harms the Economy. “The prospect of higher taxes, the notion that there’s uncertainty in the tax code makes it difficult for small business owners and company executives to plan. How can you plan if you’re uncertain about what the future’s going to be when it comes to the tax code.” [5/3/06]

 

– FACT: Not True. Economists at the Federal Reserve considered whether the temporary nature of the tax cuts might be one reason they have not had much impact on stock market value, but found that companies with no dividends performed better than high-dividend companies during the period immediately following the announcement of the tax cuts and their passage. [Gravelle, Jane G., Congressional Research Service, “Dividend Tax Relief: Effects on Economic Recovery, Long-Term Growth, and the Stock Market,” 2/14/05.]

Mike Cosgrove, Investors Business Daily, Politics Point To Higher Tax On Dividends:

Equity investors seem comfortable with the idea that the existing tax rates on dividends, capital gains and earned income will stick around until at least the end of 2010 — their scheduled expiration date. The odds of that occurring are, at best, 50-50 at this point.

One side of the 50-50 is that all major Republican candidates support extending the present tax-rate structure past 2010. The other 50 is from all major Democratic candidates who have said they will not extend existing tax rates — meaning higher tax rates on earned income, capital gains and dividends for taxpayers.

Herbert Lash, Reuters via Yahoo Investors see trade, taxes as key in White House Race:

The top Republican candidates have endorsed extending President George W. Bush’s tax cuts, except Huckabee, who proposes eliminating federal income and payroll taxes and to replace them with a federal consumption tax at the retail level.

 

Giuliani, a former New York City mayor, has proposed cutting the corporate rate to 25 percent from 35 percent. McCain supports extending Bush’s tax cuts, although he voted against them in 2001 and 2003, saying they also did not include spending reductions.

 

Among Democrats, Edwards wants to increase the tax rate on long-term capital gains to 28 percent from 15 percent, and tax dividends as ordinary income. Obama favors a rate of between 20 percent and 28 percent on capital gains and dividends.

Carnage continued for the shadow-banks as Countrywide hit another low. Accrued Interest looks at their bond prices and figures that estimated recovery on debt is 60%. Their CDS levels agree:

Credit-default swaps on $10 million of Countrywide debt cost $3 million plus $500,000-a-year for a five-year contract. The upfront cost increased from $2.8 million yesterday, according to broker Phoenix Partners Group.

Meanwhile MBIA, a monoline insurer that has fallen on hard times, is cutting its dividend and issuing deeply subordinated notes that it will consider capital:

MBIA Inc., the world’s largest bond insurer, will cut its dividend and raise $1 billion in a sale of notes to boost capital and preserve its AAA credit rating.
…
MBIA’s decision to raise more capital and shave its dividend is the second step in an effort to shore up its finances. The company last month said private-equity firm Warburg Pincus LLC agreed to purchase $500 million of new shares at $31 each and to backstop a rights offering of another $500 million.
…
MBIA said the so-called surplus notes will rank below all other debt, enabling them to be treated as capital. The interest will be fixed until 2013 and then switch to a floating rate.

There is no word as yet regarding what the rate is going to be on the surplus notes. In what may be regarded as a “carrot & stick” approach to getting what you want out of financial markets, Berkshire Hathaway is considering investing in the sector in addition to supporting its start-up insurer. This news was cheered by investors.

E*Trade is also taking desperate measures:

E*Trade Financial Corp., the worst performer in the Standard & Poor’s 500 Index last year, sold $3 billion of mortgage-backed securities and municipal bonds to bolster its finances.

The sale was completed at a loss of less than $5 million, the New York-based online brokerage said in a statement today. E*Trade also said it’s “aggressively” reducing risks from real- estate loan holdings and shuttered the institutional equities trading division.

Meanwhile, Goldman Sachs calls for a recession (but there’s lots of divergent views) while Philadelphia Fed President Charles Prosser warns of inflation:

The below-trend growth of the economy in the first half of 2008 will likely mean slower payroll employment growth for the first two to three quarters of the year. With slower job growth for a time, the unemployment rate may rise somewhat above 5 percent during the course of the year.   

At the same time we also face risks of higher inflation…I am concerned that developments on the inflation front will make the Fed’s policy decisions more difficult in 2008. Recent data suggest that inflation is becoming more broad-based. Recent increases do not appear to be solely related to the rise in energy prices. Consequently I see more worrisome signs of underlying price pressures…

And all this in a US election year!

PerpetualDiscounts continued their streak – up on each one of the past 10 trading days, commencing December 24 (which was the last day of tax loss selling). A lot of the big movers today were affected by the index rebalancing announced recently … I don’t know whether this was an influence or not, but it was a noticable correlation.

There were ten other index-included $25.00-equivalent issues trading over 10,000 shares today.

Update 2008-01-10: A troublemaker in the comments points out that the PerpetualPremium index had a massive change in average YTW, changing from 3.83% on 1/8 to 5.09% on 1/9.

This is due to CL.PR.B, which had a price change of 26.11 to 25.63, resulting in a yield-to-worst change of from -9.03% to +5.44%.

Index composition as of Jan 8 and Jan 9 has been uploaded for inspection.

Accrued Interest presents the case in favour of (US Corporate) fixed income, on the grounds that yield spreads are recessionary; stock prices ain’t. He is severely criticized for this view in the comments, but I think there is a certain amount of truth in his argument. It’s not conclusive … but it’s a piece of evidence.

Michael Woodford of Columbia University wrote a very thoughtful piece on VoxEU, discussing the Fed’s new communications strategy. This new policy was released on November 14:

In the future, the FOMC will compile and release projections four times each year rather than twice a year. In addition, the projection horizon will be extended to three years, from two. FOMC meeting participants will now provide projections for overall personal consumption expenditures (PCE) inflation, as well as for real gross domestic product (GDP) growth, the unemployment rate, and core PCE inflation. Projections of nominal GDP growth will be discontinued. Summaries and explanations of the projections will be published along with the minutes of the FOMC meeting at which they were discussed. These descriptions will provide a fuller discussion of the projections, covering not only the outcomes that most meeting participants see as most likely, but also the risks to the economic outlook and the dispersion of views among policymakers.

Prof. Woodford poses the question:

The commitment [by many central banks] to justify policy to the public in this way increases public understanding of the policy, and so should improve the public’s ability to correctly anticipate the future conduct of policy, increasing the effectiveness of policy. It also serves the goal of making the central bank more accountable, which provides democratic legitimacy for the central bank’s grant of operational independence. And finally, it can improve policy itself, by providing a check on possible temptations to base policy purely on short-run considerations, losing sight of whether policy remains consistent with the bank’s medium-run objectives.

Does the Fed’s commitment to release additional projections, and additional discussion of those projections, serve a similar function?

He concludes:

So the Fed has not yet taken too great a step toward implementation of inflation targeting in the U.S. (This is likely to come both as a relief to some and as a disappointment to others.) Does the new policy matter at all?

I think that it will make a difference, but not primarily to the degree to which outsiders are better able to understand or predict Fed policy, in the first instance. Rather, the most important consequence of the new strategy, in the short run, will be for the Fed’s own deliberations. Requiring the members of the FOMC to consciously consider the way in which the economy is likely to evolve over the next several years, and the nature of appropriate policy not just in the short run, but also over the next several years, is likely to increase the extent to which policy decisions are considered as part of a coherent strategy rather than as a sequence of unrelated decisions. Encouraging them to discuss with one another the extent to which their forecasts differ and why will facilitate the development of a shared understanding of what a sensible strategy would be like. And pressing them to consider the reasons for the changes in their forecasts from one release to the next should ultimately favour the maintenance of consistency over time in the way that policy is approached.

Prof. Woodward’s analysis makes a lot of sense but, while he mentions the issue of central bank independence, he does not address the fact that such projections will help to defend such independence. Such a formalized methodology of explaining the central bank’s decisions will serve to pre-empt political criticism … if a politician says that rates have to come down because unemployment’s up and inflation’s not a worry, there will already be a projection on the table that he will have to address.

There has, for instance, been considerable tension between Sarkozy and the ECB:

Trichet has refused to heed Sarkozy’s call for the ECB to follow the Federal Reserve and cut its benchmark interest rate from a six-year high of 4 percent. Inflation accelerated to 2.6 percent in October, the fastest pace in two years, and the price of oil yesterday rose above $96 per barrel for the first time.

It’s best to nip such tension in the bud by giving political reporters a known source of independent projections and justifications.

Those who hate the Credit Rating Agencies will be overjoyed to learn (hat tip: Financial Webring Forum) that they are firing staff:

DBRS Ltd., the Canadian ratings company, closed its European offices and cut about a quarter of its workforce because of a slump in credit markets.

The offices in Frankfurt, Paris and London closed and 43 European employees were fired, said spokeswoman Caroline Creighton. DBRS also cut jobs in North America, reducing its overall staff to about 200 people, from 270.
…
DBRS joins Moody’s Corp., the second-biggest credit-ratings company, in trimming its workforce because of the decline in credit markets and reduced demand for ratings on mortgage-backed securities and other debt. New York-based Moody’s said yesterday it plans to cut about 275 jobs, or 7.5 percent of its employees.

It’s noteworthy that the number of jobs Moody’s cut is greater than the number of jobs DBRS has. Is it any wonder that DBRS is the weak sister among the major agencies?

Not the most exciting of all possible days on the preferred share market, unless you’re subject to margin calls on your BCE.PR.B position! Volume picked up a little with a few good crosses going through and perpetuals ground out another win. Yesterday’s frothy correspondent clarified the view … projecting that a P1 would have to offer at least 5.50% to get a deal done given that demand for perpetuals is still shallow and that there should be a lot of corporate bond issuance this month.

Well, as my more Assiduous Readers will have come to expect by now … I dunno! I think that, regardless of what will happen to spreads in the coming months, spreads are now attractive … and I LOVE trading in frothy market!

One of the first things you learn as an investment counsellor is to be humble. Don’t boast about your great trade, because it jinxes your monthly return. Don’t boast about the monthly return … don’t boast about the yearly return. The market has a way of making you look like an idiot. So I won’t boast, I’ll just point out that I’ve updated Malachite Aggressive Preferred Fund‘s fourth quarter annualized return.

There were eleven other index-included $25.00-equivalent issues trading over 10,000 shares today.

I received an eMail from an Assiduous Reader today, asking whether I agreed that the pref market was looking rather frothy.

Well – I agree it’s frothy, in that there are huge discrepencies between issues – it’s not too difficult to pick pairs of issues where one is as obviously expensive as the other is cheap. However, “frothy” has a connotation of “toppy”, and I’m not so sure that I agree with the word as far as that goes. Having a look at the four bellwether indices:

Toppy? It looks more as if the bad dream of the fourth quarter has faded like gossamer … one might be able to make the case that the OpRet Index is toppy, since there’s not much interest-equivalent premium to bonds … but PerpetualDiscounts still have an average pre-tax bid-YTW of 5.49 … interest-equivalent of 7.69% … long corporates are a shade over 5.6%, according to Canadian Bond Indices …. this is within spitting distance of the October 30 spread.

Meanwhile, long Canadas yield 4.04% (!) for an interest-equivalent spread of about 365bp – this has widened considerably since this was checked on October 10.

So, as with all market-timing type questions, I will respond … “You’re asking me?”

Volume picked up slightly, but not much, on another good day. BNA.PR.C was astounding.

There were seven other index-included $25.00-equivalent issues trading over 10,000 shares today.

There’s a real dearth of news and informed commentary today!

The US had a bad jobs number today, but that’s about it.

Otherwise, the only thing I saw today of even passing interest was Springfield, Massachusetts, getting angry at Merrill because some sub-prime linked CDOs that they bought have gone down in price. According to Steven Syre of the Boston Globe:

City officials say Merrill Lynch, an active player in the municipal finance business, sold them securities that cities in Massachusetts aren’t legally allowed to own for reasons of safety and liquidity. What the broker actually disclosed about the nature of those investments at the time of the sale remains murky.

“We take very seriously the financial cost and the breach of public interest,” said Chris Gabrielli, the chairman of Springfield’s Finance Control Board and former gubernatorial candidate. “Our view is that Merrill Lynch has responsibility here and is accountable. We shouldn’t have to settle for less than getting the money back.”

A Merrill spokesman said Springfield officials had sought AAA-rated securities offering higher returns than they had been getting. “These investments met both those criteria, and each was reviewed, approved, and authorized by Springfield officials.”

Who knows? It is possible, I suppose, that Merrill misrepresented the investment. I consider it far more likely that a few snivel-servants with Springfield were just thrilled to pieces about being big-shot hard-nosed investment geniuses, until they got to the “taking responsibility” part. We’ll see!

An excruciatingly slow day on the preferred share market, but performance continued to be good.

There were three other index-included $25.00-equivalent issues trading over 10,000 shares today.