PrefBlog

There were no real surprises in the FOMC statement:

The Federal Reserve is committed to using its full range of tools to support the U.S. economy in this challenging time, thereby promoting its maximum employment and price stability goals.

The coronavirus outbreak is causing tremendous human and economic hardship across the United States and around the world. Following sharp declines, economic activity and employment have picked up somewhat in recent months but remain well below their levels at the beginning of the year. Weaker demand and significantly lower oil prices are holding down consumer price inflation. Overall financial conditions have improved in recent months, in part reflecting policy measures to support the economy and the flow of credit to U.S. households and businesses.

The path of the economy will depend significantly on the course of the virus. The ongoing public health crisis will weigh heavily on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term. In light of these developments, the Committee decided to maintain the target range for the federal funds rate at 0 to 1/4 percent. The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.

The Committee will continue to monitor the implications of incoming information for the economic outlook, including information related to public health, as well as global developments and muted inflation pressures, and will use its tools and act as appropriate to support the economy. In determining the timing and size of future adjustments to the stance of monetary policy, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

To support the flow of credit to households and businesses, over coming months the Federal Reserve will increase its holdings of Treasury securities and agency residential and commercial mortgage-backed securities at least at the current pace to sustain smooth market functioning, thereby fostering effective transmission of monetary policy to broader financial conditions. In addition, the Open Market Desk will continue to offer large-scale overnight and term repurchase agreement operations. The Committee will closely monitor developments and is prepared to adjust its plans as appropriate.

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Michelle W. Bowman; Lael Brainard; Richard H. Clarida; Patrick Harker; Robert S. Kaplan; Neel Kashkari; Loretta J. Mester; and Randal K. Quarles.

Powell’s a bit nervous:

“The path forward for the economy is extraordinarily uncertain and will depend in large part on our success in keeping the virus in check,” Mr. Powell said at a news conference following the Fed’s two-day meeting, noting that infections have surged since late June and the “pace of recovery looks like it has slowed.”

Mr. Powell said policymakers needed more data before drawing firm conclusions about the scope of the pullback, but he noted that debit and credit card spending were slowing and labor market indicators suggested that recent job gains might be weakening. More than 14 million people who held jobs in February are no longer employed, Mr. Powell said, warning that it will take a while for workers in certain industries, like restaurants, hotels and travel, to find new jobs.

“There’s probably going to be a long tail where a large number of people are struggling to get back to work,” he said, adding that the Fed was “not even thinking about thinking about thinking about” raising rates.
…
While the Fed took no major actions on Wednesday, Mr. Powell’s comments underlined both the peril ahead for American workers and the reality that interest rates are likely to be very low — making money cheap to borrow — for an extended period of time. Stock prices climbed following his remarks as investors took heart in the Fed’s patient stance.

Meanwhile US stimulus talks are going nowhere:

The prospects for a quick agreement between the Trump administration and congressional Democrats on a new round of aid for the ailing economy faded on Wednesday, as President Trump undercut his own party’s efforts to negotiate a deal and a top White House official declared that a lifeline to unemployed workers would run out as scheduled at week’s end.

With negotiations barely started to find a middle ground between Republicans’ $1 trillion plan and Democrats’ $3 trillion package, Mr. Trump poured cold water on the entire enterprise, saying that he would prefer a bare-bones package that would send “payments to the people” and protect them from being evicted.

“The rest of it, we’re so far apart, we don’t care,” Mr. Trump said before leaving the White House for an event in Texas. “We really don’t care.”
…
The breakdown reflects a predicament for Republicans that has placed Mr. Trump in a difficult negotiating position. After the enactment of nearly $3 trillion in pandemic-related stimulus in the spring, many Senate Republicans are opposed to additional deficit spending to fuel the economy, meaning that any agreement would need to attract significant support from Democrats to clear Congress.

As previously noted, monetary and fiscal policy should work in tandem, but loose monetary policy helps the rich get richer, while loose fiscal policy makes them poorer. So guess what policy mix is favoured by those who run the country!

PerpetualDiscounts now yield 5.65%, equivalent to 7.34% interest at the standard equivalency factor of 1.3x. Long corporates now yield 2.85%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has widened slightly (and perhaps spuriously) to 450bp from the 445bp reported July 22. We are now slightly above the pre-2020 record of 445bp briefly touched in 2008.

DBRS finalized the RBC LRCN rating today:

DBRS, Inc. (DBRS Morningstar) assigned a final rating of A (low) with a Stable trend to Royal Bank of Canada’s (RBC or the Bank) NVCC Additional Tier 1 (AT1) Limited Recourse Capital Notes (Capital Notes). DBRS Morningstar assigned the rating equal to the Bank’s Intrinsic Assessment of AA less four rating notches, which is consistent with DBRS Morningstar’s standard notching for capital instruments with contingent risks and its ratings for the Bank’s NVCC Preferred Shares. This is one notch below the rating of RBC’s NVCC Subordinated Debt.

On July 28, 2020, RBC issued $1.75 billion of Capital Notes that mature on November 24, 2080, and will have an initial five-year fixed rate of 4.5%. DBRS Morningstar notes that the Capital Notes were granted Tier 1 capital treatment by the Office of the Superintendent of Financial Institutions.

RATING DRIVERS
Given RBC’s high rating level and the current economic environment, an upgrade of the ratings is unlikely. Ratings would be downgraded if there is a prolonged adverse impact of the Coronavirus Disease (COVID-19) pandemic resulting in a sustained deterioration in asset quality, especially due to deficiencies in risk management. Additionally, a sustained weakening of profitability metrics would also result in a downgrade of ratings.

There was something of a peculiar Staff Note published by the Bank of Canada today, Will exchange-traded funds shape the future of bond dealing?, by Rohan Arora, Jean-Sébastien Fontaine, Corey Garriott and Guillaume Ouellet Leblanc:

The rise of exchange-traded funds (ETFs) makes JIT possible in bond markets. ETFs are securities traded on an exchange, just like stocks, that entitle the bearer to a share in a pool of assets (such as stocks or bonds). For example, a fixed-income ETF might entitle its bearers to a share of a pool of 100 bonds. We find that a dealer can use bond ETFs as a warehouse to meet investor demand to buy and sell bonds. Similar to a car maker using JIT production, the dealer can reduce its inventories of “parts” and order them from its “suppliers” through a JIT approach.

Admittedly, ETFs make up only a small share of the Canadian asset management industry. Our analysis shows that ETFs in Canada are not yet used as warehouses to a large extent. But the practice is growing in the United States. These changes to the way dealers handle bonds can transform the market by:

• improving prices
• reducing the costs of large trades
• making it easier for issuers themselves to borrow funds

…
ETF warehousing is when dealers use bond ETFs to deposit and withdraw—or push and pull—bonds instead of using inventory. Figure 1 compares the ETF warehousing model with the traditional bond dealer model:

• Typically, a dealer distributes bonds by keeping them in inventory until it finds a client that wants them. If the dealer does not hold bond inventory, it cannot fulfill client orders promptly. As a result, it might lose a trade to another dealer.
• The ETF warehousing model works differently. Instead of holding individual bonds in inventory, a dealer relies on a pool of bonds held within an ETF—an outside warehouse. Using a JIT approach, the dealer could pull bonds from the ETF to fulfill client orders or push bonds acquired from clients to the ETF.

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The 2019 US Securities and Exchange Commission ETF rule, which allows all ETFs to conduct custom exchanges, could make ETF warehousing more common. In addition, bond ETFs may become more willing to engage in custom exchanges as they grow their assets under management

The SEC rule is explained in part with:

Rule 6c-11 will provide certain exemptions from the Act and also impose certain conditions. The conditions include the following:

• Transparency. Under rule 6c-11, an ETF will be required to provide daily portfolio transparency on its website.
• Custom basket policies and procedures. An ETF relying on rule 6c-11 will be permitted to use baskets that do not reflect a pro-rata representation of the fund’s portfolio or that differ from the initial basket used in transactions on the same business day (“custom baskets”) if the ETF adopts written policies and procedures setting forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders. The rule also will require an ETF to comply with certain recordkeeping requirements.
• Website disclosure. The rule will require an ETF to disclose certain information on its website, including historical information regarding premiums and discounts and bid-ask spread information. These disclosures are intended to inform investors about the costs of investing in ETFs and the efficiency of an ETF’s arbitrage process.

So what I’m not entirely clear on about all this is: why ETFs? The only reason I can think of is because ETFs are so big … Blackrock Canada has seven corporate bond funds on offer, with a total of about 4.6-billion under management. That’s a lot of inventory and makes it very likely that Blackrock could meet an order for just about anything in any kind of reasonable size.

But there are plenty of other corporate bond portfolios under management in Canada. The Canada Pension Plan, for instance, has $40-billion in credit investments (see the 2020 Annual Report, page 14) or possibly 50.8-billion (see page 67). Why aren’t they doing this, using either extant staff or hiring an ‘overlay’ manager with a mandate to be market neutral, borrowing their short positions from the main fund?

Teachers’ has $93-billion in Fixed Income (see page 11 of the 2019 Annual Report. Where are they at?

When I was with Greydanus Boeckh so many years ago, I used to explain our basic strategy as providing month-to-month liquidity (in Canada bonds) to the dealers, who provided day-to-day liquidity to the market; much to the consternation of the smart guys who would explain to me that it’s impossible to outperform a market. I have predicted – so far unsuccessfully, I think – that US restrictions on proprietary trading by the Big Banks would bring an increase in market making by hedge funds.

Liquidity provision is fundamental to the market and there’s a lot of money to be made. I simply don’t understand why this ‘warehousing’ (I always used a car dealership analogy) concept is considered such a new idea.

Brookfield Residential Properties Inc., a wholly owned subsidiary of Brookfield Asset Management, has been downgraded to B by S&P:

• Calgary, Canada-based Brookfield Residential Properties Inc.’s profitability has suffered from diminished demand due to the coronavirus pandemic, which accelerated a downward trend that began in 2019.
• We are lowering our issuer credit rating on Brookfield Residential Properties Inc. (BRPI) to ‘B’ from ‘B+’ to reflect its higher leverage.
• At the same time, we are lowering our issue-level rating on the company’s senior unsecured notes to ‘B+’ from ‘BB-‘. Our ‘2’ recovery rating remains unchanged.
• The negative outlook reflects our expectation that BRPI’s liquidity may become constrained if it is unable to extend or renegotiate its $675 million revolving credit facility before its March 2021 maturity.

S&P has downgraded Bombardier to CCC:

• Bombardier Inc. recently announced that it had secured a commitment for a new secured term loan facility for up to US$1 billion due 2023.
• We believe the intended use of the new facility is to provide Bombardier with additional liquidity to operate its business through the COVID-19 pandemic as the company works to close previously announced divestitures.
• Based on the secured claim of the proposed term loan on certain aviation inventory and related accounts receivable, we estimate lower recovery prospects for the company’s unsecured creditors in our hypothetical default scenario.
• As a result, S&P Global Ratings lowered its issue-level rating on Bombardier’s unsecured notes to ‘CCC’ from ‘CCC+’. We revised the recovery rating to ‘5’ from ‘4’.
• All other ratings on the company are unchanged, including S&P Global Ratings’ ‘CCC+’ issuer credit rating (ICR).

The preferreds, which they downgraded to CC in March, are unaffected.