PrefBlog

What’s a Grecian earn?:

Greece will probably be forced to request a financial rescue after a European Union aid pledge failed to stop Greek borrowing costs from surging, said economists at AXA Group and Nomura International Plc.

Greek bonds dropped for a seventh day today, driving up the yield on the 10-year security to 7.5 percent, with Prime Minister George Papandreou’s government needing to sell 11.6 billion euros ($15.4 billion) of debt by the end of May. The yield premium over benchmark German bonds widened to the most since the euro’s debut in 1999, based on Bloomberg generic data.

Let’s have a big hand for the newly Assiduous Reader mega56. Only been studying the pref market for twenty minutes and he’s already on the right track!

Regarding perpetuals and rising interest rates. I’ve read in many places that perpetuals are risky during a phase where rates are rising, stay away. When I’m looking at the numbers, I don’t see it.

Example: CM.PR.E currently sits at 22.43 @$1.40
a. if it gets called (worst), you’ve got a nice gain @25.00
b. if price drops with rising rates, you still get the dividend

I’m missing the downside here.

Geez, at this rate he’ll be my competition in a few weeks!

There was some testimony to the Crisis Committee regarding Citigroup and CDOs:

Nobody could have predicted that the bank’s highest-rated collateralized debt obligations — created by repackaging mortgage bonds into new securities — would lose so much money, Prince said. The chief risk officer didn’t understand the risks, nor did Citigroup’s senior traders and bankers, he said.

“Everyone, including our risk managers, other banks and CDO structurers, all believed that these securities held virtually no risk,” Prince, 60, said. “It is hard for me to fault the traders who made the decisions to retain these positions on Citi’s books.”

Not so hard for me! Assiduous Readers will know that CDOs have been in the news quite a lot lately:Tranche Retention in the sub-prime CDO Market, The Story of the CDO Market Meltdown and Hull & White on AAA Tranches of Subprime. In the last paper, Hull & White demonstrated that CDO risk evaluation was faulty as the distributions of the risks of the securities held in the CDO were significantly different from the distributions of the risks of more normal instruments.

But it doesn’t matter. It really doesn’t matter. It happened this time and it will happen next time. Traders are business school smiley-boys, who have the job of quoting securities, rolling over their inventory, making the spread each time and telling the customer whatever he wants to hear. Whenever they suffer from delusions of intelligence, trouble ensues. Trading is different from investing and the two simply don’t mix very well. The key mistake at Citigroup – and elsewhere – was allowing traders to accumulate aged inventory, and not to impose a capital charge on this aged inventory.

The Ontario government’s plan to reduce generic drug costs has led DBRS to put Shoppers’ Drug Mart on review negative. With respect to the plan itself, I’m amused by the existence of trailer fees in the drug business:

Eliminating abuse of the system by ending so-called ‘professional allowances’ – payments generic drug companies make to pharmacy owners intended to fund patient services, but are instead being used by many pharmacies as rebates to fund fringe benefits, bonuses, overhead costs and boost profits

… but perplexed by …

Lowering the cost of generic drugs by at least 50%, to 25% of the cost of the original brand name drug for Ontario’s public drug system, private employer drug plans, and people who pay for drugs out-of-pocket, saving taxpayers millions

How is this possible? Is there no competition for generic drugs? Has the drug plan been run with no attempt to lower the price to whatever the manufacturers will bear? Or has the price been supported by a dispensing oligopoly? How on earth is it even possible to reduce costs by 50% by simple government fiat? Shoppers’ response to the plan has the amusing phrase:

Key tenants of these proposals included:

… indicating illiteracy, but no real arguments about the economics of the Ontario drug plan paying for, you know, drugs.

The Canadian preferred share market continued to see heavy trading today and, in a sharp reversal of recent experience, PerpetualDiscounts gained 50bp while FixedResets fell 25bp, bringing yields on the latter up to 3.83%. Good volatility is evident on the Performance highlights table; FixedResets continue to dominate volume.

Think we’ve got it tough in the Canadian preferred share market? Be grateful you’re not holding Greek bonds!

U.S. and European stocks fell, led by commodity producers as oil and copper dropped, while the premium investors demand to hold Greek bonds widened to the most since 1998 on speculation the nation may default.
…
Greece’s 10-year bond yields rose 0.16 percentage point to 7.14 percent and the yield premium to German debt widened to 4.03 percentage points, the most since before the euro was introduced in 1999.

How bad is it? CDSs on Greece are now trading above terrorist levels:

Swaps tied to Greece rose to 415 basis points today while those on Iceland traded at about 400 basis points, according to Markit data. The North American Markit index climbed the most since March 22 amid investor concern that contagion from a Greece default could spread to other assets, said Gavan Nolan, an analyst at Markit Group in London.

Remember Jim Kelsoe, proud portfolio manager of the worst bond fund in the history of the universe (so far)? He was last mentioned on PrefBlog on May 9, 2008. Now the SEC is alleging that his fund returns were, in fact, overstated:

The SEC’s Division of Enforcement alleges that Morgan Keegan failed to employ reasonable procedures to internally price the portfolio securities in five funds managed by Morgan Asset, and consequently did not calculate accurate “net asset values” (NAVs) for the funds. Morgan Keegan recklessly published these inaccurate daily NAVs, and sold shares to investors based on the inflated prices.

“This scheme had two architects — a portfolio manager responsible for lies to investors about the true value of the assets in his funds, and a head of fund accounting who turned a blind eye to the fund’s bogus valuation process,” said Robert Khuzami, Director of the SEC’s Division of Enforcement.

William Hicks, Associate Director in the SEC’s Atlanta Regional Office, said, “This misconduct masked from investors the true impact of the subprime mortgage meltdown on these funds.”

According to the Commission’s order instituting administrative proceedings, the SEC’s Enforcement Division alleges that James C. Kelsoe, Jr., the portfolio manager of the funds and an employee of Morgan Asset and Morgan Keegan, arbitrarily instructed the firm’s Fund Accounting department to make “price adjustments” that increased the fair values of certain portfolio securities. The price adjustments ignored lower values for those same securities quoted by various dealers as part of the pricing validation process. The Enforcement Division further alleges that Kelsoe actively screened and manipulated the pricing quotes obtained from at least one broker-dealer. With many of the funds’ securities backed by subprime mortgages, Kelsoe’s actions fraudulently prevented a reduction in the NAVs of the funds that otherwise should have occurred as a result of the deterioration in the subprime securities market.

Lots of winners and losers on a volatile day of continued heavy volume in which selling pressure on PerpetualDiscounts eased off a bit … they were down only 2bp today which, considering recent returns, is practically a win! It is interesting to speculate that the buying came from switches out of FixedResets, as they were down 16bp on the day to take yields up to 3.74%. FixedResets again scored a shut-out on the volume table.

PerpetualDiscounts now yield 6.30%, equivalent to 8.82% interest at the standard equivalency factor of 1.4x. Long Corporates continue their insouciance towards whatever it is that’s causing the current paroxysm in the preferred share market, having returned +8bp (total return) on the month-to-date and are now yielding about 5.7% (maybe a bit over?). Thus, the pre-tax interest-equivalent spread (also called the Seniority Spread) stands at about 310bp, rocketting upwards from the +285 bp reported March 31 and pushing well over what had been until recently the one-year high in the low 290s.

With help from the clerk of the committee, I can now post a link to The Standing Committee on Government Agencies Report on the OSC.

Preferred shares took a massive whacking today on very high volume. PerpetualDiscounts lost 126bp, while FixedResets were down 43bp – about what one might expect, given the respective Modified Durations. FixedResets again scored a shut-out on the volume highlights table.

That’s the worst day in over a year for PerpetualDiscounts. There were two worse days in 2009, March 5 and March 9. There were 17 worse days in 2008, eight of them in November.

The bright side of this is that I anticipate increased opportunities for heavy relative-values trading. My reports of candidate trades are getting lengthier…

The jobs number on Friday was encouraging:

Payrolls rose by 162,000 workers last month, the third gain in the past five months and the most since March 2007, figures from the Labor Department showed today in Washington.
…
Among the top indicators the group uses is payrolls, according to its Web site. The government revised the January and February job count up by a combined 62,000, putting the March gain at 224,000 after including the updated data.

This knocked Treasuries for loop:

Government securities fell for a second consecutive week ahead of the Treasury’s scheduled offering of $82 billion of notes and bonds next week, including a record-tying $40 billion sale of three-year securities.
…
The 10-year note yield rose 9 basis points, or 0.09 percentage point, to 3.94 percent, according to BGCantor Market Data. The yield touched the highest this week since it reached 4 percent on June 11. Two-year note yields rose 6 basis points to 1.1 percent. Thirty-year bond yields increased to as high as 4.81 percent, also the most since June.

… and over the weak, investors decided that German debt is better than EU promises:

The yield on Germany’s 10-year bund, Europe’s benchmark government security, fell 7 basis points in the week to 3.09 percent as of 5:30 p.m. in London yesterday. It dropped to 3.05 percent on March 23, the lowest this year. The two-year note yield slipped 5 basis points to 0.95 percent.

The Greek 10-year yield advanced 33 basis points to 6.56 percent, and the two-year yield soared 69 basis points to 5.28 percent.

The New York Times has an editorial on taxation of hedge fund fees:

To add insult to injury, some hedge fund managers and, more commonly, private equity fund managers are able to pay a much lower rate of tax than the typical working professional.

The tax disparity results from an outdated rule that lets a money manager in a private partnership treat a chunk of his fees as if they were long-term capital gains, taxed at a special low rate of 15 percent. Fees for managing someone else’s money should be taxed as ordinary income, like wages and salary, at rates as high as 35 percent.

President Obama has included a provision to end that special treatment in his most recent budget. For three years running, the House has passed a bill to close the loophole. In the Senate both Democrats and Republicans have resisted, all for fear of losing lucrative campaign donations.

This has been an issue for quite some time I remember commenting on the issue on the old “Captain’s Quarters” blog (the principal, Ed Morrisey, has now moved to Hot Air) … the idea of fixing the loophole by other commenters as a tax increase. By me, it’a a loophole. Preferential taxation of capital gains – regardless of what it may actually accomplish – should be restricted to those who have skin in the game. A hedge fund manager who achieves a total return of -100% will suffer a loss of capital only to the extent he has invested in the fund: capital gains tax rates should apply only to his earnings on that capital at risk.

Assiduous Reader GAndreone sends in this chart of Exchange Market Share for MFC.PR.C for your edification:

Click for Big

An interesting trend is corporate bonds that step-up on downgrades:

Bonds with built-in protection against rating cuts are making up a record share of debt issues as investors hedge against a slowdown in the economic recovery.

Anheuser-Busch InBev NV, the brewer of Budweiser and Stella Artois, is among companies issuing so-called step-up bonds, whose interest increases if a borrower is downgraded. Sales surged to $37.3 billion in March, or 12.4 percent of all debt issued, according to data compiled by Bloomberg. Most of the notes are sold in the U.S., where almost half of bonds rated as so-called junk or on the cusp of non-investment grade include the protection.
…
Anheuser-Busch InBev, the world’s largest brewer, sold $3.25 billion of bonds with a step-up coupon on March 24, Bloomberg data show. The conditions require the Leuven, Belgium- based company to pay 25 basis points more in interest for every one rating notch it’s cut below investment grade, up to a maximum of 200 basis points, according to Bloomberg data. The brewer is rated Baa2 by Moody’s and one level higher at BBB+ by S&P.

It’s an interesting problem due to the potential for a cascading decline in credit quality. Quick! You’re the Grand Pooh-Bah of Financial Stability! Can you do anything? Should you do anything?

It has taken over a year, but finally the world is noticing the sheer brilliance and uncanny accuracy of PrefBlog’s commentary. Assiduous Readers will remember that I support internal management for large pension funds; not because of cost but because internal management has a captive customer, can concentrate of achieving good returns and doesn’t have to spend time, effort, and client portfolio positioning on the necessity of bringing in the Assets Under Management. As best as I can recall, I last discussed this on March 31, 2009. Janet McFarland has written a feature for the Globe, Canada’s Pension Funds: stronger returns, at a cost:

Despite the higher salary costs in Canada, internal management has been a bigger advantage than it has been a cost, said pension specialist Keith Ambachtsheer, director of the International Centre for Pension Management at the University of Toronto.

Research shows internal teams not only save money by cutting high external money management fees, but also perform better as investors because they are more closely aligned to the mission of the pension fund, he said.

According to data from CEM Benchmarking, internal management improves returns by 0.5 per cent annually over external management, Mr. Ambachtsheer said.

It is disappointing that the article followed fashionability to the extent it did, by focussing almost exclusively on the aspect of fees. It is far more interesting, and far more important for public policy purposes, to consider the aspect of the effects of structure on gross investment return.

The Globe also had an astonishingly patronizing editorial in today’s print edition (it does not appear to be available on-line) titled “The next complexity”:

The challenge for the future, however, is how to formulate rules that will cover the new mind-bending products that will emerge in the next wave of irrational exuberance and excessive financial ingenuity. In other words, legislators and regulators will need to decide what is too complex for unsophisticated investors.

I have some succinct advice for the Globe’s editorial board: shove it. While wearing my hat as a retail investor, I don’t want any pandering politician or smarmy regulator deciding what is and what is not too complex for unsophisticated investors who haven’t been annointed. Show me somebody – anybody – who got seriously hurt by ABCP and I’ll show you a fool. Canadian ABCP was a good product, of very good credit quality. The market was done in by lack of liquidity, not credit; and the only people who were badly hurt by it were the ones who were overexposed. Ain’t nothing gonna protect anybody from the downside of overexposure, whether it’s to ABCP or securities that have been blessed by the really, really savvy investors on the Globe’s editorial board.

I haven’t been able to find a copy of the report itself on-line. This may mean I’m insufficiently sophisticated at finding things, but it wouldn’t surpise me to learn that access to the report has been restricted to those smart enough to agree with the committee’s conclusions.

What the ABCP and Lehman crises showed was simply that the implicit sponsor guarantee on Money Market Funds needs to become explicit. Full stop.

Crash! Bang! Smash ’em up! PerpetualDiscounts got hit severely today, losing 76bp to bring median yield to 6.22%, while FixedResets were almost precisely flat. The performance highlights indicate that it was the major, high quality banks that bore the brunt of the sell off, although there are a few familiar names amongst the losers. Volume continued to be quite heavy and FixedResets scored a shut-out on the volume highlights table.