Archive for February, 2008

Federal Budget – Effect on Prefs

Tuesday, February 26th, 2008

With a hat-tip to the Financial Webring, we can look at a story in the National Post:

Canadians may be wise putting dividend-paying stocks into their TFSAs. While the government announced last October it would slash corporate income tax rate to 15% by 2012 from 19.5%, individual investors will be making up some of that lost revenue.

The average rate investors will pay on dividend income at the top marginal tax rate of 46% will rise to 25.3% by 2012 from 18.5% in 2008.

Marginal rate of dividends increasing? What will that do?

Old / New Regimes for
Dividend Tax Credit
and Gross-up
  Old New
Interest Income $1.00 $1.00
Tax on Interest $0.46 $0.46
Net Interest After Tax (A) $0.54 $0.54
Dividend Income $1.00 $1.00
Tax on Dividend $0.185 $0.253
Net Dividend After Tax (B) $0.815 $0.747
Equivalency Factor (=B/A) 1.509 1.383

To check these figures … If we receive $1.509 in interest and pay 46% tax, or $0.694, we’re left with $0.815, which is the same as the net left after tax from dividends of $1.00 under the old regime, so that’s OK.

If we receive $1.383 in interest and pay 46% tax, or $0.636, we’re left with $0.747, which is the same as the net left after tax from dividends of $1.00 under the new regime, so that’s OK.

I don’t know where the Post got their figures from. The equivalency factor in Ontario is currently 1.40, not 1.509 as per their figures; I use a marginal rate on dividends of 21.0% and 46.4% on interest.

Throughout the 1990’s, I used 48.8% on income and 32.9% on dividends, which gave an equivalency factor of 1.311.

Before opining on the effects of the change, I want to know just what the change is! I’ll wait for the accountancy firms to crunch the numbers, then pontifficate.

Update: KPMG notes:

Dividend tax credit (DTC) For 2010 and later years, the dividend gross-up factor and DTC will be adjusted in increments to reflect the corporation tax reductions to 15% in 2012 introduced in the October 30, 2007 mini-budget (for details on the corporate tax cuts, see TaxNewsFlash-Canada 2007-28, “Highlights of the 2007 Federal Mini-Budget”).

The KPMG report on the fall 2007 mini-budget states:

The mini-budget documents also say that, in light of the corporate tax rate cuts, the federal government will consider corresponding changes to the enhanced dividend tax credit for eligible dividends. The enhanced credit is designed to ensure that the combined corporate and personal tax rate on dividends from large corporations is comparable to the rate applying to other income. The credit was established based on the total average federal-provincial corporate tax rates that were expected to apply in 2010.

Update, 2008-2-29: Follow up article, with projected rates is Dividend Taxation Changes.

IQW.PR.C / IQW Conversion Ratio For March 1 Announced

Tuesday, February 26th, 2008

Quebecor World has announced:

the final conversion rate applicable to the 3,975,663 Series 5 Cumulative Redeemable First Preferred Shares (TSX: IQW.PR.C) (the “Series 5 Preferred Shares”) that will be converted into Subordinate Voting Shares effective as of March 1, 2008. Taking into account all accrued and unpaid dividends on the Series 5 Preferred Shares up to and including March 1, 2008, Quebecor World has determined that, in accordance with the provisions governing the Series 5 Preferred Shares, each Series 5 Preferred Share will be converted on March 1, 2008 into 12.93125 Subordinate Voting Shares. Registered holders of Series 5 Preferred Shares who submitted notices of conversion on or prior to December 27, 2007 will receive in the coming days from Quebecor World’s transfer agent and registrar, Computershare Investor Services Inc., certificates representing their Subordinate Voting Shares resulting from the conversion. Approximately 51.4 million new Subordinate Voting Shares will thus be issued by Quebecor World to holders of Series 5 Preferred Shares on March 1, 2008. Quebecor World will apply to list the 51.4 million Subordinate Voting Shares on The Toronto Stock Exchange (TSX), although there can be no assurance that the TSX will accept the listing of such shares.

Quebecor World is currently in creditor protection and is on review for possible delisting. The conversion of over half the IQW.PR.C has been discussed previously.

FDIC Quarterly Report on US Banks

Tuesday, February 26th, 2008

As noted by the WSJ, the American Federal Deposit Insurance Corporation has released its 4Q07 Quarterly Banking Report. It starts off with a bang!:

Record-high loan-loss provisions, record losses in trading activities and goodwill impairment expenses combined to dramatically reduce earnings at a number of FDIC-insured institutions in the fourth quarter of 2007. Fourth-quarter net income of $5.8 billion was the lowest amount reported by the industry since the fourth quarter of 1991, when earnings totaled $3.2 billion. It was $29.4 billion (83.5 percent) less than insured institutions earned in the fourth quarter of 2006. The average return on assets (ROA) in the quarter was 0.18 percent, down from 1.20 percent a year earlier. This is the lowest quarterly ROA since the fourth quarter of 1990, when it was a negative 0.19 percent. Insured institutions set aside a record $31.3 billion in provisions for loan losses in the fourth quarter, more than three times the $9.8 billion they set aside in the fourth quarter of 2006. Trading losses totaled $10.6 billion, marking the first time that the industry has posted a quarterly net trading loss. In the fourth quarter of 2006, the industry had trading revenue of $4.0 billion. Expenses for goodwill and other intangibles totaled $7.4 billion, compared to $1.6 billion a year earlier. Against these negative factors, net interest income remained one of the few positive elements in industry performance. Net interest income for the fourth quarter totaled $92.0 billion, an 11.8-percent ($9.7-billion) year-over-year increase.

… but things aren’t always as they seem …

Earnings weakness was fairly widespread in the fourth quarter. More than half of all institutions (51.2 percent) reported lower net income than in the fourth quarter of 2006, and 57.1 percent reported lower quarterly ROAs. However, the magnitude of the decline in industry earnings was attributable to a relatively small number of large institutions. In contrast to the steep 102 basis-point drop in the industry’s ROA, the median ROA fell by only 14 basis points, from 0.93 percent to 0.79 percent. Seven large institutions accounted for more than half of the total year-over-year increase in loss provisions. Ten large institutions accounted for the entire decline in trading results. Five institutions accounted for three-quarters of the increase in goodwill and intangibles expenses, and sixteen institutions accounted for three-quarters of the year-over-year decline in quarterly net income. One out of every four institutions with assets greater than $10 billion reported a net loss for the fourth quarter. Institutions associated with subprime mortgage lending operations and institutions engaged in significant trading activity were among those reporting the largest earnings declines.

… and capital ratios were, by and large, reasonable …

Total equity capital increased by $25.1 billion (1.9 percent) during the fourth quarter. This increase lagged behind the 2.6-percent increase in assets during the quarter, and the industry’s equity-to-assets ratio declined from 10.44 percent to 10.37 percent. Goodwill accounted for almost one-third ($7.9 billion) of the increase in equity, despite large write-downs of goodwill at several institutions. The industry’s leverage capital ratio registered a larger decline during the quarter, because leverage capital does not include goodwill. The leverage ratio fell from 8.14 percent to 7.98 percent, a four-year low. In contrast, the industry’s total risk-based capital ratio, which includes loss reserves, increased from 12.74 percent to 12.79 percent. At the end of 2007, 99 percent of all insured institutions, representing more than 99 percent of total industry assets, met or exceeded the highest regulatory capital standards.

… although things got a little hairy at the margins (and, presumably, with the big money-centre banks) …

The number of FDIC-insured institutions reporting financial results declined from 8,559 to 8,533 during the fourth quarter.2 Fifty newly chartered institutions were added during the quarter, while 74 institutions were absorbed by mergers. One insured commercial bank failed in the fourth quarter. For the full year, 181 new insured institutions were chartered, 321 charters were absorbed in mergers, and three insured institutions failed. In the previous two years, there were no failures of FDIC-insured institutions, an interval unprecedented since the inception of the FDIC. In 2004, four insured institutions failed. Five mutually owned savings institutions, with combined assets of $4.8 billion, converted to stock ownership in the fourth quarter. For the entire year, ten insured savings institutions with total assets of $10.1 billion converted from mutual ownership to stock ownership. At the end of 2007, there were 76 FDIC-insured commercial banks and savings institutions on the “Problem List,” with combined assets of $22.2 billion, up from 65 institutions with $18.5 billion at the end of the third quarter.

All in all, I think the report justifies my remark in the Crony Capitalism? post:

As far as the overall health of the banking system is concerned, let’s look at the Fed’s Term Auction Facility. The last one was reported on February 12; there was one today. The very low premium on this money relative to Fed Funds – and the continuing drop in the TED Spread – leads me to conclude that insolvency, potential or undiscovered, is not a problem in the banking system. It’s illiquidity, pure and simple.

February 25, 2008

Monday, February 25th, 2008

Today’s post may be foreshortened, due to the time I spent on crony capitalism. Well, anyway, here goes…

Naked Capitalism leads off with a piece suggesting that there’s not much worth saving in the monolines taking great exception to the idea that the proposed recapitalization of Ambac will be via a rights offering. I don’t see anything wrong with a rights offering myself … it allows existing shareholders to avoid dilution and, perhaps, get in on the opportunity to increase their position at a discounted price. And if they don’t want to increase their position, they can sell their rights to take their money off the table. Such procedures are much more fair to extant shareholders than private placements; I don’t understand why there aren’t more of them.

Naked Capitalism suggests that even the Good Insurer part of potential splits might be not all that good, citing a third party’s mention of the City of Vallejo, CA’s current problems:

Vallejo is a municipality. Presumably its debt would be considered AAA. Yet its civic leaders are talking about filing for bankruptcy. You wonder why local government and public works-related auction bonds are failing left, right and centre? US state and municipal finances are in dire shape – just as you would expect when the housing market is in deep depression and the economy is in recession.

And if you think Vallejo is a one off, consider California itself (isn’t it something like the tenth largest economy in the world in its own right?). Remember, US states are constitutionally bound to run a balanced budget. California is now faced with a US$16bn deficit (see here). Some legislators are calling for unilateral tax INCREASES (where’s your $170bn stimulus package now Mr Bush?) as well as spending CUTS. The US is in deep, deep trouble and it isn’t coming out of it for years.

So I looked a little into press reports about Vallejo:

Vallejo may run out of cash as early as March, council member Stephanie Gomes said.

“Not only that, but now we have 20 police and fire employees retiring because they are afraid of not getting their payouts,” Gomes said. “That means we have another few million dollars in payouts that we had not expected. So the situation is quite dire.”

The city currently has a $135 million liability for the present value of retiree benefits already earned by active and retired employees and an additional $6 million a year as employees continue to vest and earn this future benefit, [City Manager] Tanner said.

“The problem is basically bloated union contracts,” [Council Member] Shively said.

… and, with a bit more detail:

[Council Member] Gomes said salaries and benefits for public safety workers account for 80 percent of Vallejo’s general operating budget. “The city cannot support this anymore,” she said.

Gomes said that last year, 98 firefighters made more than $100,000 and 10 made more than $200,000 including overtime. It is overtime that some firefighters say they would just as soon not have to work.

This is happening in a city with a population of about 120,000. Quick! Somebody call David Miller! We’ve finally found a city that’s run worse than Toronto!

Vallejo was recently downgraded by Moody’s (enormous spreadsheet) to A3 (Watch Negative) from Aaa (Watch Negative), as a result of the downgrade of FGIC.

The monolines did catch a break today! S&P affirmed MBIA as AAA though it remained on Watch Negative. Ambac is still under review.

Naked Capitalism also reprints a report on the collateral accepted by the TAF. The Fed claims it lends only to sound banks, irrespective of collateral; NC says he doubts it. I’ll go with the Fed.

In what BCE shareholders will hope is not a foreshadowing of things to come, Wachovia has sued Providence Equity Partners (part of the BCE acquisition group) to get out of a financing:

Wachovia, the fourth-largest U.S. bank, said Providence officials changed the terms of the accord without consent from the Charlotte, North Carolina-based bank and voided the agreement, according to a lawsuit filed in state court in North Carolina Feb. 22. Providence and two of its investment banks, Goldman Sachs Group Inc. and UBS AG, agreed over the weekend to drop the price from $1.2 billion for the Clear Channel unit, a person briefed on the negotiations said.

Well! They drop the price and Wachovia jumps at the opportunity to call foul! This is an interesting development.

Rather a dull day for prefs, although the fact that this is only the third trading day this month that PerpetualDiscounts were down gave it some interest. Not much price action and the volume was rather lame as well.

Still no sign of new issues, much to my chagrin!

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 5.53% 5.57% 40,359 14.5 2 -0.1424% 1,078.9
Fixed-Floater 5.00% 5.68% 73,089 14.67 7 +0.1869% 1,026.0
Floater 4.93% 5.00% 68,529 15.45 3 -0.0640% 857.0
Op. Retract 4.81% 2.42% 77,218 3.18 15 -0.1979% 1,047.6
Split-Share 5.27% 5.30% 97,838 4.06 15 +0.0872% 1,048.3
Interest Bearing 6.20% 6.32% 58,114 3.34 4 +0.1008% 1,088.1
Perpetual-Premium 5.71% 3.92% 345,216 5.01 16 -0.0213% 1,033.2
Perpetual-Discount 5.35% 5.38% 276,617 14.83 52 -0.0932% 962.2
Major Price Changes
Issue Index Change Notes
MFC.PR.A OpRet -2.2306% Now with a pre-tax bid-YTW of 3.57% based on a bid of 25.86 and a softMaturity 2015-12-18 at 25.00.
HSB.PR.C PerpetualDiscount -1.9421% Now with a pre-tax bid-YTW of 5.45% based on a bid of 23.73 and a limitMaturity.
SLF.PR.E PerpetualDiscount -1.3483% Now with a pre-tax bid-YTW of 5.12% based on a bid of 21.95 and a limitMaturity.
IGM.PR.A OpRet +1.0825% Now with a pre-tax bid-YTW of 3.16% based on a bid of 27.08 and a call 2009-7-30 at 26.00.
BCE.PR.I FixFloat +1.1378%  
Volume Highlights
Issue Index Volume Notes
TD.PR.Q PerpetualPremium 168,836 Nesbitt crossed 142,000 at 25.60. Now with a pre-tax bid-YTW of 5.38% based on a bid of 25.55 and a call 2017-3-2 at 25.00.
POW.PR.A PerpetualDiscount 145,895 Nesbitt crossed 145,000 at 25.00. Now with a pre-tax bid-YTW of 5.68% based on a bid of 24.96 and a limitMaturity.
BNS.PR.L PerpetualDiscount 24,880 Now with a pre-tax bid-YTW of 5.22% based on a bid of 21.70 and a limitMaturity. 
RY.PR.A PerpetualDiscount 24,189 Now with a pre-tax bid-YTW of 5.13% based on a bid of 21.73 and a limitMaturity.
CM.PR.I PerpetualDiscount 24,098 Now with a pre-tax bid-YTW of 5.67% based on a bid of 20.99 and a limitMaturity.

There were twelve other index-included $25-pv-equivalent issues trading over 10,000 shares today.

HIMIPref™ Preferred Indices : June 2006

Monday, February 25th, 2008

All indices were assigned a value of 1000.0 as of December 31, 1993.

HIMI Index Values 2006-06-30
Index Closing Value (Total Return) Issues Mean Credit Quality Median YTW Median DTW Median Daily Trading Mean Current Yield
Ratchet 1,365.9 1 2.00 4.38% 16.7 34M 4.38%
FixedFloater 2,285.0 6 2.00 4.10% 1.7 100M 5.05%
Floater 2,124.2 5 2.00 -9.46% 0.1 52M 4.55%
OpRet 1,886.2 18 1.45 3.36% 2.7 79M 4.70%
SplitShare 1,950.0 17 1.83 4.01% 3.1 42M 5.08%
Interest-Bearing 2,329.2 8 2.00 5.30% 1.0 55M 6.83%
Perpetual-Premium 1,476.4 42 1.55 4.69% 4.7 109M 5.31%
Perpetual-Discount 1,576.8 11 1.27 4.82% 15.8 460M 4.77%
HIMI Index Changes, June 30, 2006
Issue From To Because
MUH.PR.A SplitShare Scraps Volume
PWF.PR.A Scraps Floater Volume
NA.PR.L PerpetualDiscount PerpetualPremium Price

There were the following intra-month changes:

HIMI Index Changes during June 2006
Issue Action Index Because
AIT.PR.A Deleted Scraps Redeemed
DBC.PR.A Added Scraps Issued

Index Constitution, 2006-06-30, Post-rebalancing

Is Crony Capitalism Really Returning to America?

Monday, February 25th, 2008

Menzie Chinn writes in Econbrowser a very gloomy piece about the state of the US banking industry and urges a bail-out … of some kind:

As I’ve said before, “Just say ‘no'” is not a viable policy. The key point is to realize that, just like some of the East Asian economies in 1997, we are well past the point about worrying about the impact of current policies on “moral hazard” (see this analysis [pdf]). We needed prudential regulation in the period leading up to the housing boom (sadly, policy makers failed in that respect).

And make no mistake — the financial system is to some degree already frozen, and there is little prospect for a complete unfreezing of the system without substantial government intervention.

In this sense, the current crisis is very much like the S&L crisis. And as it looks more and more likely that the government will have to spend billions of dollars bailing out investors, banks, and households, it seems to me that accountability is required.

And we should look very carefully at the proposals that are being pushed by the financial industry, even as we acknowledge that laissez faire is not tenable, and we seek to establish procedures and institutional reforms that will prevent a replay. In particular, thinking about a well-funded, integrated, regulatory system that is insulated from political pressures would be a good place to start.

Now, I’m the last to deny that the banking industry is having problems, but this is simply too much.

At this point, it is not accurate to say that the current crisis is reminiscent of the S&L crisis, for the very good reason that there have been no failures or insolvencies of note. Illiquidity and losses have led to the takeover of Countrywide by Bank of America, and to Citigroup getting expensive new capital, but this is not the same thing as insolvency. The American banking system has been regulated sufficiently (by the Fed, through such measures as Tier 1 Capital ratios) that the system has been bent, but not broken.

Even the nationalization of Northern Rock in the UK (very briefly mentioned on February 19 – as the ultimate consequence of illiquidity and a subsequent run on deposits – has not been due to insolvency: it has been due to illiquidity, which is not the same thing.

In Germany, there has been a government bail-out of IKB Bank, which has been criticized (see February 13 and February 14).

As far as the overall health of the banking system is concerned, let’s look at the Fed’s Term Auction Facility. The last one was reported on February 12; there was one today. The very low premium on this money relative to Fed Funds – and the continuing drop in the TED Spread – leads me to conclude that insolvency, potential or undiscovered, is not a problem in the banking system. It’s illiquidity, pure and simple.

Given that insolvency is not a problem, the illiquidity will sort itself out over time, as loans, good and bad, run off the books. There are continuing anecdotal reports of credit being scarce, but that too will become less problematic as operators improve their balance sheets – either by the sale of new equity or simply reducing share buy-backs and retaining a greater proportion of earnings – to take advantage of the tighter conditions.

All this being said, there are clearly improvements that can be made to the regulatory process, improvements that will be familiar to assiduous readers of PrefBlog.

Firstly, the boundary between the core banking system and the shadow banking system must be more sharply defined. Willem Buiter has suggested regulating hedge funds like banks if they act like banks; presumably this would apply as well to SIVs. I say no; this will choke off innovation and, perhaps more to the point, a respectable and well-understood channel for speculative animal spirits. There will always be speculators, and God bless ’em. Let us ensure that they speculate in ways that are both useful and at least one step removed from the real economy … that is, in the financial markets.

But while letting the speculators speculate, we should ensure the core financial system is not put at risk; this may be accomplished simply by increasing the capital charges on banks’ exposures to shadow-banking. The capital charge for liquidity guarantees to SIVs does not appear to have been enough – double it! And, as I have argued, it appears that in practice, banks retain credit exposure to instruments held by their money market funds – they should be taking a capital charge for this exposure.

I suggest as well – given the Northern Rock experience – that the definition of Risk Weighted Assets for regulatory purposes, in addition to the charges for operational risk and market risk, include a charge for financing risk … too much dependence on any one source of financing would result in the need for more capital.

Other potential improvements to capital adequacy rules will doubtless be apparent to those who are more specialized students of the banking system than I.

Americans should also be taking a hard look at the ultimate consumer friendliness of their financial expectations. They take as a matter of course mortgages that are:

  • 30 years in term
  • refinancable at little or no charge (usually; this may apply only to GSE mortgages; I don’t know all the rules)
  • non-recourse to borrower (there may be exceptions in some states)
  • guaranteed by institutions that simply could not operate as a private enterprise without considerably more financing
  • Added 2008-3-8: How could I forget? Tax Deductible

And, quite frankly, I find it hard to cry about the current decline in housing prices. James Hamilton of Econbrowser reports, for instance, that house prices in San Diego have doubled in the last seven years. What goes up very often goes down. Get used to it.

As my parting shot, I will take further issue with Mr. Chinn’s assertion that the current situation bears resemblance to the S&L crisis. As discussed above, there is the important difference that we are not seeing much in the way of insolvencies at the present time; but the roots of the situation are more to the point. I suggest that the causes of the current situation bear a lot of resemblance to the bond bear market of 1994, in which a lot of people – notably, Orange County – got hurt because they had engaged in term-extension trades to take advantage of 1993’s extremely steep yield curve. I suggest that term-extension trades – in SIVs, in Auction Rate Municipals, in Northern Rock’s financing strategy, in the pricing of RMBS at spreads to LIBOR – are deeply implicated in the current crisis.

Update: Taking the last point a little further, I will highlight my confusion as to why the brokerages are taking such enormous write-downs on sub-prime product. This has never made a lot of sense to me … but, if we accepts that a lot of this stuff is issued at a spread to LIBOR, how about the following transmission mechanism:

  • Client buys long-term spread product
  • Client levers the hell out his position (given that it’s investment-grade rated spread product, the temptation to do this may have been overwhelming)
  • Price goes down
  • Margin call gets made
  • Client walks, and/or
  • Position sold out at a loss

I suggest that one things the authorities could look at is whether (or, perhaps I should say, how much of) the losses are due to this mechanism. If significant, perhaps an extra capital charge could be levied with respect to loans collateralized by securities which have a term greatly in excess of their spread index.

This could, possibly, be made more general: if you’re building a nuclear power station, get fixed-rate financing for the long term!

Update, 2008-2-27: James Hamilton at Econbrowser highlights the new housing price numbers and (rather sniffily, I thought!) points out the danger:

The reason to be concerned about this is that the farther house prices fall, the greater the number of homeowners who move into the category of negative net equity, that is, owe more on their mortgage than the home is worth. And the farther into the red a household becomes, the greater the incentive and propensity for the homeowner to default on the loan. More defaults mean more losses and greater risk of insolvency for large financial institutions.

And if you think the economy can continue to hum along without those institutions continuing to extend credit, well, we may get some interesting additional data relevant for your hypothesis in a rather short while.

In other words, regardless of how good a ride it’s been for the decade as a whole, a downward trend is going to lead to more jingle-mail.

Well, that certainly is a factor. What I don’t know at this point is:

  • What the current loan-to-value distribution of mortgages is
  • how the reaction of new negative equity holders will compare with the older ones (presumably, the outright scam artists and cavalier speculators have already mailed in their keys
  • how much of the damage will be borne by the banking sector, as opposed to the investment sector (e.g., pension fund investments)
  • how much of this damage has been discounted already

Stay tuned!

Update, 2008-02-27: I note a Cleveland Fed Research Report:

The Federal Reserve Board’s January 2008 survey of senior loan officers (covering the months of October 2007 through December 2007) found considerable tightening of credit standards for commercial and industrial loans since the last survey. About one-third of all domestic banks and two-thirds of all foreign banks surveyed reported having tightened standards for these types of loans for small as well as large and medium-sized firms. The remaining fraction of banks reported little change. The reasons cited for tightening included a less favorable economic outlook, a reduced tolerance for risk, and worsening of industry-specific problems. A large fraction of domestic and foreign banks increased the cost of credit lines and the premiums charged on loans to riskier borrowers. About two-fifths of the domestic banks and nearly eight-tenths of the foreign banks surveyed raised lending spreads (loan rates over the cost of funds).


Preferred Shares & Volatility

Saturday, February 23rd, 2008

My name has come up in a Financial Webring discussion of preferreds, with sufficient questions that I’ll address the questions here.

I diligently read Mr. Hymas’s PrefBlog and Pref Info websites. 

Diligently? PrefBlog should be read assiduously!

Creditworthiness, maturity, aside for the moment, would it be wiser to invest in preferreds with a low mean / standard deviation or a high one? Case in point: TD.PR.Q (5.6) has a high of $25.74 and low of $25.00 for a mean of $25.37 and SD of .52. It trades today at $25.64 for yield of 5.46.
TD.PR.O (4.8%) has a high of $26.72, low of $22.01 for a mean of $24.37 and SD of 3.33. It trades at 23.50 for a yield of 5.16. My thoughts, for restful nights, the lower SD would be the way to go but then again, it would stand to reason that the higher SD share would have the greater potential so maybe it would be the way to go, no?

Well, this isn’t a particularly good example, because TD.PR.Q has been trading for less than a month. Having missed the market bottom, it is not surprising that its trading range is significantly less than comparables.

Another thing that makes this not the best example is the big difference in coupons: TD.PR.O pays $1.2125 annually, while TD.PR.Q pays $1.40. This difference makes TD.PR.Q more likely to be called once its call period commences than TD.PR.O (they have similar schedules, by the way; TD.PR.O commences 2010-11-1, TD.PR.Q commences 2013-1-31; both at $26.00 initially, declining by $0.25 annually until they reach $25.00, after that, they’re redeemable forever at the $25.00. price.

The big difference in coupons leads to a major diffence in the manner of calculating yields. It is prudent to suppose (as the initial approximation) that TD.PR.O will never be redeemed – after all, it’s quoted at 23.72-75, if market yields don’t change, why should TD give you a present of $1.25? It is also prudent to suppose that TD.PR.Q – quoted at 25.55-60 – will be redeemed at $25 on the first possible date at this price of 2017-3-2. This will cause a capital loss and represents your worst-case-scenario (short of default, given no change in market yields), which is what one should examine when looking at these things. Always assume that the issuer will do whatever it can to give you the least money it legally can!

In turn, this probability of capital loss should be incorporated into the yield calculation. The quoted yield of 5.46% for TD.PR.Q is the current yield ( = Dividend / Price). But if we account for a redemption, we can use the formula Yield = (Dividend – Return of Capital) / Average Capital Invested. The gross dividend is $1.40; the return of capital is the total expected capital loss ($0.64) divided by the number of years (9) or about 7 cents per year. The average capital invested is 0.5*(25.64 + 25.00) = 25.32. Thus, roughly, Yield to Worst is (1.40 – 0.07) / 25.32 = 5.25%.

The above is only a rough calculation; a precise calculation (by HIMIPref™) that takes into account every cash flow on its precise date indicates that the yield-to-worst is 5.37% (in this case, it’s much higher than the rough calculation, because I’m using the Feb 22 bid of 25.55, and because a full quarter’s dividend will be earned on April 4). To do this calculation, you can always use Shakespeare’s Calculator (broken link redirected 2024-2-1), which I have previously discussed.

Yield-to-Worst is a superior predictor of performance than Current Yield, as I have showed in A Call, too, Harms.

The difference in gross dividends has another effect. When you performed the yield calculation recommended, you are assuming that you will eventually “sell” the TD.PR.Q at a price of $25.00, representing a capital loss. To a certain extent, this gives you protection against market interest rate increases that lower the prices of existing issues – you’ve lost the money already, right? How much do you really care whether you lose it now or lose it on redemption? This concept was discussed in yet another article, Perpetual Hockey Sticks. Note, however, that TD.PR.Q, while above the line that separates PerpetualPremiums from PerpetualDiscounts, is still relatively close to it and, in general, you want to be as far away from that line as possible (unless enticed by large mounds of extra yield). I discuss this in (you guessed it!) an article about Convexity.

One more question: Given the new eligible dividend credit tax scheme, would one be wise/foolish to put all their non-registered funds into quality preferreds? Thinking not only of the tax but principal preservation/safety as well.

I generally recommend that no more than 50% of total fixed income assets be held in preferred shares. The total should include all your interest-rate-sensitive assets, including the bonds and GICs, etc., you have socked away in your RRSP. Why 50%? Well, why not 50%? If you’re looking for pages of math that use some kind of correlation matrix to prove that it should actually be 49.5842%, rounded to 50%, you won’t find it here! 50% is simply a figure that I feel comfortable putting my name on.

Firstly, Prefs are very much a retail product and more sensitive to the vagaries of fashion than bonds, which have a high institutional following. We certainly learned this in 2007 (which … wait for it … has been discussed in an article) a year in which preferred share spreads to bonds rose dramatically and prices got thumped big-time. Anybody who held 100% prefs last year and had to sell something to raise cash is less happy than they would have been had they been 50/50.

Secondly, Prefs are less liquid than bonds. If you need to sell a pref in a hurry, you’re taking your chances – there might not be any bids on the board at that moment in time, and you may not be willing just to sit on the offer side of the market for a week.With bonds, your dealer will (almost!) always make a market for you and charge you a spread against the institutional market that, while appalling, will at least be at least sort-of reasonable.

Thirdly, there’s taxation risk in prefs. If dividends were taxed as income, prices would fall dramatically. I’m as sure as I am of most things that the dividend-tax-credit-and-gross-up is safe … but I don’t feel like eating cat food for the rest of my life if I’m wrong. Remember, the Canadian public has seen fit to elect a grossly incompetent, mindlessly partisan Prime Minister – and if anybody ever mentions to him that the Dividend Tax Credit was introduced in 1971 by Pierre Trudeau … we’re in trouble.

Fourthly, bonds are senior to prefs in the event of bankruptcy. This can have an effect on prices in times of stress and an effect on recovery in times of … er … extreme stress. Pref Holders of Quebecor World will, I’m sure, be happy to explain this at length, with charts and diagrams.

This is not an exhaustive list of risks. There are many investment managers who, to their chagrin, did not include “global financial meltdown” on their list of things to worry about at this time last year. The thing about risk, you see, is that it’s risky. Diversify!

My thoughts were to get ones with a low SD (low volatility) and “hang on”.

Well, I don’t have much reliance on measure of Standard Deviation at the best of times, and this is not the best of times. Preferreds have just emerged (I hope) from their biggest bear market of the 15 years or so I have on record … probably not the worst ever, but there probably weren’t too many fixed-rate perps around in the 70’s. Any measure of SD that is reliant on the recent past is going to grossly overestimate the market risk of prefs going forward.

Also, I suggest an experiment: do the SD calculation on corporates vs. Canadas … or, if you don’t have the data (I don’t either, so don’t feel bad), look at the yields for all governments and all corporates from Canadian Bond Indices. Speaking very generally, the yield action in the past year has happened in governments … corporate yields have increased, to be sure, but rather sedately. It’s the spread that’s gone nuts, not the yield! Just off the top of your head, are you willing to compare the safety of governments vs. corporates based on SD of price or yield?

Take a more pro-active approach: read some of my articles where I talk about the various classes of preferred shares, understand the investment and likely sensitivity to various scenarios, and choose from there. Maybe use SD as a ballpark guide / second opinion, but don’t take it too seriously.

As AltaRed and Shakes point out prefs move with long term interest rates. A 1% increase in long term rates would decrease the value of a bank pref 18%, where the duration is 18 years.

True enough, but I must point out – as hinted at above – that long spreads are just as important as long rates, if not more so. I … all together now, 1, 2, 3! – write about spreads from time to time.

And, having spent more time than I really expected on this post, I will reward myself with an ad: Consider a subscription to PrefLetter to help with individual security selection or, perhaps, consider an investment in Malachite Aggressive Preferred Fund.

February 22, 2008

Friday, February 22nd, 2008

Not much today! I did, however, post about RS’s attitude towards icebergs and Inflation Expectations … you guys will just have to make do with that.

I see there are rumours of an Ambac rescue:

Banks may invest about $3 billion in the company, said the person, who declined to be named because no details have been set. The New York-based company rose 16 percent in New York Stock Exchange trading today after CNBC Television said Ambac and its banks were preparing to announce a deal.

A rescue that enabled Ambac to retain its AAA rating for the municipal and asset-backed securities guaranty units would help banks and municipal debt investors avoid losses on securities it guarantees. Banks stood to lose as much as $70 billion if the top-rated bond insurers, which include MBIA Inc. and FGIC Corp., lose their credit ratings, Oppenheimer & Co. analysts estimated.

Let me see if I have this straight … the banks are looking at a mark-to-market loss of $70-billion, which they can avoid with an investment of … oh, call it $10-billion, if Ambac gets three. How can anybody talk about market efficiency with a straight face?

Volume picked up today and performance was good … nothing earthshattering, but given that down days are currently rare, monny a mickle maks a muckle. As they say.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 5.52% 5.56% 40,919 14.5 2 -0.0994% 1,080.4
Fixed-Floater 5.01% 5.68% 74,305 14.66 7 +0.1006% 1,024.1
Floater 4.93% 4.99% 69,111 15.46 3 +0.4983% 857.6
Op. Retract 4.80% 2.17% 77,970 2.71 15 +0.1666% 1,049.7
Split-Share 5.27% 5.43% 98,908 4.11 15 +0.4300% 1,047.4
Interest Bearing 6.21% 6.27% 58,091 3.35 4 +0.3539% 1,087.0
Perpetual-Premium 5.70% 3.98% 348,148 5.07 16 +0.0956% 1,033.4
Perpetual-Discount 5.34% 5.38% 279,272 14.84 52 +0.0077% 963.1
Major Price Changes
Issue Index Change Notes
BNA.PR.C SplitShare +1.0401% Asset coverage of 3.3+:1 as of January 31, according to the company. Now with a pre-tax bid-YTW of 6.78% based on a bid of 20.40 and a hardMaturity 2019-1-10 at 25.00. Compare with BNA.PR.A (5.19% to 2008-10-31 call) and BNA.PR.B (7.03% to 2016-3-25 maturity). 
BSD.PR.A InterestBearing +1.0515% Asset coverage of 1.6+:1 as of February 15, according to Brookfield Funds. Now with a pre-tax bid-YTW of 6.97% (mostly as interest) based on a bid of 9.61 and a hardMaturity 2015-3-31 at 10.00.
BCE.PR.C FixFloat +1.0947%
FTU.PR.A SplitShare +1.1446% Asset coverage of just under 1.6:1 as of February 15, according to the company Now with a pre-tax bid-YTW of 6.04% based on a bid of 9.72 and a hardMaturity 2012-12-1 at 10.00.
MFC.PR.A OpRet +1.2367% Now with a pre-tax bid-YTW of 3.23% (!) based on a bid of 26.45 and a softMaturity 2015-12-18 at 25.00. 
MFC.PR.B PerpetualDiscount +1.2549% Now with a pre-tax bid-YTW of 5.02% based on a bid of 23.16 and a limitMaturity.
BNA.PR.B SplitShare +1.4392% See BNA.PR.C, above.
MFC.PR.C PerpetualDiscount +1.5200% This is exciting! Now with a pre-tax bid-YTW of 5.00% (actually, I make it 4.9971%) based on a bid of 22.51 and a limitMaturity. It’s been a long time since a PerpetualDiscount yielded less than 5.00% … September 26, 2007, in fact.
BAM.PR.B Floater +1.6393%  
Volume Highlights
Issue Index Volume Notes
BAM.PR.N PerpetualDiscount 309,820 Now with a pre-tax bid-YTW of 6.44% based on a bid of 18.80 and a limitMaturity.
CM.PR.H PerpetualDiscount 95,100 Now with a pre-tax bid-YTW of 5.54% based on a bid of 21.89 and a limitMaturity.
BCE.PR.C FixFloat 73,300  
BAM.PR.M PerpetualDiscount 42,725 Dundee (who?) bought 35,000 from RBC at 19.10. Now with a pre-tax bid-YTW of 6.35% based on a bid of 19.06 and a limitMaturity.
RY.PR.B PerpetualDiscount 23,100 Now with a pre-tax bid-YTW of 5.22% based on a bid of 22.64 and a limitMaturity.

There were twenty other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Inflation Expectations

Friday, February 22nd, 2008

I once heard an explanation of why economics is termed “the dismal science”. It’s because, you see, you can spend ten years of your life, full-time, working on a particular model of something … capturing inputs, backtesting sensitivity, creating theoretically acceptable models of transmission mechanisms … and finally, finally, have something that looks really good.

You walk down the street, show it to the first guy you meet, he says “What about taxes?”

You say “Oh …. bugger!” and go back to your office for another ten years. 

Inflation talk is all the rage now and the following paragraph by James Hamilton on Econbrowser caught my eye:

Greg Ip, Felix Salmon and Greg Mankiw are concerned that the 5-year TIPS-nominal spread has fallen relative to the 10 year, implying that the 5-year forward inflation rate (the so-called 5-year, 5-year break-even rate) has gone up. But I agree with the analysis by knzn and particularly Francisco Torralba that the facts are much less alarming than Ip’s graph might have seemed to suggest, and that the basic impression of stability of longer term expectations that one brings away from the graph I’ve plotted above is the correct one.

Well, let’s have a look at some fresh data:

Fed H.15 Data, Feb 20, 2008
Term Nominal TIPS Breakeven
5-Year 3.02% 0.77% 2.25%
10-Year 3.93% 1.55% 2.38%
5/5 Breakeven (Approx.: 2*2.38-2.25) 2.51%

So, as of February 20, the 5/5 Breakeven rate was (approximately) 2.51%, which is basically what it was on January 30, according to knzn. So far, so good: we’re getting a relatively constant number for the 5/5 BE. However, compare the data further with knzn’s calculations:

Time Series of 5/5 BE Rate Approx
Date 5-Year BE 10-Year BE 5/5 BE Effective
Fed Funds 
Jan 9 2.16% 2.25% 2.35%  4.26%  2.69%
Jan 30 2.12% 2.33% 2.54%  3.26%  2.30%
Feb 20 2.25% 2.38% 2.51%  3.00%  2.14%

I snuck two extra columns into the time-series because they’re important. The 2-Year Nominal is generally accepted as being the market expectation of the average Fed-Funds rate through the period. (I had a quick look for some research regarding just how good a predictor it is, but didn’t see anything. Somebody must have created the spreadsheet at some time! Come on, now! Let’s see a scatter plot of 2-Year Nominal Treasury Yields vs. two-years-following cumulative Fed Fund returns! Anybody?)

Anyway … it seems to me that if we’re to take the 5/5 BE rate as an estimate of inflation expectations, then we are assuming that the market is rational. And if the market is rational, then the two-year Treasury must also be a rational estimate of Fed Funds expectations. So right off the bat, we see that the estimate of 2.5% inflation from 2013-18 is dependent upon a pretty low Fed Funds rate over the next two years.

It should be noted that the argument developed here is very, very approximate. There is a liquidity premium that should be accounted for with investments of different terms (and isn’t); there are segmentation effects (only a few institutions can get the Fed Funds rate directly; anybody can buy a treasury); there are preferred habitat effects (some players will not switch between reals and nominals no matter how many fancy graphs you show them). All of the other caveats noted by Francisco Torralba apply as well.

OK, be patient, I’m getting to the point! As noted on Econbrowser Taylor has used coefficients of 0.5 for output and 1.5 for inflation to determine appropriate policy responses to deviations from ideal conditions.

OK, now here’s where my argument starts getting a little hairy! We will assume that the change in CPI is zero. Based on recent observations, we can be pretty sure inflation is not declining; the argument in Econbrowser that inspired this post is that expectations haven’t changed, either. The hairy part of this is that inflation expectations five years out are not the same thing as currently measured (trailing) inflation and they’re not the same thing as expectations for next year, either! It’s fairly difficult to refute an argument that inflation is expected to do … something … for the next year and then return to normal (due to wise actions by the omniscient Fed) in time for 5/5 BE to be unchanged too.

But I’m making an argument about the consistency of economic models here, so we’ll assume that the (simplified) theory presented here is accurate: there is an expectation that inflation will increase by 20bp over the next five years. The appropriate policy response, therefore (based solely on the inflation term) is to increase Fed Funds 30bp.

But Fed Funds have not been increased by 30bp … they’ve been dropped 125bp. The difference between these two figures, 155bp, must (if we are to assume perfection of our models AND perfection of Fed policy) be due to a Taylor response to the output term, which has a coefficient of 0.5. This only resolves if we have an output gap of 3%.

The situation gets worse if we consider the two-year note to be a good predictor of Fed Funds under the expectations hypothesis: the yield is now 2.14% (it’s been sub-2% recently) so let’s add a tiny term/liquidity/segmentation premium and say the market expects Fed Funds to be 2.00% for the forseeable future, which is a drop of about 2.5% from mid-January, which  resolves to an output gap of 5.6%.

Assume that potential real GDP growth is 3%.

We conclude that one of the following must be true:

  • Inflation expectations have in fact increased far beyond that shown by the simple model, or
  • The two-year note yield is not an reliable forecast of average Fed Funds, or
  • The Taylor rule has stopped working, or
  • Simple models are not capturing all the interelationships, or 
  • We’re going to have one hell of a recession … maybe a depression.

My bet is that both of the first two potential explanations are correct, with maybe a small contribution from natural scatter in Taylor Rule explanations. But I’ll bet a whole lot more on the idea that these models being discussed are just plain too damn simple.

And my point is … the markets are not just lacking in omniscience, they’re lacking in rationality. Don’t take the signals too seriously, or spend too much time obsessing over understanding what it’s trying to tell you.

Addendum: I will note, as I did on February 7 that the 5-year corrected market-derived inflation expectations measure is most certainly not flat:

The Cleveland Fed has updated its estimate of inflation expectations from TIPS … very interesting indeed. The breakeven rate is increasing slightly, but the analytical rate – which attempts to incorporate adjustments for the inflation-risk-premium and liquidity-premium – is skyrocketting. This epsiode [sic] will be very useful in determining the validity of these adjustments!

Presumably, a similarly derived correction to the 5/5 BE will have roughly the same size as the correction to the 5-BE. But I don’t know that for sure.

Also, note that segmentation plays a really strong role in some aspects of some markets. I’ll bet there are lots of players who would love to try on the arbitrage of long Fed-Funds / short 2-Year notes … but either can’t, or are scared of the rather special risks of shorting short Treasuries.

RF.PR.A Closes – Will Not Be Tracked by HIMIPref™

Friday, February 22nd, 2008

CA Bancorp has announced:

C.A. Bancorp Canadian Realty Finance Corporation (the “Corporation”) has closed its initial public offering (the “Offering”).

Gross Proceeds: At the closing, the Corporation issued 1,440,000 Preferred Shares, Series 1 (the “Preferred Shares”) for aggregate gross proceeds of $36,000,000. The agents have been granted an over-allotment option to purchase up to 216,000 Preferred Shares at any time during the next 30 days.

Trading Information: The Preferred Shares commenced trading on the Toronto Stock Exchange (“TSX”) today under the symbol RF.PR.A.

This issue will not be tracked by HIMIPref™ for reasons that have been previously discussed.