PrefBlog

There are rising expectations for low rates forever:

Just six months ago, money market traders expected the Federal Reserve to raise interest rates by the end of 2013. Now, they see borrowing costs staying at record lows for about three more years as the economic outlook worsens.

Bond market measures from overnight index swaps, which indicate no increase in the federal funds rate until mid-2015, to a 62 percent decline in a measure of volatility in government bonds signal that rates will stay near zero for longer. The gap between two- and five-year Treasury yields, which decreases when traders expect benchmark rates to remain subdued, is more than 50 percent narrower than its average since 2008.

It was an off day for the Canadian preferred share market, with PerpetualPremiums and FixedResets down 7bp, while DeemedRetractibles lost 9bp. Volatiltiy was average, all on the downside. Volume continued at holiday levels.

US Payrolls weren’t very encouraging:

Payrolls rose less than projected in August and the unemployment rate was unexpectedly driven down by Americans leaving the labor force, boosting the odds of additional Federal Reserve easing to spur a faltering recovery.

The economy added 96,000 workers after a revised 141,000 increase in July that was smaller than initially estimated, Labor Department figures showed today in Washington. The median estimate of 92 economists surveyed by Bloomberg called for a gain of 130,000. The jobless rate fell to 8.1 percent.

European banks still aren’t doing very well:

ECB President Mario Draghi said yesterday the central bank will lend against assets in dollars, pounds and Japanese yen, as well as in euros, reopening a program that ran for two years following the September 2008 bankruptcy of the U.S. investment bank. The ECB also eased borrowing against government-issued or guaranteed assets by dropping rating requirements.

Investors’ reluctance to lend to banks in countries where bond yields soared has forced those banks to fund at the ECB. Spanish banks borrowed 375.5 billion euros ($476 billion) from the central bank as of the end of July, sucking collateral out of a government bond market that totals about 690 billion euros, according to data compiled by Bloomberg.

The ECB’s 1 trillion-euro longer-term refinancing operations in December and February took collateral out of the market, in particular in Spain and Italy, whose banks were the biggest borrowers. ECB bond buying as part of its new Outright Monetary Transactions program will pile more pressure onto a market that is already “highly illiquid,” said Chris Clark, a strategist at ICAP Plc, the largest broker of transactions between banks.

“There’s so little Spanish paper that hasn’t been lodged at the ECB that pretty much every single bond has gained a very significant premium to borrow,” he said. “If the ECB buys more bonds, it may dry up liquidity in the Spanish government bond market even more. These looser collateral rules will help.”

Apropos of which, Fitch Ratings has a most interesting report titled U.S. Money Fund Exposure and European Banks: Shift to Japan Continues:

U.S. prime money market funds (MMF) continued to increase their exposure to Japanese banks, which as of end-July represent 12.3% of total MMF holdings or a 118% increase on a dollar basis since end-May 2011 (see Shift to Japan Continues chart and Change in Exposure [on a Dollar Basis] table). This exposure exceeds aggregate MMF allocations to eurozone banks, which increased moderately since the prior reporting period and now constitute 8.5% of total MMF assets, still 76% below end-May 2011 levels on a dollar basis. This “disengagement” between MMFs and eurozone banks appears to be persisting, as MMF risk aversion continues and both eurozone banks and their regulators seem cautious towards this potentially volatile form of funding. Aggregate MMF allocations to European banks outside of the eurozone also grew with allocations to Nordic, Swiss, and U.K. banks all rising since end-June on a dollar basis. Outside of Europe, MMF allocations to Canadian banks declined slightly, while exposures to Australian banks remained constant over the same period. However, since end-January 2012, MMF exposures to Australian banks have declined by roughly 25%, consistent with efforts by these banks to gradually reduce their use of short-term wholesale funding. U.S. banks remain the largest single-country exposure at 12.4% of MMF assets as of end-July.

I am pleased to announce the existence of a prominent adult investor:

Mark Cuban, owner of the Dallas Mavericks basketball team, wrote a post on his blog in response to a column in which Andrew Ross Sorkin of the New York Times pinned the blame on David Ebersman, Facebook’s chief financial officer. Cuban said:

“I bought and sold FB shares as a TRADE, not an investment. I lost money. When the stock didn’t bounce as I thought/hoped it would, I realized I was wrong and got out. It wasn’t the fault of the FB CFO that I lost money. It was my fault. I know that no one sells me shares of stock because they expect the price of the stock to go up. So someone saw me coming and they sold me the stock. That is the way the stock market works. When you sit at the trading terminal you look for the sucker. When you don’t see one, it’s you. In this case it was me.”

Amazing, isn’t it?

There’s a (very US-centric) article on preferred shares in the Wall Street Journal, titled Playing ‘Preferred’ Shares.

DBRS confirmed MFC:

DBRS has today confirmed its ratings on Manulife Financial Corporation (Manulife or the Company) and its affiliates, including The Manufacturers Life Insurance Company, its primary operating company. The rating trend is Stable.
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While DBRS is prepared to acknowledge that, barring a major economic crisis, the Company has probably hit its nadir, it does not believe that the lost profitability associated with the U.S. operation will recover quickly, especially since the former earnings levels benefited from favourable equity markets and a more favourable interest rate environment. DBRS is also mindful that the Company’s core earnings performance is dampened by hedging costs, reduced earnings opportunities related to potential recovery in capital markets, and more competitive market conditions. The Company has indicated that it also expects to take another material charge in Q3 2012 related to changes in actuarial assumptions driven by new standards of practice and the ambient macroeconomic environment, though much of this specific charge will relate to products and policy liabilities that are not part of the Company’s current growth plans. Other sources of potential earnings volatility relate to the indeterminate policyholder behaviours that are not addressed by current hedging activity, and a possible additional write down of goodwill reflecting the adverse interest rate environment.

At the Company’s current level of core earnings as DBRS defines them, fixed charge coverage ratios are below 5x with a core return on equity (ROE) of about 10%, well below the greater than 10x coverage and greater than 15% ROE reported prior to the onset of the 2008 financial crisis. Without the heft of the Company’s business franchises in Canada, Asia and the United States, such ratios and the accompanying earnings volatility would not be consistent with the DBRS quantitative criteria for Company’s rated at the current levels. Should these business franchises deteriorate, there could be negative rating implications.
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To meet its regulatory capital requirements over the same period of market disruption, the Company has raised over $14 billion in net capital through market issues of common and preferred shares, reduced cash dividends and senior and subordinated debt issues. Correspondingly, the Company has consistently reported strong regulatory capital ratios, as its financial leverage ratios (total debt plus preferred as a proportion of capitalization) have increased to 32.2% from 17.1% in 2007, and remain above the Company’s 25% target. The Company reported an MCCSR ratio of 213% for the period ending June 30, 2012, which is among the strongest ratios in the industry and well above a reasonable minimum level, especially given the Company’s risk-mitigating hedges for which the regulatory ratio gives no credit. However, given the unstable economic environment regulatory uncertainty associated with Solvency II, IFRS accounting for Insurance Contracts and Employee Benefits and OSFI’s and the Canadian Institute of Actuaries requirements regarding required capital for variable annuity guarantees, DBRS feels that the relatively high regulatory capital ratios are prudent at this time.

DBRS also confirmed GWO:

DBRS has today confirmed the ratings of Great-West Lifeco Inc. (GWO or the Company) and its affiliated operating subsidiaries, including the Claims Paying Ratings at The Great-West Life Assurance Company, The Canada Life Assurance Company and London Life Insurance Company; all trends are Stable. The existing ratings for the Company and its operating subsidiaries reflect the continuing strong financial performance and the notable absence of earnings volatility associated with recent exogenous market factors. Stable earnings are a testament to the Company’s diversification by product and geography, as well as its conservatism with respect to embedded product risks, actuarial assumptions and asset quality.

Like its major peers, the Company is anchored by Canadian operations that benefit from an oligopolistic industry structure, which limits the worst of price competition.
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The MCCSR ratio of the Company’s major regulated operating subsidiary has hovered just over 200% for the last two years. While this is lower than that of some major competitors, it reflects the Company’s lower-risk asset portfolio and insurance liabilities, and does not include $825 million of cash at the holding company that could easily be advanced to the regulated entities in the form of capital, if required. With longer experience as a shareholder-owned company, GWO has traditionally operated with higher financial leverage than most of its Canadian peers, a reflection of its debt-financed mergers and acquisitions activity and the historical attention paid to the efficient use of shareholder capital. At 32.2% at the end of June 2012, the Company’s total debt plus preferred has come into alignment with that of the peer group, as Great-West has reduced financial leverage and de-mutualized competitors have increased theirs. Fixed-charge coverage ratios at GWO nevertheless remain healthier than those of its peers, reflecting stronger profitability. The Company is actively retiring capital instruments issued at its operating companies in order to have a higher proportion of capital issuance at the holding company level, which will serve to reduce its double leverage ratio. In short, DBRS considers the Company’s financial leverage and capital position to be consistent with the current rating category, as long as it continues to operate conservatively.

As an integral component of Power Financial Corporation’s group of companies, GWO benefits from its parent’s financial support and its strong governance and risk management controls and procedures, which reinforce the conservative bottom-line focus of the Company.

It was a mixed day for the Canadian preferred share market, with PerpetualPremiums gaining 6bp, FixedResets off 2bp and DeemedRetractibles up 4bp. Volatility was minimal. Volume remained at holiday levels.

The European Central Bank is going to purchase sovereigns:

As announced on 2 August 2012, the Governing Council of the European Central Bank (ECB) has today taken decisions on a number of technical features regarding the Eurosystem’s outright transactions in secondary sovereign bond markets that aim at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy. These will be known as Outright Monetary Transactions (OMTs) and will be conducted within the following framework:
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Transactions will be focused on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years.

No ex ante quantitative limits are set on the size of Outright Monetary Transactions.

Creditor treatment The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.

Sterilisation The liquidity created through Outright Monetary Transactions will be fully sterilised.

Transparency Aggregate Outright Monetary Transaction holdings and their market values will be published on a weekly basis. Publication of the average duration of Outright Monetary Transaction holdings and the breakdown by country will take place on a monthly basis.

Pari passu treatment for ECB holdings would be a pleasant change … provided one can count on the Europeans to keep their word.

Jason Heath writes a piece in the Financial Post regarding a CDHowe report on Annuities:

But the C.D. Howe report is really interest-rate agnostic — focused more on reasons other than interest rates that Canadians are not opting for annuities. Among those reasons: poor annuity market infrastructure and pricing; non-integration of insurance, banking, pension and tax regulations; insufficient annuity product options; and a lack of government websites and resources to assist in our decisionmaking.

The CDHowe commentary by Norma L. Nielson is titled Annuities and Your Nest Egg: Reforms to Promote Optimal Annuitization of Retirement CapitalRetiring. I’ve scanned it – it follows the basic Financial Economist reasoning that Liquidity Value = 0, therefore Annuities = Good. I was particularly struck by the suggestion:

In some cases, public policymakers decide there is a need to subsidize one group at the expense of another. State social security systems may incorporate a significant element of wealth transfer from the rich to the poor, for example. In the case of decumulation products, it may be determined that it is socially desirable to provide gender-neutral annuities; i.e., for men to subsidize women.

Interesting report from a relatively free-market airline business:

Qantas Airways Ltd. (QAN)’s decision to drop a 17-year pact with British Airways (IAG) in favor of a deal with Dubai-based Emirates reveals the potential for fast-growing Gulf carriers to shatter the established airline order.

The 10-year accord, announced yesterday, will lead Qantas to scrap its revenue-sharing pact with British Airways to gain access to 70 Emirates destinations. While the Australian carrier will carry on code-sharing with BA, the move puts in doubt the standing of the Oneworld global alliance the pair helped form.

Too bad we won’t even let Emirates fly here as much as they like! But it’s just another example of the extent to which competition and efficiency is stifled in Canada. When politicians (such as Junior Minister Carney) say “Productivity!”, I say “Milk.”

It was a mixed day for the Canadian preferred share market, with PerpetualPremiums gaining 1bp, FixedResets down 8bp and DeemedRetractibles off 2bp. Volatility was minimal. Volume remained very low.

The BoC stood pat:

In Canada, while global headwinds continue to restrain economic activity, underlying momentum remains at a pace roughly in line with the economy’s production potential. Economic growth is expected to pick up through 2013, with consumption and business investment continuing to be its principal drivers, reflecting very stimulative financial conditions. Business investment remains solid. There are tentative signs of slowing in household spending, although the household debt burden continues to rise. Canadian exports are projected to remain below their pre-recession peak until the beginning of 2014, reflecting the dynamics of foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar.

Core inflation has been softer than expected in recent months but, with the economy operating near its production potential, it is expected to return, along with total CPI inflation, to 2 per cent over the course of the next 12 months.

Reflecting all of these factors, the Bank has decided to maintain the target for the overnight rate at 1 per cent. To the extent that the economic expansion continues and the current excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate, consistent with achieving the 2 per cent inflation target over the medium term. The timing and degree of any such withdrawal will be weighed carefully against domestic and global economic developments.

Transalta bought a power plant and issued equity:

TransAlta Corporation (TransAlta) (TSX: TA; NYSE: TAC) announced today that its wholly owned subsidiary has entered into an agreement with Fortescue Metals Group Ltd. (Fortescue) (ASX: FMG) to acquire its 125 megawatt (MW) dual-fuel Solomon power station for U.S. $318 million.

In connection with the acquisition, TransAlta also announced today that it has entered into an agreement with a syndicate of underwriters, led by CIBC and RBC Capital Markets as bookrunners, under which the underwriters have agreed to purchase from TransAlta and sell to the public 19,250,000 Common Shares. The purchase price of Cdn $14.30 per Common Share will result in gross proceeds to TransAlta of approximately Cdn $275 million.

DBRS calls it credit-neutral:

Overall, DBRS views this transaction as credit neutral.

(1) BUSINESS RISK PROFILE – Negative
Based on its preliminary review, DBRS views the proposed acquisition as negative with respect to TAC’s business risk profile. Although the PPA reduces earnings and cash flow volatility, the PPA is with a weaker counterparty. FMG Solomon operates in a cyclical industry and is significantly exposed to pricing volatility and geographic and product concentration risk. However, given the relative size of the Project’s incremental cash flow to TAC’s cash flow from operations (approximately 5% of fiscal 2011 cash flow from operations), the proposed acquisition is viewed as non-material to TAC’s overall business risk profile.

(2) FINANCIAL RISK PROFILE – Positive

Based on DBRS’s review of the proposed acquisition and financing strategy, pro forma the proposed acquisition and equity offering (i.e., post-acquisition), DBRS estimates an improvement in TAC’s key credit metrics. DBRS expects the Company to fund the majority of the proposed acquisition with common equity, which will improve the Company’s capital structure going forward. The proposed acquisition is also expected to generate annual incremental cash flow of approximately $40 million for TAC under a stable PPA framework. Pro forma post-acquisition (including TAC’s preferred shares issuance on August 10, 2012; see the related DBRS press release on August 10, 2012), DBRS estimates that the debt-to-capital ratio will be approximately 54% and that the interest coverage and cash flow-to-debt ratios will improve modestly.

The equity guys seem less impressed:

Following the news, TransAlta’s stock skidded 57 cents or 3.9 per cent to $14.11 (Canadian) on the Toronto Stock Exchange – the lowest closing price since March, 2000.

TransAlta’s dividend yield is now 8.2 per cent – a level some analysts view as unsustainable without an uptick in power prices.

TLM was confirmed at Pfd-3(high) by DBRS:

DBRS has today confirmed the ratings of the Unsecured Debentures & Medium-Term Notes and Cumulative Redeemable Preferred Shares for Talisman Energy Inc. (Talisman or the Company) at BBB (high) and Pfd-3 (high), respectively, both with Stable trends. The confirmation reflects the Company’s reasonable reserve and production growth profile and geographically diverse operations, but also considers the Company’s high level of exposure to North American natural gas and high capital expenditure relative to cash flow.
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DBRS anticipates that Talisman will be free cash flow negative for 2012 (approximately $1.4 billion) due to aggressive capital spending ($3.6 billion) and continued weak North American gas pricing. This is expected to be funded, in part, by asset sales (approximately $2.5 billion to date). DBRS anticipates that future cash flow deficits will be funded with asset sales as well as debt issuances.

It was a negative day overall for the Canadian preferred share market, with PerpetualPremiums flat, FixedResets losing 11bp and DeemedRetractibles off 1bp. Volatility was low. Volume continued very low.

PerpetualDiscounts – all three of them – now yield 4.95%, equivalent to 6.44% interest at the standard equivalency factor of 1.3x. Long Corporates now yield about 4.3%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 215bp, unchanged from August 29.