PrefBlog

Here’s a straw in the wind:

This was supposed to be a tough year for fixed income. But so far it is turning out very differently. The bond bears are suffering. Global fixed income assets have returned 4.1 per cent in the year to date, compared with 2.5 per cent for global equities, according to Bank of America Merrill Lynch. And there is probably more pain in store for asset managers who are under-invested in debt.

Inflation is persistently low and central banks are determined to keep monetary policy accommodative. The European Central Bank is likely to ease in June. And the U.S. Federal Reserve and the Bank of England are proving more dovish than expected. Investors are pushing their timing for the first hike in official rates a few months further into the future.

But, as usually happens, there’s another straw in the wind:

These bond bears just won’t go away.

Some even appear to be doubling down as their losses mount.

Exhibit A: As the ProShares UltraShort 20+ Year Treasury (TBT) fund plunged 21.6 percent this year, investors have responded by plowing $525.3 million into the exchange-traded fund, which uses leverage and derivatives.

Exhibit B: Investors have boosted short wagers on Treasuries using futures contracts trading on the Chicago Board of Trade to 56 percent more than their five-year average. A few weeks ago, there were the most since March 2008.

As I mentioned on May 13, Rob Carrick recently wrote a piece titled GICs beat laddered bond ETFs, hands down, to which I took some exception; what I didn’t mention was that I repeated my remarks in the comments section and waited to see what would happen. Well, it turned out to be a long drawn-out argument with a guy who’s really swallowed the Kool-Aid: GIC ladders are always best and anybody who doesn’t agree is either stupid or paid. He referred to a Financial Post piece by a stockbroker which isn’t very interesting: it boils down to ‘Don’t time the market’, but while searching for it I stumbled across a more interesting piece by Jane Bryant Quinn, a well regarded US financial journalist who takes another view: Seven Reasons Why Bond Ladders are Bad for Investors.

1. Bond ladders deprive you of current income. The money you put into individual bonds pays you an income at a fixed rate. When rates in the marketplace go up, your income will stay the same. In a bond mutual fund, by contrast, the managers will be adding higher-rate bonds to the pool. Your interest income – and spending money – will increase.

Well, sure. A bond fund will – normally – trade more than any individual investor, both because more issues are held, because frictional costs are so much less, and because many PMs feel that if they don’t fiddle with portfolio often enough they’ll get fired. But I do not accept this as a point in favour of funds because (i) it only considers the case in which yields rise – income will be adversely affected when yields fall, and (ii) it is therefore a market-timing argument and (iii) one purpose of Fixed Income is to FIX your INCOME and volatility of income is, if anything, to be deprecated.

2. Bond ladders often force you to reinvest at lower rates. If you’re not spending the interest income you get from individual bonds, you need to reinvest it. What are you doing with that money? It might not be enough to buy more than one or two bonds, at a high commission cost. If you want that money to be readily available, you’ll siphon it into a money market fund whose interest rate is kissing zero.

In a bond mutual fund, by contrast, you can reinvest all your interest income in new shares, at the market’s current, higher yields. In other words, you’ll be buying more shares at a lower price. When interest rates decline again, the value of your bond fund shares will rise. You’ll have more shares than you started with, which means more dollars in your pocket.

I’ll agree with her on this one. I alluded to the problem when I spoke to John Heinzl about Why only millionaires should invest in bonds directly

3. Bond ladders deprive you of future capital gains. When you hold individual bonds and interest rates decline, your bonds will rise in market value. They’ll be worth more than you paid for them. But in ladders, you hold to maturity so you’ll never collect the capital gains. In a mutual fund, the manager will harvest those gains and add them to the value of your shares.

On the face of it, this is nonsensical. Assuming the only difference between the bonds is the coupon, then the yields to maturity should be the same (and this is usually basically true), therefore there’s nothing to be gained by executing the swap.

It gets more interesting when taxes are taken into consideration. I considered the case of a 6% bond maturing 2024-5-16, exactly ten years hence. At a yield of 3%, it trades at 125.753. We hold 10MM face value of these, with a book value of par, because we bought them at issue ten years ago. So, what should we do?

• Hold them, getting $600,000 interest annually and paying tax on that? Or
• Sell them, pay the capital gains tax, buy 12.5753MM of 3%-coupon bonds trading at 100.00, get $377,259 in interest annually and pay tax on that?

Pre-tax, the MS-Excel XIRR function returns a value of 3.01974% Internal Rate of Return for the 6% coupon and 3.01985% IRR for the 3% coupon.

After tax, the values of 0.91590% is returned for the 6% coupon and 1.38098% for the 3% coupon – so it’s clearly in the investor’s interest to execute the swap.

Purists will notice that there is a negative cash flow after tax in 2015, since there’s a tax bill of $590,511 compared to interest income of $377,259, but purists can go jump in the lake, since I’m assuming taxes are paid from other resources (i.e., by the investor, not the fund). I used tax rates of 40% for income and 20% for capital gains, by the way. Purists will also be quick to inform me that the duration of the 3% bond is significantly higher than that of the 6% bond, 8.71 vs. 7.95, so I really should be swapping into a weighted combination of Bills and the 3% (about 91% bonds, 9% bills) … purists can do their own damn calculations.

So on point (3) we’ll award Ms. Quinn part marks: she is correct, but only for taxable accounts, only if the PM actually executes the swap and only if there’s differential taxation on capital gains (when I change capital gain taxation to 40%, the same as income, the Swap Scenario yields 0.95643%, which, to be fair, is 4bp more than the Hold Scenario as long as the swap isn’t duration neutral.

4. Bond ladders carry more default risk. Individual investors might hold no more than 10 or 20 bonds. If one of them goes bad, it could take a mean slice out of your portfolio. Ladders should be built only with high-quality bonds but – in municipals, especially — you never know when a snake is hidden in the underbrush.

Mutual funds are far better diversified, owning hundreds, even thousands of bonds (Vanguard’s Intermediate-Term Tax-Exempt fund holds 4,641 of them). Like ladders, the bonds come in varying maturities, from short to long.

This is phrased badly (the default risk is the same for both the ladder and the fund; but the ladder’s default risk is more concentrated), but is true. It only applies to corporate bonds, though; there will be some who will compare only GICs and Canadas.

5. Bond ladders leave you unprepared for emergencies. Sometimes, you can’t hold individual bonds to maturity. You might have unexpected medical bills or one of your kids might need some cash. You might have inherited the bonds and want to convert them into cash. Selling bonds before maturity is more expensive than you imagine. If interest rates have risen, their market value will be down – especially for small, retail lots. The markets trade in amounts of $100,000 or more, and clip 2 to 3 percent off the price if you’re selling just 25 or 30 bonds. You pay your broker a sales commission. And, after the sale, you don’t have a ladder any more – one or more of the rungs is gone.

With a mutual fund, on the other hand, you can sell shares at any time and at no cost if you have a no-load fund. The remainder of your investment will be just as diversified as it was before.

Spot on, this is a very compelling argument against ladders. As I pointed out in my discussion in the Globe comments, an investor seeking to have $X annual liquidity out of a five year ladder must invest $5X – and even then, the funds are only available between maturity and reinvestment. There is therefore the potential where the investor could be simultaneously short of liquidity and over-invested in short-term securities. This is less important if the ladder has marketable rungs than if it’s in GICs.

6. Bond ladders are expensive. You’ll probably work with a broker to set one, paying 2 percent in markups, at retail price. The ladders have to be managed, meaning more sales commissions. A no-load mutual fund, by contrast, charges no commissions and costs only a small amount per year in management fees – at Vanguard, about 0.2 percent. Also, funds buy their bond at institutional prices, which are much lower than the price you pay in the retail market.

Ms. Quinn gets part marks for this one. Is it better to pay X% in markups on 1/N of your portfolio every year (where N is the number of rungs in your ladder)? Or is it better to pay Y% on all of your portfolio every year? This will depend on the relative values of X and Y, on the value of N, and how fussy you are about maintaining a precise ladder – if you buy corporate bonds as new issues, you’ll pay less mark-up, but you’ll be lucky to get the next rung of your ladder within three months of where you want it. And – my antagonist in the Globe’s comments section will be quick to point out – there’s no commission on GICs and those are available as new issues on demand. But I don’t recommend GICs for ladders anyway.

7. What about other kinds of ladders? Ladders built from certificates of deposit instead of bonds face many of the same drawbacks: No increase in income when interest rates rise and a penalty if you’re forced to sell before maturity. The same is true of ladders build from Treasury securities. But there’s no default risk and you don’t have to pay sales commissions (for Treasuries, you’d have to build the ladder yourself, using Treasury Direct).

No marks for this one, I consider it at best a duplication of the first six points.

Ivo Krznar and James Morsink wrote an IMF working paper titled With Great Power Comes Great Responsibility: Macroprudential Tools at Work in Canada:

The goal of this paper is to assess the effectiveness of the policy measures taken by Canadian authorities to address the housing boom. We find that the the last three rounds of macroprudential policies implemented since 2010 were associated with lower mortgage credit growth and house price growth. The international experience suggests that—in addition to tighter loan-to-value limits and longer amortization periods—lower caps on the debt-to-income ratio and higher risk weights could be effective if the housing boom were to reignite. Over the medium term, the authorities could consider structural measures to further improve the soundness of housing finance.

I have to admit to some astonishment that they are advocating increased micro-management rather than simply capping the amount of mortgage insurance offered.

Most loans are five-year fixed-rate mortgages that are rolled over into a new five-year fixed rate contract for the life of the loan (typically 25 years) with the rate renegotiated every five years. In the case of variable-rate mortgages (which are less prevalent), the monthly payment is typically fixed, but the fraction allocated to interest versus principal changes every month with fluctuations in interest rates. Longer-term fixed rates were phased out in the 1960s after lenders experienced difficulties with volatile interest rates and maturity mismatches.

I didn’t know that about the ’60’s. I consider the whole 5-year-term thing to be not just outrageous, but probably also linked to the CDIC rules on insuring deposits with a maximum term of five years. I’d like to see that increased (with an extra premium being charged to the banks for longer dated deposit insurance), but the feds seem intent on destroying the market for long-dated bank paper with the forthcoming bail-in rules.

Insured mortgage loans have lower risk weights than uninsured loans. CMHC-insured mortgages have a capital risk weight of zero under the standardized approach and an average risk weight of about 0.5 percent under the internal ratings based (IRB) approach, reflecting the fact that CMHC obligations are considered sovereign exposures.

This is an insidious and under-recognized consequence of CMHC insurance. Not only are the banks laying off their actual business risk when they insure, they’re also reducing their regulatory capital requirement.

Limits on government-backed mortgage insurance and CMHC securitization: The government has announced plans to prohibit the use of government-backed insured mortgages in non-CMHC securitization programs, plans to limit the insurance of low-LTV mortgages to those that will be used in CMHC securitization programs, and limits on CMHC securitization programs. In addition, CMHC is now required to pay the federal government a risk fee on new insurance premiums written.8 It has also announced that it will increase mortgage insurance premiums by about 15 percent on average for newly extended mortgage (for all LTV ranges), effective May 1, 2014.9

Limiting the amount issued and auctioning it off to the highest bidder would be way too simple. A very major shortcoming of this paper is that they do not examine, or even list, the growth in CMHC outstanding (although they do show the growth rate from 2006 on).

Over the long run, the authorities could consider the possibility of eliminating the government’s extensive role in mortgage insurance. In this regard, Australia’s experience is relevant. Australia’s mortgage insurance system before 1998 was similar in important respects to Canada’s current system. A government-owned mortgage insurance company, the Home Loan Insurance Corporation (HLIC), was created in 1965. By the early 1990s, HLIC had a market share of about 55 percent.28 The mortgage market was operating efficiently and private sector mortgage insurance was well established, competitive, and available at reasonable cost. In December 1997, the government decided that it was no longer necessary for the government to play a direct role in mortgage insurance and passed legislation to allow for the privatization of HLIC. GE Capital (now Genworth) subsequently purchased the company and entered the Australian mortgage insurance market. Australia provides an example of the development over time of a well established private-sector mortgage insurance industry that alleviates the need for public sector involvement, with the associated risk to the government’s balance sheet stemming from the government insuring most of the mortgages in the country.

I like this idea. I didn’t know this about Australia. ┴ɥosǝ ∀nssᴉǝs oɟʇǝu ɥɐʌǝ ƃoop ᴉpǝɐs; qǝᴉuƃ ndsᴉpǝ poʍu ɯnsʇ ɥǝld ʇɥǝ ɟloʍ oɟ qloop ʇo ʇɥǝ qɹɐᴉu˙

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Click for Big

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts down 28bp, FixedResets off 13bp, but DeemedRetractibles managed to eke out a gain of 1bp. Volatility picked up; the list is comprised entirely of losers. Volume was extremely low, presumably due to the long weekend, as those of us employed in the best-compensated industry on the planet can’t be bothered to do a full day’s work before a long weekend.

Scotiabank will be selling its minority position in CI Financial:

Scotiabank owns 37 per cent of CI Financial Corp., a position now worth $3.8-billion. The country’s third-largest lender intends to “monetize” the stake at a time when wealth managers are in heavy demand and the S&P/TSX composite index nears a record high. Since the start of 2013, CI’s stock has climbed 44 per cent and the company now has $97-billion worth of assets under management.
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Under the terms of an agreement between the two parties, Scotiabank cannot sell more than 20 per cent of CI to one purchaser. For that reason, the position could either be split up among multiple strategic parties, or could be sold directly to investors through a public offering.

DBRS confirmed FFN.PR.A at Pfd-4(high):

Although downside protection has increased over the past year, the Preferred Share dividend coverage ratio is below 1.0 times and the monthly Class A Share distribution is expected to result in a grind on the portfolio of 4.5% for the remaining six months until maturity. As a result, the rating of the Preferred Shares has been confirmed at Pfd-4 (high).

DBRS is behind the times – the term was extended yesterday.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts up 4bp, FixedResets off 7bp and DeemedRetractibles gaining 3bp. Volatility was minimal. Volume was below average.

PerpetualDiscounts now yield 5.24%, equivalent to 6.81% interest at the standard equivalency factor of 1.3x. Long corporates yield about 4.4%, so the pre-tax interest-equivalent spread is now about 240bp, a significant tightening from the 250bp reported May 7.

Scandal at the Fed!

Some investors may have gotten early word of changes to Federal Reserve policy between 1997 and 2013 and profited by trading before the policy shifts were publicly announced, according to Singapore-based researchers.

Trading records show abnormally large price movements and imbalances in buy and sell orders that are “statistically significant and in the direction of the subsequent policy surprise,” according to a paper by Gennaro Bernile, Jianfeng Hu and Yuehua Tang at Singapore Management University.

The moves occurred before and during the time that reporters were given the Federal Open Market Committee statement in so-called media lockups.

I wonder if this allegation will be investigated with as much hand-wringing and vigour as the LIBOR and FX pseudo-scandals.

Speaking of scandals…:

Ex-U.S. Treasury Secretary Timothy Geithner must comply with Standard & Poor’s demand that he provide documents related to its claim the U.S. sued the company in retaliation for downgrading government debt.

Harold W. McGraw III, chairman of S&P parent McGraw Hill Financial Inc. (MHFI), said in a court statement that Geithner called him days after S&P downgraded the U.S. debt in August 2011 and told him that the company would be held accountable for it. McGraw said Geithner told him there would be a “response” for the downgrade, which the government said was based on an error.

Geithner is the highest former government official S&P has pursued for information to support its allegations. S&P, the only credit rating company sued by the Justice Department for allegedly giving fraudulent ratings to mortgage-backed securities, has said it was singled out because of the downgrade.

The Justice Department and Geithner have denied there is a connection between the downgrade and the lawsuit filed last year. The government has said it may seek as much as $5 billion in civil penalties from S&P for losses to federally insured financial institutions that relied on its ratings for mortgage-backed securities and collateralized-debt obligations, or CDOs, that lost value after the housing market collapsed.

Here’s a step in the right direction!:

Wall Street’s bonus pool may rise as much as 10 percent this year for asset managers while fixed-income traders could see a 15 percent cut, according to compensation consultant Johnson Associates Inc.
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“Many asset-management firms pay the same or better than the big banks, and this year that gap will get even bigger,” [founder of the consultancy Alan] Johnson said in the interview.

It was a day of modest gains for the Canadian preferred share market today, with PerpetualDiscounts winning 9bp, FixedResets gaining 1bp and DeemedRetractibles up 4bp. Volatility was modest. Volume was average.

Boyd Erman of the Globe comments on the HFT study that I reviewed yesterday:

The Bank of Canada has released a research paper on high-frequency trading that, unfortunately for those looking for a silver bullet that finally answers whether HFT is good or bad, provides ammunition for both sides.
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In other words, it gets harder for those who had been in the market to read the new market, and it’s tougher to trade. That’s a tick in the column of the HFT opponents, who say HFT’s constant use of orders and cancellations to try to figure out the market’s direction creates noise that makes it difficult for other investors.

With respect to the “constant use of orders” point … that’s not what the study says. The study says:

Third, following entry by Aggressive HFT firms, those that mainly take liquidity, incumbents experience a loss in their ability to trade in the direction of future price movements.
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In contrast, Aggressive HFT strategies are associated with informed trading, since they trade in the direction of future price movements (Biais, Foucault and Moinas 2013; Foucault, Hombert and Rosu 2012; Martinez and Rosu 2013). With more market participants monitoring for arbitrage opportunities, price predictability should decline. We study whether incumbent HFTs are less able to trade in the direction of future price changes.
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Aggressive HFT entry decreases the price impact of the most informed incumbents’ trades. The average incumbent price impact decreases on average by 0.3 cents for a trade of $10,000. The first Aggressive entries decrease the incumbents’ price impact by a maximum of 1.3 cents.

Successive HFT entrants have a diminishing effect on incumbents’ informedness. In fact, there is no statistically significant impact after the second event. This suggests that HFTs are less able to predict future prices and that HFT trades are more reflective of short-term information.

The study does not address in any way the order fill-to-cancel ratio.

With respect to the claim that the actual point is “a tick in the column of the HFT opponents” … I don’t understand it. To the extent that directionality on a five-second time scale exists, what does it matter who gets the money? Is this some kind of argument that it’s better for ‘real money’ to make the profit, as opposed to HFT money? The paper itself refers only to incumbent HFT, not to who was exploiting the information beforehand.

I will make exactly the opposite point, that eliminating directionality on a five-second time horizon is actually a point in favour of HFT. We want markets to be efficient – HFT exploits, and eventually eliminates, the inefficiency on a five-second time-scale. Isn’t that good?

This also reduces the penalty for being poorly informed, which I understand is also a hobby-horse of the anti-HFT mob. In the extreme case, we have a single stock on the exchange, bid at say, 25.00-10, and a single ETF (which holds only the single stock). Ignoring frictional costs, we can then say that ideally the ETF will also be quoted at 25.00-10. But then somebody lifts the offer on the stock with a great big bid and the quote on the stock changes to 25.10-20. Then Granny Oakum puts in her market order to sell the ETF … she only gets 25.00 for it. Isn’t it an objective of market designers to assist Granny to get 25.10? Wouldn’t it be a good thing if somebody (an HFT, for instance) whipped an order to buy the ETF in between the big stock trade and Granny’s order, so that Granny makes an extra dime? Naturally, there will always be the chance that Granny’s order follows so swiftly behind the big stock trade that she doesn’t make that dime anyway. But reducing the time for which this obvious discrepancy is effective is a Good Thing for Granny.

The real problem that the anti-HFT crowd has is that the free dime used to be picked up by a big bank trader with a good pedigree and an expensive private school education. Now it’s going to some bum who nobody’s ever heard of, one of the geeks who was always screwing around with computers instead of attending the polo matches like a normal person. BooHooHoo.

My other complaint about today’s offerings from the Globe is Rob Carrick’s column GICs beat laddered bond ETFs, hands down:

A ladder of guaranteed investment certificates is better, as long as you don’t foresee the need to sell your holdings before maturity. Laddered bond ETFs can be bought and sold any time during the trading days, so they win decisively over GICs on liquidity.
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If you invest equal amounts in these GICs, thereby creating a five-year ladder, your average yield would be 2.12 per cent.
…
The iShares 1-5 Year Laddered Government Bond Index Fund (CLF) … net yield of 1.22 per cent.
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The iShares 1-5 Year Laddered Corporate Bond Index (CBO) … after-fee-yield of 1.6 per cent
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The laddered bond ETF … also offers the possibility of capital gains if interest rates fall, or capital losses if rates rise. Given the flat to rising outlook for rates, losses seem more likely than gains.

So my first objection to this story is in the phrase “you don’t foresee the need to sell your holdings before maturity”. If you don’t foresee that, then why are you holding short-term instruments in the first place? That’s almost certainly just poor portfolio planning. It is possible that you hold the short-term instruments to counter-balance longer-term fixed income (such as the preferred shares that this blog is ostensibly about) – but then you’re frozen into your long-term position as well.

The other objection is “Given the flat to rising outlook for rates, losses seem more likely than gains”, a very common misconception. As I made clear in my article Bond ETFs demystified, there’s no real difference between the two vehicles; the only apparent difference is that an ETF makes visible the opportunity costs of a rise in interest rates that GIC holders like to ignore. Additionally, the objectionable phrase depends upon market timing for its validity and can be ignored solely on those grounds.

The Bank of Canada has released the Bank of Canada Review Spring 2014, with the following articles:

• The Canadian Dollar as a Reserve Currency
• Understanding Platform-Based Digital Currencies
• The Art and Science of Forecasting the Real Price of Oil
• Measuring Uncertainty in Monetary Policy Using Realized and Implied Volatility
• Beyond the Unemployment Rate: Assessing Canadian and U.S. Labour Markets Since the Great Recession

And at the Fed, they’re doing some work on the term premium.

Kevin Carmichael in the Globe comments on Tim Geithner’s book tour:

The European Union now is doing something similar [to the US public stress tests]. We can only wonder what the global economy would be like today if the Europeans had followed Mr. Geithner’s model sooner.
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The Office of the Superintendent of Financial Institutions does one macro stress test a year and ad hoc tests on specific issues as necessary. But the results remain private, shared only with the Bank of Canada to help it with its twice-a-year assessments of the financial system.

Mr. Geithner would disapprove of the secrecy. I didn’t ask him to comment specifically on Canada, but I did ask how important it was that market participants be allowed to see the stress test results. “It’s central,” he said. “You need to let private investors, shareholders and creditors of banks, have enough information that they can better discriminate across institutions. You need to make the loss estimates transparent, you need to make the impact to individual markets transparent, if you are going to allow the markets to provide that form of triage.”

Well, the Europeans eventually did do stress tests, but they were fake, relaxed stress tests, as discussed on July 23, 2010. You only publicize stress tests if you know that the answer is going to be good.

It was a poor day for the Canadian preferred share market, with PerpetualDiscounts off 4bp, FixedResets down 13bp and DeemedRetractibles losing 27bp. The Performance Highlights table is lengthy by recent standards, but balanced with no clear pattern. Volume was above average, with GWO-group issues notable on the Volume Highlights table, presumably due to the GWO new issue.