PrefBlog

PIMCO’s in some kind of trouble with the SEC:

Pacific Investment Management Co. said it’s cooperating with regulators examining how the firm assigned asset prices at Bill Gross’s Pimco Total Return ETF.

“Pimco has been cooperating with the SEC in this non-public matter, and we take our regulatory obligations and responsibilities to our clients very seriously,” Mark Porterfield, a spokesman for Newport Beach, California-based Pimco, said in an e-mailed statement. “We believe our pricing procedures are entirely appropriate and in keeping with industry best-practices.”
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“What they’re being accused of is in fact the industry standard accounting process,” Dave Nadig, the chief investment officer at ETF.com, a San Francisco-based ETF research and analysis firm, said in a telephone interview.

By law, fund managers have to come up with a price, either by asking dealers for quotes or by extrapolating from data points such as credit rating, size, structure, and comparable securities, Nadig said.

“Because Pimco is an 800-pound gorilla, they negotiate a really good price,” he said. “If the SEC wants to change how bonds are priced, then they can do that, but that’s going to change everybody.”

The ETF attributed some of its outperformance against its benchmark to “an allocation to non-Agency mortgages which benefited from limited supply and a recovery in the housing sector,” according to the latest quarterly report on its website.

Kirsten Grind, Gregory Zuckerman and Jean Eaglesham of the Wall Street Journal explain:

The investments believed to be in question, such as small amounts of mortgage securities—or "odd lots" in the terminology of the financial markets—tend to receive lower prices because of their small sizes or because they are backed by smaller institutions, among other factors.

After the launch of the ETF, Wall Street traders were encouraged by Pimco to offer these small securities to the Pimco ETF, according to some of the people familiar with the matter. Mortgage bonds with a relatively small $500,000 face amount, for example, might have sold for only $480,000, because few investors wanted them, due to the small size.

But when Pimco, shortly after purchasing the bonds, placed a value on them, it typically used outside pricing companies that often assigned higher valuations because they used a similar, but much larger, pool of mortgage bonds to compare them with, according to people close to the firm. Placing a $500,000 valuation on a bond purchased for $480,000, for example, would have allowed Pimco to claim a quick 4% gain on the $500,000 bond, or $20,000.

If that maneuver happened with enough bonds, early results of the ETF could have been aided, these people say.

Traders say buying discounted bonds, then using an outside ratings company to place a higher valuation on those bonds, is akin to buying a used car on the cheap because it is in poor shape but having a lender rely on the list price when making a loan.

Matt Levine of Bloomberg points out:

The point of a bond ETF is, in large part, to make the illiquid liquid: to make it easy for small investors to buy and sell diversified bond portfolios in small sizes. The point of the ETF structure, on the other hand, is to use the market to prevent mispricing: The market in the underlying acts as a check on the valuation of the fund. And the point of the bond market sometimes seems to be to slice credit into tiny weird units that trade in idiosyncratic ways and reward cleverness. Those three things don’t really go together. It sounds like the SEC’s worry is that Pimco’s ETF made the illiquid liquid, but at the cost of losing the check on its valuation. Which then provided idiosyncratic opportunities to reward cleverness.

It’s a complex story, and not completely apparent that anything wrong is happening. It is quite well known that investors (even retail investors!) can make very good returns simply by asking their salesman to alert them to any strange odd-lots the brokerage might have hanging around. Brokerages will often provide liquidity for transferable GICs, for instance, by offering a really, really crumby price – like 150bp over market yield. They’ll then sell it for 100bp over market yield, recouping their costs while giving the ultimate buyer a great deal on his GIC … provided he doesn’t mind buying some weird dollar value of GIC with a basically random maturity date. But when you do that as part of an ETF … complications ensue.

But I will point out that a large fund (such as anything run by PIMCO!) might quite rationally take a long view … buy enough discounted small lots of the same issue and eventually that discount is no longer applicable.

But perhaps a new way of potentially scoring excess returns is coming!

With interest rates barely above zero, the typical U.S. savings account has all the excitement of, well, waiting in line at the bank. But what if instead of marketing yet another CD or credit card, banks held raffles and gave millions away each month to savers? The local bank might feel less like the villain behind those big overdraft fees and more like a casino on the Vegas strip.

A bank in South Africa tried this in 2005. The First National Bank’s Million-a-Month Account promised savers a chance to win 113 prizes a month, including a grand prize of 1 million South African rand (about U.S.$150,000 at the time). Within 18 months, the bank had more prize-eligible accounts than regular ones. These new customers, many of them poor, saved an extra 1 percent of their incomes, a recent study found, and boosted their overall saving 38 percent.

The only thing preventing a big bank from doing this in the U.S.: It’s completely illegal. A bill in Congress — which passed the U.S. House of Representatives on Sept. 16 — would change the law. If it’s passed by the U.S. Senate in the next few months and signed by President Barack Obama, banks of all sizes could start tempting savers with “savings promotion raffles.”
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In the U.S., federal law already lets credit unions offer prizes to savers, as long as states are okay with it. The Save-To-Win game, started in Michigan in 2009, is available at credit unions in four states. In Michigan, every $25 saved increases the chance that a customer could win dozens of monthly prizes worth up to $3,750, or six $10,000 grand prizes each year. So far, more than 50,000 people have saved more than $94 million through the game.

The fun of competing for prizes does get more people saving, the studies of the South African and Save-To-Win experiments suggest. And low-income people especially benefit from this extra cushion of cash. A quarter of Americans tell researcher they’re certain they’d have no way to come up with $2,000 in the next month.

In a paper titled International Transmission Channels of U.S. Quantitative Easing: Evidence from Canada, Tatjana Dahlhaus, Kristina Hess and Abeer Reza claim:

The U.S. Federal Reserve responded to the great recession by reducing policy rates to the effective lower bound. In order to provide further monetary stimulus, they subsequently conducted large-scale asset purchases, quadrupling their balance sheet in the process. We assess the international spillover effects of this quantitative easing program on the Canadian economy in a factor-augmented vector autoregression (FAVAR) framework, by considering a counterfactual scenario in which the Federal Reserve’s long-term asset holdings do not rise in response to the recession. We find that U.S. quantitative easing boosted Canadian output, mainly through the financial channel.
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Standard economic theory, however, provides ambiguous implications for the international spillover of monetary easing (Rogoff [2002]). Through the expenditure-switchingeffect, a monetary expansion in the United States would depreciate the home currency and deteriorate its terms of trade, making home goods cheaper for foreigners. The resulting increase in home country net exports would then detract from the real output of the foreign economy. The income-absorption effect, on the other hand, implies that as long as expansionary monetary policy in the home country drives up domestic income, home demand for imports would rise, boosting the economy of foreign exporters. Finally, in the presence of globalfinancial market integration, any increase in asset prices and reductions in yields in the domestic financial market resulting from QE may be reflected by similar movements in corresponding foreign financial market variables,2 which in turn would boost foreign consumption and investment through the same mechanism as it does in the domestic case. Therefore, whether Canada benefits from the U.S. expansion through QE depends on which of these effects dominate, and is an empirical question that we attempt to answer here.

R Split III Corp., proud issuer of RBS.PR.B was confirmed by DBRS at Pfd-2:

On September 24, 2013, DBRS upgraded the ratings on the Preferred Shares to Pfd-2 from Pfd-2 (low) based on the increased downside protection levels available to holders of the Preferred Shares over the prior year, as well as the increase in distribution coverage ratio. Since the rating was upgraded, the net asset value of the Company has generally been increasing steadily, rising from $43.55 on September 12, 2013, to $54.22 on September 11, 2014. Downside protection available to holders of the Preferred Shares increased to 74.9% as of September 11, 2014, compared to 68.8% on September 12, 2013. In addition, RBC raised its dividends twice this year, on February 26, 2014, and most recently on August 22, 2014, increasing quarterly distributions to 75 cents per share from 67 cents per share. This dividend boost increases the Preferred Share distribution coverage ratio to 2.9 times (up from 2.6 times in September 2013). The confirmation of the rating of the Preferred Shares is based primarily on the current level of downside protection available and the current distribution coverage ratio.

With a market capitalization of less than $10MM, RBS.PR.B is not tracked by HIMIPref™.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts rocketing up 34bp (more than half of this was due to strength in three BAM issues), FixedResets off 1bp and DeemedRetractibles down 4bp. Volatility was good, highlighted by winning BAM PerpetualDiscounts. Volume was below average.

RBC issued sub-debt at 3.45%+112:

Royal Bank of Canada (RY on TSX and NYSE) today announced an offering of $1 billion of subordinated debentures (“the Notes”) through its Canadian Medium Term Note Program.

The Notes bear interest at a fixed rate of 3.45 per cent per annum (paid semi-annually) until September 29, 2021, and at the three-month Banker’s Acceptance Rate plus 1.12 per cent thereafter until their maturity on September 29, 2026 (paid quarterly). The expected closing date is September 29, 2014. RBC Capital Markets is acting as lead agent on the issue.

The bank may, at its option, with the prior approval of the Office of the Superintendent of Financial Institutions Canada, redeem the Notes on or after September 29, 2021 at par, in whole at any time or in part from time to time, on not less than 30 days and not more than 60 days notice to registered holders.

Net proceeds from this transaction will be used for general business purposes.

Rumblings about corporate bond liquidity are getting more frequent:

Index fund managers are finding it hard to secure the bonds they need at the prices they want, forcing them to make trade-offs that can hurt investors and leave managers vulnerable in a market downturn.

Bond liquidity has all but dried up for corporate issues after new regulations and capital requirements forced Wall Street banks to slash their inventories of fixed-income products following the financial crisis. That’s especially challenging for index fund managers who must acquire certain bonds to be able to track specific benchmarks.

The lack of liquidity also means funds may have trouble selling bonds in the event interest rates rise and the investors who have sunk about $1.2-trillion (U.S.) in net deposits into long-term bond funds since the end of 2004 head for the exits.

The Financial Stability Board (FSB) is examining whether exchange-traded funds pose a risk to the global financial system for precisely that reason, according to the Bank of Canada’s representative to the committee at the Bank for International Settlements.

“There’s been investments and positions taken that may not have the liquidity there that people expect, especially as interest rates start to normalize,” Carolyn Wilkins, senior deputy governor at Canada’s central bank, told Bloomberg News in an interview. “So the liquidity illusion, if you want to put it that way, is something that we’re worried about.”

I certainly hope she was misquoted in the Bloomberg story regarding that interview:

The efforts of the Basel Committee are helping to restore faith in the financial system, Wilkins said.

“People are going to have the knowledge that the banks not only in Canada, but globally are safer,” she said. “That means that the probability of something going wrong that they’ll be on the hook for later as taxpayers will be lower.”

While additional regulatory requirements may translate into extra transaction costs for the banks and businesses and customers they deal with, “those costs should be worth it because they’re reducing the chances that something goes pear shaped,” she said.

Well, of course there are benefits to increased capital levels, although I don’t have quite the same certainty with respect to some regulatory requirements. And anybody will agree there are costs. The hard part is – and what has been consistently ignored by OSFI, the Bank of Canada, and every apparatchik in the apparatus – is balancing the two. We have a very safe banking system in Canada – and it has come at the expense of innovation and economic growth.

What job do you look for when you’re an unemployed Master of the Universe?

As trading in dollar-denominated bonds declined 22 percent in the past five years to an average daily $809 billion, so have the jobs, leaving even some of the most senior traders and salesmen moving from firm to firm. Dozens of journeymen are populating an industry that used to attract the young in throngs, lured by money and prestige, according to Michael Maloney, president of fixed-income recruiting firm Michael P. Maloney Inc.

“The business model is broken and 50 percent of the people in our world who are in trading are stuck right now,” Maloney said in an interview in his New York office.
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While the size of the U.S. bond market ballooned by more than $5 trillion since 2008 to $37.8 trillion at year-end, trading in the debt has slumped, according to data from the Securities Industry & Financial Markets Association. Average daily turnover fell to $809 billion last year from $1.04 trillion in 2008.

That’s partly because banks have pulled back from making markets in bonds as higher capital requirements make it less profitable. The business — where buyers and sellers are primarily matched over the telephone or through e-mails — has also suffered shrinking margins because of regulator-mandated price transparency and the rise of electronic trading.
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Transaction costs declined after the Financial Industry Regulatory Authority introduced its bond-price reporting system, called Trace, in 2002. Wall Street bond traders lost about $1 billion in fees in the next year, or about $2,000 a trade, according to a study in the Journal of Financial Economics. The system is intended to provide transparency in an opaque market, and help prevent investors from being fleeced.
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The number of credit traders working for the firms plunged 30 percent to about 300 over the same period, even as companies issued record amounts of bonds in the U.S. to take advantage of historically low interest rates, according to Options Group and data compiled by Bloomberg.

The ‘broken’ corporate bond market was also discussed yesterday.

Now, never let it be thought that I consider secondary market trading to be an important thing in and of itself. Secondary market trading is important only insofar as it affects the issuance market, because the purpose of the corporate bond market is exactly the same as that of the equities market: to transfer money from sources of capital to sinks, to be returned (with luck!) as an income stream from the real-world investment that’s done with the money. And issuance in recent years has been monstrous in the past few years so, we might rashly conclude – no problem!

However, as has been pointed out by Ron Mendel of Hartford Investment Management in his admirable essay Private Placement Debt: Diversification, yield potential in a complementary IG asset:

Private placement investors require additional yield relative to comparable public bond issues, as lenders demand greater yield to compensate for increased liquidity risk as well as the underwriting and monitoring costs. This premium is variable over time and is a function of technical, supply and demand characteristics, credit fundamentals and insurance liability requirements. The typical liquidity premium historically ranges between 25 – 45 basis points.

That’s a hell of a spread, although not as much as we get in the Canadian preferred share market! It will also be noted that this is the rate in an environment comprised largely of insurance companies; other investment entities, including individuals, are probably going to want a bigger premium for giving up liquidity. Additionally, the ability to issue corporate debt has not yet been tested in an environment of increasing policy rates or general doom and gloom (after the extraordinary gloom and doom of the credit crunch, anyway).

A lack of secondary market liquidity will ultimately increase spreads at issuance and will therefore harm the economy, hurting workers; in addition, the economic harm will be mitigated to some extent by lower policy rates, hurting savers. This is just a mess all ’round.

On a brighter note, King Timmy is unconcerned about the inversion clampdown:

Scott Bonikowsky, a Tim Hortons spokesman, said the deal is “moving forward as planned” and is driven by long-term growth and not tax benefits. The actions to curb inversions announced yesterday by Treasury Secretary Jacob J. Lew are getting an immediate test as eight U.S. companies with pending deals decide whether to move forward.

It was a modestly negative day for the Canadian preferred share market, with PerpetualDiscounts down 13bp, FixedResets off 10bp and DeemedRetractibles flat. Volatility was low. Volume was slightly below average.

I have often railed against the high cost of university education nowadays, blaming it largely on the huge increase in the number of university administrators, which results in mission creep (see March 6, 2014). I can’t find my post where I talked about the increase in administrative costs, but just so you know I’m not blowing smoke … Where all that money is going:

Shockingly, 20 cents is now spent on central administration for every dollar spent on instruction and non-sponsored research; back in 1987-88, 12 cents went to administration. At the average top 25 university, central administration (including external relations) now consumes $18 million that previously would have flowed to instruction. (For a G13 school, it’s $20 million; for the top 5, $39 million.)

… and Administrator Hiring Drove 28% Boom in Higher-Ed Work Force, Report Says:

The report, “Labor Intensive or Labor Expensive: Changing Staffing and Compensation Patterns in Higher Education,” says that new administrative positions—particularly in student services—drove a 28-percent expansion of the higher-ed work force from 2000 to 2012. The report was released by the Delta Cost Project, a nonprofit, nonpartisan social-science organization whose researchers analyze college finances.

What’s more, the report says, the number of full-time faculty and staff members per professional or managerial administrator has declined 40 percent, to around 2.5 to 1.

… and Administrators Ate My Tuition:

Between 1975 and 2005, total spending by American higher educational institutions, stated in constant dollars, tripled, to more than $325 billion per year. Over the same period, the faculty-to-student ratio has remained fairly constant, at approximately fifteen or sixteen students per instructor. One thing that has changed, dramatically, is the administrator-per-student ratio. In 1975, colleges employed one administrator for every eighty-four students and one professional staffer—admissions officers, information technology specialists, and the like—for every fifty students. By 2005, the administrator-to-student ratio had dropped to one administrator for every sixty-eight students while the ratio of professional staffers had dropped to one for every twenty-one students.

To be fair to the universities, mission creep isn’t entirely their own idea – it’s pushed by politicians:

A group of lawmakers is pressuring U.S. News & World Report to update its influential college ranking system to indicate which universities have come under fire for failing to adequately handle sexual assault cases on campus. The rankings are currently based on a range of academic indicators, like SAT scores and graduation rates.

I also understand – although I confess I can’t find the reference – that some of these policy changes come from a desire to appeal to parents of prospective students, who for some reason think they should have a say in the choice of school.

Anyway, the story that caught my attention was on Bloomberg, College Debt Leaves Generation X Grads Less Wealthy Than Parents:

While 82 percent of Generation X Americans with at least a bachelor’s degree earn more than their parents did, just 30 percent have greater wealth. A smaller share of workers without college education — 70 percent — have surpassed their parents’ incomes yet almost half had higher wealth, according to a Pew Charitable Trusts report released today.

Lackluster saving among the cohort, those born between 1965 and 1980, has come as student-loan balances persist into middle age. Generation X’s financial straits could come with economic aftershocks, making it difficult for parents to afford college for the next generation and forcing workers to hold onto jobs longer or lower their living standards as they age.
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People between the ages of 30 and 39 held about $321 billion in total student debt at the end of 2012, up from about $124 billion at the start of 2005, according to data from the Federal Reserve Bank of New York. Those between 40 and 49 owed $168 billion, up from $53 billion.

This is all based on a study from the PEW Charitable Trusts titled A New Financial Reality:

•• Most Gen Xers have higher family incomes than their parents did at the same age, but only one-third have greater family wealth. Three-quarters of Gen Xers have higher family incomes than their parents did, earning a median of $43,000 annually, after adjusting for family size. However, just 36 percent of Gen Xers have exceeded their parents’ family wealth, and the typical Gen Xer has $5,000 less wealth than their parents did at the same age.

•• Gen Xers’ lower wealth is due in part to their debt totals, which are nearly six times higher than their
parents’ were at the same age. Nearly all Gen Xers report holding student loan, medical, credit card, or other debt, with a median of more than $7,000. In contrast, their parents held just over $1,000 in debt at the same point in their lives.

•• Generation X has experienced exceptional stickiness at the top and bottom of the income ladder. Among Gen Xers raised at the bottom of the income ladder, half remain stuck there and nearly three-quarters never reach the middle. There is similar stickiness at the top: Nearly 7 in 10 Gen Xers who are on the top income rung in their 30s were raised by parents who were also above the middle in their 30s.

•• The persistent stickiness at both ends of the income ladder for Gen Xers is linked to sharp demographic differences. Among Gen Xers stuck at the bottom of the income ladder, median wealth, excluding home equity, is less than $800, more than half are single, and only 2 percent have a college education. In contrast, of Gen Xers who were born in and remain at the top, 83 percent are part of a couple, 71 percent have a college education, and all have more than $69,000 in non-home-equity wealth.

•• Gen Xers whose family wealth exceeds that of their parents also far surpass their peers in wealth holdings. Gen Xers who are upwardly wealth-mobile—that is, they have more wealth than their parents did at the same age—have nearly nine times the non-home-equity wealth of their peers who have less wealth than their parents and more than three times that of the typical Gen Xer.

•• Among Gen Xers who have exceeded their parents’ income, those with college degrees are less likely to surpass their parents’ wealth, mostly due to student loan debt. Nearly 4 in 10 Gen Xers who have college degrees and have more income than their parents did hold student loan debt, with a median amount owed of $25,000.

OSFI has released its Public Disclosure Requirements related to Basel III Leverage Ratio:

4. Disclosure requirements for D-SIBs

The disclosure requirements set out in the BCBS LR Framework, require D-SIBs to publicly disclose:

• I. Summary comparison table – D-SIBs are required to report the reconciliation of their balance sheet assets from their financial statements with the leverage ratio exposure measure, using the attached Reporting Table 1 in the Annex I.
• ii. Common disclosure template – D-SIBs are required to provide a breakdown of the main leverage ratio regulatory elements, using the attached Reporting Table 2 in the Annex I.

  OSFI requires D-SIBs to report the LR using both the transitional measure of Tier 1 capital and the all-in measure of Tier 1 capital. Lines 1 to 22 of this template are based on the Basel transitional LR. Lines 23 to 26 should be used to report the all-in LR.

• iii. Reconciliation with public financial statements – D-SIBs are required to disclose the source of material differences between their total balance sheet assets (net of on-balance sheet derivative and securities financing transaction (SFT) assets) as reported in their financial statements and their on-balance sheet exposures in line 1 of the common disclosure template.
• iv. Other – D-SIBs are required to explain the key drivers of material changes in their Basel III leverage ratio observed from the end of the previous reporting period to the end of the current reporting period (whether the changes stem from changes in the numerator and/or from changes in the denominator).

The SEC has triumphantly declared a milestone in its assault on ethics:

The Securities and Exchange Commission today announced an expected award of more than $30 million to a whistleblower who provided key original information that led to a successful SEC enforcement action.

The award will be the largest made by the SEC’s whistleblower program to date and the fourth award to a whistleblower living in a foreign country, demonstrating the program’s international reach.

“This whistleblower came to us with information about an ongoing fraud that would have been very difficult to detect,” said Andrew Ceresney, Director of the SEC’s Division of Enforcement. “This record-breaking award sends a strong message about our commitment to whistleblowers and the value they bring to law enforcement.”

That’s right, folks! You, too, can obtain multi-generational wealth by sneaking up to your bedroom at midnight, drawing the blinds, taking your ‘phone under the bed and denouncing your colleagues to the authorities! Sadly, the SEC did not state whether or not each whistleblower receives a shiny new “Junior Secret Policeman” badge.

Many investors long for a return to the days when they could get a two or three percent real return from T-Bills. ‘Don’t hold your breath’, says Rhys R. Mendes in a Bank of Canada discussion paper titled The Neutral Rate of Interest in Canada:

A measure of the neutral policy interest rate can be used to gauge the stance of monetary policy. We define the neutral rate as the real policy rate consistent with output at its potential level and inflation equal to target after the effects of all cyclical shocks have dissipated. This is a medium- to longer-run concept of the neutral rate. Under this definition, the neutral rate in Canada is determined by the longer-run forces that influence savings and investment in both the Canadian and global economies. Structural forces have likely reduced the neutral rate by more than a percentage point since the mid-2000s. The Bank’s estimates of the real neutral policy rate currently stand in the 1 to 2 per cent range, or 3 to 4 per cent in nominal terms. The current gap between the policy rate and the neutral rate reflects policy stimulus in response to significant excess supply and in the face of continuing headwinds. As long as these headwinds persist, a policy rate below neutral will be required to maintain inflation sustainably at target.
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We define the neutral rate as the real policy rate consistent with output at its potential level and inflation equal to the 2 per cent target after the effects of all cyclical shocks have dissipated. This is a medium- to long-run concept which varies over time with lower-frequency factors such as demographic change and shifts in trend productivity growth. The deviation of the actual policy rate from neutral – the interest rate gap – is a measure of the stance of monetary policy.

The Bank’s estimates of this concept of the neutral policy rate currently stand in the range of 1 to 2 per cent in real terms, or 3 to 4 per cent in nominal terms. This range reflects the range of estimates from the various approaches discussed in this paper. Thus, with the nominal policy rate currently at 1 per cent, monetary policy is stimulative in Canada.
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The Bank’s estimates of the neutral rate have declined by more than 1 percentage point since the mid-2000s as a result of structural changes in the Canadian and global economies. This decline largely reflects a lower global neutral rate and reduced potential output growth in Canada.
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The global savings rate began to increase in the early 2000s. This rise was interrupted by the crisis, but the International Monetary Fund (IMF) expects it to continue in the future (Figure 6). The IMF projects the global savings rate to average 26 per cent over the 2014–19 period, more than 3 percentage points above its 1999–2006 average.
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The preceding analysis of savings and investment assumed that there is a single risk-free interest rate in the economy. In reality, households and firms do not generally have access to credit at the risk-free rate. When borrowing to finance investment or consumption, private economic agents pay a rate of interest equal to the risk-free rate plus a risk premium or credit spread. Since credit spreads influence private sector behaviour, they affect the level of the neutral rate….Figure 8 shows effective spreads for households and firms in Canada. The 2013 average level of effective spreads was about 20 bps higher for households and 45 bps higher for firms, relative to the 1999–2006 average. Were this increase in spreads to persist, it would imply a lower neutral rate.

Did everybody get that last bit? Since credit spreads have increased, households and firms will have to pay more to borrow, which means they will borrow less, which reduces growth, which means the policy rate will have to decrease in order to maintain the growth rate, which means households and firms will get paid less for their savings. Hurray for financial repression! Mr. Mendes says we can give thanks to our glorious leaders for keeping us safe!

Relative to the pre-crisis benchmark, changes in spreads are not uniform across economies. In particular, spreads have not increased universally. However, increased costs of financial intermediation, partly as a result of needed financial regulatory reform, may cause spreads to settle at higher levels than in the pre-crisis period. A joint analysis by the Financial Stability Board and the Basel Committee on Banking Supervision attempted to quantify this effect. It found that a 3-percentage-point increase in banks’ common equity Tier 1 capital ratio would raise lending spreads by around 45 to 50 basis points (BCBS and FSB 2010). The Bank’s estimates for Canada are of a similar magnitude (Bank of Canada 2010). This could be reinforced by changes in investors’ perceptions and pricing of risk in light of the experience of the crisis. As Caballero and Farhi (2014) show, an increase in the relative demand for safe assets can increase the spread between risky and risk-free assets and lead to a lower neutral rate.

Blackrock, the people who bring to you more ETFs than you can shake a stick at, has released a “Viewpoint” with the thesis Corporate Bond Market Structure: The Time For Reform Is Now:

We believe the secondary trading environment for corporate bonds today is broken, and the extent of the breakage is masked by the current environment of low interest rates and low volatility, coupled with the positive impact of QE on credit markets. The current environment also breeds complacency—for issuers and investors alike. When any of these factors change, the extent to which today’s fixed income markets are not “fit for purpose” will be exposed. Market regulators are right to call for change now, while the benign state still exists. In this paper we make four recommendations for reform. As we explain, these are not just regulatory changes, but much broader reforms—to fix corporate fixed income markets will require changes in behavior by all market participants—issuers, intermediaries and investors. And yes, by regulators, too.

Their problem is one I have harped on until you guys are all bored to death of the topic:

For the last several years, both retail and institutional investors have been concerned about deteriorating liquidity in the corporate bond market.

… and they propose four steps:

Market Changes to Improve Liquidity

There is no “silver bullet” that will cure the corporate bond liquidity challenge. However, there are four drivers which, together, have the potential to substantially improve liquidity in the corporate bond market.

• More “all to all” trading venues – not just “dealer-to-customer” or “dealer-to-dealer”;
• Adoption of multiple electronic trading (e-trading) protocols – not just request for quote (RFQ) or central limit order book (CLOB);
• Standardization of selected features of newly-issued corporate bonds; and
• Behavioral changes by market participants recognizing the fundamentally changed landscape.

The first idea is, essentially, exchange trading for bonds:

Increased development and acceptance of “all-to-all” trading venues, where multiple parties, from both the buy-side and the sell-side, could come together and communicate would provide opportunities to uncover latent liquidity. Greater use of “all-to-all” venues, including exchanges, clearinghouses, electronic communication networks (ECNs), and similar platforms would enhance liquidity by enabling greater market connectivity and centralization of liquidity than the current bi-lateral framework. Such venues already exist, but see limited trading activity. For example, the New York Stock Exchange (NYSE) operates NYSE Bonds which trades in a similar manner to the NYSE stock exchange; however, NYSE Bonds has limited volume of largely small-sized trades.

I can’t agree with this one. As I often bore you by reiterating (most recently on June 23, 2014) public exchanges lead to thin, brittle markets. Exchanges are OK for tiny little markets like equities, but the bond market deals with real money.

Their introduction to the explanation of their ‘multiple protocol’ idea amused me:

Currently, trading in the corporate bond market is primarily conducted via the request for quote (RFQ) method, where a trader from the buy-side will communicate an interest in buying or selling a particular bond to a dealer and ask the dealer for a price. The buy-side trader may ask several dealers for a price quote and will then select a dealer with whom to conduct the transaction.

Ha-ha! As I most recently noted on September 16, 2014, your average portfolio manager is far too lazy to get multiple quotes. The general rule, enthusiastically endorsed by our wise regulators, is for bozo-boy to call ‘his’ salesman at ‘his’ firm, exchange wise remarks about whatever was in the headlines of the Wall Street Journal that morning, and then take whatever price he’s given for whatever the salesman is selling. Then he calls his mummy and tells her what a big shot he is; having received a confidence-raising pat on the head, he then calls his clients and tells them what a hard-nosed skin-flint he is. That’s reality.

Anyway, they contrast the RFQ system, above, with the CLOB system:

In comparison, a central limit order book (CLOB), one of the primary protocols used in the equity markets, allows buy and sell orders for a particular stock that is listed on an exchange to be matched up, and facilitates efficient execution for these securities. Central limit order book protocols work best when the instruments being traded are highly liquid and standardized.

They want to form other protocols:

RFQ systems	All-to-all RFQ systems are all-to-all trading venues, where multiple parties from both the buy-side and the sell-side are connected and quotes can be requested from several different parties electronically. RFQ can be made anonymously or disclosed. Multiple requests could be made simultaneously via lists to multiple participants on the venue. This enables aggregating some of the fragmented liquidity and supports broader market participation.
Open trading protocols	Open trading systems that pool together sell-side inventory and orders with buy-side orders enhance liquidity by broadening the universe of potential matches. MarketAxess is an ECN that has been a thought leader in defining new protocols, and offers both open trading and list-based all-to-all RFQ protocols.
Session-based protocols	Session-based protocols aggregate liquidity in a given security at defined times of day by announcing a time when certain securities will be traded. Parties interested in buying and selling that particular security will do so at that time, which in turn addresses timing mismatches, where there is no buyer when a market participant wants to sell a security or vice versa.
Crossing systems	Enables anonymous matching of desired buy and sell orders using electronic systems, usually executed at a mid-market price.

Well, these things might be OK, or at least interesting, when raising or spending cash. But I can’t see any applicability for spread trading, which makes all this useless. Session-based protocols aren’t much good – corporate bonds trade by appointment, and a rational trader won’t even know he wants to trade something until after he’s shown a good price. So let’s just say on this that I retain an open mind, but I’m going to need a lot more explanation and justification!

My first thought when reading their recommendation for ‘standardization’ was that it was going to be a reprise on the idiotic covenant standardization idea mocked on March 10, 2014; fortunately, Blackrock isn’t that dumb. What they want is:

Standardization would reduce the number of individual bonds, via steps such as issuing similar amounts and maturities at regular intervals and re-opening benchmark issues to meet on-going financing needs. Standardized terms would improve the ability to quote and trade bonds, and would create a liquid curve for individual issuers.

They offer up a number of purported advantages of such a change, but don’t really address the question of how the poor old issuer is supposed to refund the monster issues when they come due. Governments can have a set schedule of issuance, there is always a good deep bid for governments … but for credit? I’m not so sure.

Their desired behavioral changes are a real grab-bag:

For investors, this behavioral change means a willingness to give up new issue gains and liquidity arbitrage strategies for lower transaction costs, access to deeper markets, and for institutional investors in particular, the ability to buy and sell in greater size. Investors must become price makers as well as price takers. Issuers must begin to assess the benefits of standardization (potentially lower issuance costs) against the cost (some compromises in flexibility) not only in today’s benign environment but also when interest rates rise and volatility increases. Bankers should provide leadership in product innovation and structure debt offerings to improve liquidity, as the status quo is not sustainable. Larger, more frequent issuers, particularly wholesale-funded banks that are also the leading debt underwriters, are natural parties to lead the market evolution. Trading venues need to develop new ways to trade beyond the standard protocols. And regulators, given concerns about transparency and market liquidity need to consider the benefits of standardization and how best, within their mandate, to promote it.

I continue to feel that the best path – and the one that makes most sense in terms of markets – is for large bond-holders to start making markets. Blackrock could take the lead here. How about a corporate bond fund that covenants not to approximate the index as closely as possible, but one that will invest in a universe defined by such-and-such an index, maintaining metrics such as duration, convexity, average coupon, issuer exposure, etc., to within a certain tolerance of the index (a multiple-dimension cell system would be ideal)? As I understand it, that is the objective, more or less, of the HPR: Horizons AlphaPro Preferred Share ETF:

“We’re very happy to be working with Natcan once again. Their fixed income team has done a great job in managing the recently launched Horizons AlphaPro Corporate Bond ETF, Canada’s largest actively managed ETF. We expect more of the same with the Preferred Share ETF based on our belief that an active strategy can overcome many of the limitations found in trying to replicate a preferred share index,” said Ken McCord, President of AlphaPro.

… but of course, that would involve Blackrock hiring actual traders and actual salesmen to run their fund … and those guys make a little bit more than the spreadsheet wretches they have on staff now … ‘You first!’ exhort the bold visionaries at Blackrock! Maybe Guggenheim, or one of the other players who have been buying US annuity books will step up. It would be a natural fit.

And … almost finally … there are questions swirling about the King Timmy merger:

The Treasury Department announced steps that will make it harder for U.S. companies to move their addresses outside the country to reduce taxes, clamping down on the practice known as inversions.
…
Among the eight pending inversions is Burger King Worldwide Inc. (BKW)’s planned merger with Tim Hortons Inc. (THI), which would put the combined company’s headquarters in Canada.
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Under current law, U.S. companies that invert through a merger are still treated as domestic for tax purposes if the former U.S. company’s shareholders own more than 80 percent of the combined company. The administration wants to reduce that 80 percent to 50 percent; that requires legislation.

In the absence of legislation, the Treasury Department looked for ways to make it harder for companies to get around the 80 percent limit.

The rules announced today seek to limit so-called spin-versions, in which U.S. companies spin off units into a foreign company.

It also would restrict the use of a technique known as skinnying down, in which companies make special dividends to reduce their size before a merger to meet the current law’s requirements. U.S. companies would be less able to seek out so-called old and cold foreign companies with cash and other passive assets as merger partners to meet the rules.
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Scott Bonikowsky, a spokesman for Tim Hortons, didn’t immediately respond to messages seeking comment. Burger King, based in Miami, declined to comment.

Power Corporation, proud issuer of POW.PR.A, POW.PR.B, POW.PR.C, POW.PR.D, POW.PR.F and POW.PR.G, has confirmed at Pfd-2(high) by DBRS:

DBRS has today confirmed the Senior Debt and preferred shares ratings of Power Corporation of Canada (POW or the Company) at A (high) and Pfd-2 (high), respectively. The trends on the ratings remain Stable. The credit strength of POW is directly tied to its roughly two-thirds equity interest in Power Financial Corporation (PWF), which represents a substantial majority of the Company’s earnings and cash flow, as well as the Company’s estimated net asset value. The Senior Debt rating of the Company is A (high), or one notch below the AA (low) rating on the Senior Debentures of PWF, reflecting the structural subordination of the holding company’s obligations.

Power Financial Corporation, proud issuer of PWF.PR.A, PWF.PR.E, PWF.PR.F, PWF.PR.G, PWF.PR.H, PWF.PR.I, PWF.PR.K, PWF.PR.L, PWF.PR.O, PWF.PR.P, PWF.PR.R, PWF.PR.S and PWF.PR.T, has been confirmed at Pfd-1(low) by DBRS:

DBRS has today confirmed both the Issuer Rating and Senior Debentures rating of Power Financial Corporation (PWF or the Company) at AA (low) and the Cumulative and Non-Cumulative First Preferred Shares at Pfd-1 (low). All trends remain Stable. The financial strength of PWF, and DBRS’s rating assessment, is largely derived from its controlling interests in two of Canada’s leading financial service providers: Great-West Lifeco Inc. (GWO; senior debt rated AA (low)), one of the three largest life insurance concerns in Canada, and IGM Financial Inc. (IGM; senior debt rated A (high)), one of the largest mutual fund complexes in Canada.
…
The Company’s financial leverage has been maintained at a reasonable level for the past ten years. The Company’s capitalization remains conservative and the fixed charge coverage ratios are similarly strong relative to both earnings and cash flow. Liquidity is not a source of concern, with about $800 million in cash and short-term securities at the holding company at June 30, 2014, in addition to stores of liquidity at both GWO and IGM.

It was a modestly positive day for the Canadian preferred share market, with PerpetualDiscounts up 4bp, FixedResets winning 8bp and DeemedRetractibles gaining 3bp. Volatility was average. Volume was below average.

Interesting to see that having a down-payment for a house isn’t good enough any more:

The Bank of Mom and Dad is playing a growing role as lender of last resort for a housing recovery struggling to provide more traction for the U.S. economy.

Last year, 27 percent of those purchasing a home for the first time received a cash gift from relatives or friends to come up with a down payment, according to data from the National Association of Realtors. That’s up from 24 percent in 2012 and matches the highest share since the group began keeping records in 2009.

Those numbers will probably keep growing this year as younger Americans remain constrained by student debt, tough entry into the job market and stricter mortgage-lending rules that require more cash up front. At the same time, rising stock and property values give their baby boomer parents the ability to assist those wanting to lock in near record-low borrowing costs.
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The increase in such cash gifts also has lenders on guard against unstable sources of down payment funds.

“The regulatory agencies are very, very specific about the paper trail requirements,” said Staci Titsworth, a regional loan officer in Pittsburgh who works in the mortgage division of PNC Financial Services Group Inc. “It truly needs to be a gift with no expectation to repay, because once expectation to repay comes into the equation, now you’ve got borrowed funds for down payment, which is unacceptable.”

PNC, as with other lenders such as Regions Financial Corp. and BB&T Corp., requires that the gift be from a relative by blood or marriage, with few exceptions. A “gift letter” with the mortgage application typically must include the amount of the gift, date the funds were transferred, donor’s basic identification and relationship to the buyer, and a statement that no repayment is expected, according to representatives of the three banks.

Financial institutions are careful about determining the source of funds because, while mortgages secured with the help of gifts from family are about as sound as those without any help, gifts linked to the seller were found to have increased default rates during the housing crisis, according to data from the Federal Housing Administration. Gifts from the seller are now banned by the agency.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts down 11bp, FixedResets off 2bp and DeemedRetractibles gaining 4bp. Volatility was muted. Volume was a little below average.