PrefBlog

There were no real surprises in the FOMC statement:

The Federal Reserve is committed to using its full range of tools to support the U.S. economy in this challenging time, thereby promoting its maximum employment and price stability goals.

The coronavirus outbreak is causing tremendous human and economic hardship across the United States and around the world. Following sharp declines, economic activity and employment have picked up somewhat in recent months but remain well below their levels at the beginning of the year. Weaker demand and significantly lower oil prices are holding down consumer price inflation. Overall financial conditions have improved in recent months, in part reflecting policy measures to support the economy and the flow of credit to U.S. households and businesses.

The path of the economy will depend significantly on the course of the virus. The ongoing public health crisis will weigh heavily on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term. In light of these developments, the Committee decided to maintain the target range for the federal funds rate at 0 to 1/4 percent. The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.

The Committee will continue to monitor the implications of incoming information for the economic outlook, including information related to public health, as well as global developments and muted inflation pressures, and will use its tools and act as appropriate to support the economy. In determining the timing and size of future adjustments to the stance of monetary policy, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

To support the flow of credit to households and businesses, over coming months the Federal Reserve will increase its holdings of Treasury securities and agency residential and commercial mortgage-backed securities at least at the current pace to sustain smooth market functioning, thereby fostering effective transmission of monetary policy to broader financial conditions. In addition, the Open Market Desk will continue to offer large-scale overnight and term repurchase agreement operations. The Committee will closely monitor developments and is prepared to adjust its plans as appropriate.

Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Michelle W. Bowman; Lael Brainard; Richard H. Clarida; Patrick Harker; Robert S. Kaplan; Neel Kashkari; Loretta J. Mester; and Randal K. Quarles.

Powell’s a bit nervous:

“The path forward for the economy is extraordinarily uncertain and will depend in large part on our success in keeping the virus in check,” Mr. Powell said at a news conference following the Fed’s two-day meeting, noting that infections have surged since late June and the “pace of recovery looks like it has slowed.”

Mr. Powell said policymakers needed more data before drawing firm conclusions about the scope of the pullback, but he noted that debit and credit card spending were slowing and labor market indicators suggested that recent job gains might be weakening. More than 14 million people who held jobs in February are no longer employed, Mr. Powell said, warning that it will take a while for workers in certain industries, like restaurants, hotels and travel, to find new jobs.

“There’s probably going to be a long tail where a large number of people are struggling to get back to work,” he said, adding that the Fed was “not even thinking about thinking about thinking about” raising rates.
…
While the Fed took no major actions on Wednesday, Mr. Powell’s comments underlined both the peril ahead for American workers and the reality that interest rates are likely to be very low — making money cheap to borrow — for an extended period of time. Stock prices climbed following his remarks as investors took heart in the Fed’s patient stance.

Meanwhile US stimulus talks are going nowhere:

The prospects for a quick agreement between the Trump administration and congressional Democrats on a new round of aid for the ailing economy faded on Wednesday, as President Trump undercut his own party’s efforts to negotiate a deal and a top White House official declared that a lifeline to unemployed workers would run out as scheduled at week’s end.

With negotiations barely started to find a middle ground between Republicans’ $1 trillion plan and Democrats’ $3 trillion package, Mr. Trump poured cold water on the entire enterprise, saying that he would prefer a bare-bones package that would send “payments to the people” and protect them from being evicted.

“The rest of it, we’re so far apart, we don’t care,” Mr. Trump said before leaving the White House for an event in Texas. “We really don’t care.”
…
The breakdown reflects a predicament for Republicans that has placed Mr. Trump in a difficult negotiating position. After the enactment of nearly $3 trillion in pandemic-related stimulus in the spring, many Senate Republicans are opposed to additional deficit spending to fuel the economy, meaning that any agreement would need to attract significant support from Democrats to clear Congress.

As previously noted, monetary and fiscal policy should work in tandem, but loose monetary policy helps the rich get richer, while loose fiscal policy makes them poorer. So guess what policy mix is favoured by those who run the country!

PerpetualDiscounts now yield 5.65%, equivalent to 7.34% interest at the standard equivalency factor of 1.3x. Long corporates now yield 2.85%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has widened slightly (and perhaps spuriously) to 450bp from the 445bp reported July 22. We are now slightly above the pre-2020 record of 445bp briefly touched in 2008.

DBRS finalized the RBC LRCN rating today:

DBRS, Inc. (DBRS Morningstar) assigned a final rating of A (low) with a Stable trend to Royal Bank of Canada’s (RBC or the Bank) NVCC Additional Tier 1 (AT1) Limited Recourse Capital Notes (Capital Notes). DBRS Morningstar assigned the rating equal to the Bank’s Intrinsic Assessment of AA less four rating notches, which is consistent with DBRS Morningstar’s standard notching for capital instruments with contingent risks and its ratings for the Bank’s NVCC Preferred Shares. This is one notch below the rating of RBC’s NVCC Subordinated Debt.

On July 28, 2020, RBC issued $1.75 billion of Capital Notes that mature on November 24, 2080, and will have an initial five-year fixed rate of 4.5%. DBRS Morningstar notes that the Capital Notes were granted Tier 1 capital treatment by the Office of the Superintendent of Financial Institutions.

RATING DRIVERS
Given RBC’s high rating level and the current economic environment, an upgrade of the ratings is unlikely. Ratings would be downgraded if there is a prolonged adverse impact of the Coronavirus Disease (COVID-19) pandemic resulting in a sustained deterioration in asset quality, especially due to deficiencies in risk management. Additionally, a sustained weakening of profitability metrics would also result in a downgrade of ratings.

There was something of a peculiar Staff Note published by the Bank of Canada today, Will exchange-traded funds shape the future of bond dealing?, by Rohan Arora, Jean-Sébastien Fontaine, Corey Garriott and Guillaume Ouellet Leblanc:

The rise of exchange-traded funds (ETFs) makes JIT possible in bond markets. ETFs are securities traded on an exchange, just like stocks, that entitle the bearer to a share in a pool of assets (such as stocks or bonds). For example, a fixed-income ETF might entitle its bearers to a share of a pool of 100 bonds. We find that a dealer can use bond ETFs as a warehouse to meet investor demand to buy and sell bonds. Similar to a car maker using JIT production, the dealer can reduce its inventories of “parts” and order them from its “suppliers” through a JIT approach.

Admittedly, ETFs make up only a small share of the Canadian asset management industry. Our analysis shows that ETFs in Canada are not yet used as warehouses to a large extent. But the practice is growing in the United States. These changes to the way dealers handle bonds can transform the market by:

• improving prices
• reducing the costs of large trades
• making it easier for issuers themselves to borrow funds

…
ETF warehousing is when dealers use bond ETFs to deposit and withdraw—or push and pull—bonds instead of using inventory. Figure 1 compares the ETF warehousing model with the traditional bond dealer model:

• Typically, a dealer distributes bonds by keeping them in inventory until it finds a client that wants them. If the dealer does not hold bond inventory, it cannot fulfill client orders promptly. As a result, it might lose a trade to another dealer.
• The ETF warehousing model works differently. Instead of holding individual bonds in inventory, a dealer relies on a pool of bonds held within an ETF—an outside warehouse. Using a JIT approach, the dealer could pull bonds from the ETF to fulfill client orders or push bonds acquired from clients to the ETF.

…
The 2019 US Securities and Exchange Commission ETF rule, which allows all ETFs to conduct custom exchanges, could make ETF warehousing more common. In addition, bond ETFs may become more willing to engage in custom exchanges as they grow their assets under management

The SEC rule is explained in part with:

Rule 6c-11 will provide certain exemptions from the Act and also impose certain conditions. The conditions include the following:

• Transparency. Under rule 6c-11, an ETF will be required to provide daily portfolio transparency on its website.
• Custom basket policies and procedures. An ETF relying on rule 6c-11 will be permitted to use baskets that do not reflect a pro-rata representation of the fund’s portfolio or that differ from the initial basket used in transactions on the same business day (“custom baskets”) if the ETF adopts written policies and procedures setting forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders. The rule also will require an ETF to comply with certain recordkeeping requirements.
• Website disclosure. The rule will require an ETF to disclose certain information on its website, including historical information regarding premiums and discounts and bid-ask spread information. These disclosures are intended to inform investors about the costs of investing in ETFs and the efficiency of an ETF’s arbitrage process.

So what I’m not entirely clear on about all this is: why ETFs? The only reason I can think of is because ETFs are so big … Blackrock Canada has seven corporate bond funds on offer, with a total of about 4.6-billion under management. That’s a lot of inventory and makes it very likely that Blackrock could meet an order for just about anything in any kind of reasonable size.

But there are plenty of other corporate bond portfolios under management in Canada. The Canada Pension Plan, for instance, has $40-billion in credit investments (see the 2020 Annual Report, page 14) or possibly 50.8-billion (see page 67). Why aren’t they doing this, using either extant staff or hiring an ‘overlay’ manager with a mandate to be market neutral, borrowing their short positions from the main fund?

Teachers’ has $93-billion in Fixed Income (see page 11 of the 2019 Annual Report. Where are they at?

When I was with Greydanus Boeckh so many years ago, I used to explain our basic strategy as providing month-to-month liquidity (in Canada bonds) to the dealers, who provided day-to-day liquidity to the market; much to the consternation of the smart guys who would explain to me that it’s impossible to outperform a market. I have predicted – so far unsuccessfully, I think – that US restrictions on proprietary trading by the Big Banks would bring an increase in market making by hedge funds.

Liquidity provision is fundamental to the market and there’s a lot of money to be made. I simply don’t understand why this ‘warehousing’ (I always used a car dealership analogy) concept is considered such a new idea.

Brookfield Residential Properties Inc., a wholly owned subsidiary of Brookfield Asset Management, has been downgraded to B by S&P:

• Calgary, Canada-based Brookfield Residential Properties Inc.’s profitability has suffered from diminished demand due to the coronavirus pandemic, which accelerated a downward trend that began in 2019.
• We are lowering our issuer credit rating on Brookfield Residential Properties Inc. (BRPI) to ‘B’ from ‘B+’ to reflect its higher leverage.
• At the same time, we are lowering our issue-level rating on the company’s senior unsecured notes to ‘B+’ from ‘BB-‘. Our ‘2’ recovery rating remains unchanged.
• The negative outlook reflects our expectation that BRPI’s liquidity may become constrained if it is unable to extend or renegotiate its $675 million revolving credit facility before its March 2021 maturity.

S&P has downgraded Bombardier to CCC:

• Bombardier Inc. recently announced that it had secured a commitment for a new secured term loan facility for up to US$1 billion due 2023.
• We believe the intended use of the new facility is to provide Bombardier with additional liquidity to operate its business through the COVID-19 pandemic as the company works to close previously announced divestitures.
• Based on the secured claim of the proposed term loan on certain aviation inventory and related accounts receivable, we estimate lower recovery prospects for the company’s unsecured creditors in our hypothetical default scenario.
• As a result, S&P Global Ratings lowered its issue-level rating on Bombardier’s unsecured notes to ‘CCC’ from ‘CCC+’. We revised the recovery rating to ‘5’ from ‘4’.
• All other ratings on the company are unchanged, including S&P Global Ratings’ ‘CCC+’ issuer credit rating (ICR).

The preferreds, which they downgraded to CC in March, are unaffected.

Canadian inflation has surged!

Canada’s inflation rate surged in June, as the re-opening of more of the economy following COVID-19 shutdowns pushed consumer prices back into positive territory.

Statistics Canada reported Wednesday that consumer price index (CPI) was up 0.7 per cent year over year, a sharp reversal from the declines of 0.4 per cent in May and 0.2 per cent in April. It was the biggest increase in the annual inflation rate in nine years.
…
The index surged 0.8 per cent from May to June, as the easing of pandemic-containment restrictions triggered rebounds in prices for consumer goods, which had slumped amid a dearth in demand during the lockdowns. The biggest contributor was gasoline, which jumped 10.5 per cent from May. Excluding energy prices, CPI was up 0.4 per cent month-over-month, and 1.2 per cent on an annual basis.

Among the leading price gains in the month were clothing and footwear, as stores in many provinces re-opened. Beef prices also surged, reflecting COVID-related shutdowns and production slowdowns at several meat processing plants.

The much discussed RBC LRCNs, given credit for a nice little pop in the market last week, have been priced:

Royal Bank of Canada bolstered its balance sheet this week by selling $1.75-billion of a new, tax-efficient security, opening the door to what’s expected to be a wave of similar offerings from rival Canadian banks.

The country’s largest bank sold what is known as a “limited recourse capital note,” or LRCN, that is seen as debt by institutional investors but will be treated similar to equity by federal regulators for the purpose of calculating RBC’s all-important capital requirements.

RBC’s launch of LRCNs is shaking up the domestic preferred share market, with some investors expecting the new notes to take the place of new preferred share offerings.
…
The LRCN offering was snapped up by 105 institutional investors, with demand more than twice the supply of notes.

RBC’s LRCNs pay 4.5-per-cent interest for the next five years, then the payout resets every five years at a set premium above the interest rate on Government of Canada debt. Each RBC note has a face value of $1,000 and matures in 60 years. The product can only be sold to institutional investors.

From RBC’s point of view, the LRCN is far more tax efficient than preferred shares, as the interest payments on the note can be deducted from the bank’s income for tax purposes, while dividends on preferred shares are not tax deductible.
…
The structure is attractive for several reasons. RBC managed to price the deal around 75 basis points, or 0.75 per cent, below where similar preferred shares are trading. It also managed to attract a huge amount of interest from institutional investors.

The official announcement from RBC reads:

Royal Bank of Canada (RY on TSX and NYSE) today announced the offering of $1.75 billion of non-viability contingent capital (NVCC) Additional Tier 1 (AT1) Limited Recourse Capital Notes, Series 1 (the “LRCNs”).

The LRCNs will bear interest at a rate of 4.50 per cent annually, payable semi-annually, for the initial period ending November 24, 2025. Thereafter, the interest rate on the LRCNs will reset every five years at a rate equal to the prevailing 5-year Government of Canada Yield plus 4.137 per cent. The LRCNs will mature on November 24, 2080. The expected closing date of the offering is July 28, 2020. RBC Capital Markets is acting as lead agent on the issue.

Concurrently with the issuance of the LRCNs, the bank will issue NVCC Non-Cumulative 5-Year Fixed Rate Reset First Preferred Shares, Series BQ (“Preferred Shares Series BQ”) to be held by Computershare Trust Company of Canada as trustee for a newly formed trust (the “Limited Recourse Trust”). In case of non-payment of interest on or principal of the LRCNs when due, the recourse of each LRCN holder will be limited to that holder’s proportionate share of the Limited Recourse Trust’s assets, which will consist of Preferred Shares Series BQ except in limited circumstances.

The bank may redeem the LRCNs during the period from October 24 to and including November 24, commencing in 2025 and every five years thereafter, only upon the redemption by the bank of the Preferred Shares Series BQ held in the Limited Recourse Trust, in accordance with the terms of such shares and with the prior written approval of the Superintendent of Financial Institutions (Canada), in whole on not less than 15 nor more than 60 days’ prior notice.

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

The prospectus for this issue is not yet available but there is a term-sheet on SEDAR. I am not permitted to link directly to this document, because the Canadian Securities Administrators think you’re too dumb to read it, but search for “Royal Bank of Canada Jul 21 2020 22:55:26 ET Marketing materials – English PDF 198 K”. Anyway, the part I’m interested in is just what “Limited Recourse” means:

Limited Recourse: If (i) there is non-payment by the Bank of the principal amount of the Notes, together with any accrued and unpaid interest, on the Maturity Date, (ii) a Failed Coupon Payment Date occurs, (iii) the Bank does not pay the Redemption Price in connection with a redemption of the Notes in cash, (iv) an event of default under the Notes occurs or (v) a Trigger Event (defined below) occurs (each such event, a “Recourse Event”), the recourse of each Noteholder will be limited to that Noteholder’s proportionate share of the assets (the “Trust Assets”) held by a third party trustee (the “LRT Trustee”) in respect of the Notes in a newly formed trust (the “Limited Recourse Trust”). The LRT Trustee may hold assets in the Limited Recourse Trust in respect of more than one series of limited recourse capital notes, in which case the assets (including the Bank’s preferred shares) for each such series will be held separate from the assets for other series. Initially, Computershare Trust Company of Canada will act both as the LRT Trustee and the Indenture Trustee (defined below).

Initially, at the time of issuance of the Notes, the Trust Assets will consist of the Bank’s Non-Cumulative 5-Year Fixed Rate Reset First Preferred Shares, Series BQ (“Preferred Shares”) issued at an issue price of C$1,000 per Preferred Share. The Trust Assets may alternatively consist of (i) Preferred Shares, (ii) cash if the Preferred Shares are redeemed for cash by the Bank with the prior written approval of the Superintendent, (iii) Common Shares upon the conversion of the Preferred Shares into Common Shares as a result of a Trigger Event or (iv) any combination thereof, depending on the circumstances.

The number of Preferred Shares issued at the time of issuance of the Notes will be equal to the total principal amount of the Notes divided by C$1,000. If the Trust Assets consist of Preferred Shares at the time a Recourse Event occurs, the Bank will deliver to each Noteholder one Preferred Share for each C$1,000 principal amount of Notes held, which shall be applied to the payment of the principal amount of the Notes, and such delivery of Preferred Shares will be each Noteholder’s sole remedy against the Bank for repayment of the principal amount of the Notes and any accrued but unpaid interest thereon then due and payable.

Upon the occurrence of a Recourse Event that is a Trigger Event, the Bank will deliver to each Noteholder that Noteholder’s proportionate share of the Common Shares issued in connection with the Trigger Event. The number of Common Shares issuable in connection with the Trigger Event will be calculated based on a Share Value (as defined below in the Preferred Share Final Term Sheet) of C$1,000. Such Common Shares shall be applied to the payment of the principal amount of the Notes, and such delivery of Common Shares will be each Noteholder’s sole remedy against the Bank for repayment of the principal amount of the Notes and any accrued but unpaid interest thereon then due and payable. See “NVCC Automatic Conversion” below.

The receipt by a Noteholder of its proportionate share of the Trust Assets upon the occurrence of a Recourse Event shall exhaust the remedies of the Noteholders under the Notes. If a Noteholder does not receive its proportionate share of the Trust Assets under such circumstances, the sole remedy of the Noteholder for any claims against the Bank shall be limited to a claim for the delivery of such Trust Assets.

In case of any shortfall resulting from the value of the Trust Assets being less than the principal amount of and any accrued and unpaid interest on the Notes, all losses arising from such shortfall shall be borne by the Noteholders.

All claims of Noteholders against the Bank under the Notes will be extinguished upon receipt of the Trust Assets.

So anyway, what happens in sixty years when the maturity date of the notes arrives but market conditions are such that the underlying preferred shares may be reasonably expected to trade below par? The choices available to the bank will be to
(a) redeem the preferreds anyway, or
(b) distribute the preferreds to the noteholders.

Seeing that option (b) will be viewed by the market as a default, it seems to me that that’s a helluva incentive to redeem the preferreds. And Tier 1 Capital is not supposed to have any incentive to redeem (that’s why banks and insurers can’t offer minimum rate guarantees on their marketable preferreds). I can only wonder at how the skilled logicians at OSFI have managed to square that circle.

The term sheet for the preferreds, attached to the term sheet for the LRCNs states:

Concurrently with or upon the maturity of the Notes, with the prior written approval of the Superintendent, the Bank may redeem all but not less than all of the outstanding Preferred Shares by the payment of an amount in cash for each share redeemed of C$1,000 and apply, or cause the LRT Trustee to apply, the proceeds of such redemption towards the repayment of the aggregate principal amount of and any accrued and unpaid interest on the Notes.

To add to my discussion of July 15, July 16 and July 17, I will quote from an eMail I sent recently:

It’s entirely possible that LRCNs will rise in price in the future and narrow their spreads; and it also seems quite likely that future supply of bank – and probably insurance – issues will be constrained.

But there’s more going on than just that. Supply has been virtually nil since late May 2019 (when TD & CM came out with new issues) and not much of a positive effect has been observed (to put it mildly!). I will also note that supply was massive during the great FixedReset issuance frenzy (and of pretty poor quality to boot) and prices just continued to rise until one day they didn’t.

I keep reading that limited supply will raise prices dramatically, but it all seems just a little desperate to me. I haven’t seen one single supply-and-demand curves graph, for instance. Given the overwhelming influence of rate-anticipation on the preferred market for the past ten years, I’m not even sure how one would go about creating one!

It is also important that there are limits on the issuance of LRCNs – … RBC has about $4.2-billion of issuance capacity. But as of YE 2019, they had about $5.7-billion in preferreds outstanding (see https://prefblog.com/?p=41139 ), so they couldn’t redeem them all with LRCN proceeds even if they wanted to. I suspect that they will use the proceeds of one note to redeem all their outstanding NVCC non-compliant issues and then simply issue LRCNs when they need capital.

Bank treasurers will also want to keep the preferred share market reasonably healthy simply to keep a financing avenue available.

LRCNs may will trade at a lower yield than preferreds, but I’m highly uncertain about the potential for preferreds to gain in price as a direct result, particularly if the LRCNs are issued in foreign currencies. Who is going to sell LRCNs to buy preferreds? Especially if they’re of a different currency? Canadian institutions will be writing off the tax benefits of preferreds; Canadian retail investors won’t be allowed to buy LRCNs in the first place; all investors will have to deal with the scanty liquidity available in the Canadian preferred share market; price volatility is enormous in the preferred share market, for those who care about such things; and there are other technical issues, such as investment mandates that specify that only bonds (or things that look a little bit like bonds) can be purchased and just what exactly can be pledged to Central Banks in times of stress.

I believe there will be some effect. I believe that the existence (and the potential for further issuance) of LRCNs is somewhat beneficial for the market. But I believe that the overwhelmingly most influential factor in preferred share market levels at this time is government interest rate anticipation – and I don’t think the market will be forecasting sharply higher rates any time soon.

I will also note that it is my understanding (unconfirmed, because FTSE Russell wants me to register – and presumably pay – just to read their damned index announcements) that the issue will not be included in the FTSE Canada Universe Bond Index or other FTSE Canada fixed-rate indexes. I’m very pleased that OSFI’s prior attempts to influence the indices and hoodwink investors have been beaten back.

PerpetualDiscounts now yield 5.68%, equivalent to 7.38% interest at the standard equivalency factor of 1.3x. Long corporates now yield 2.91%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has widened slightly (and perhaps spuriously) to 445bp from the 440bp reported July 15. We are now back at the pre-2020 record of 445bp briefly touched in 2008.