PrefBlog

Accrued Interest leads off with an interesting post on the US Municipal market:

What’s the result? Friday it was possible to buy 5-year pre-refunded municipals (which are backed by Treasury bonds held in escrow) at yields in the 3.50’s. In other words, around 80bps higher than Treasury rates. That is literally Treasury credit at a 80bps spread to Treasuries tax-exempt. Dozens of large new issue municipal deals came at significant spreads to Treasury rates.

There’s an interesting aside to this escrow issue which may be unfamiliar to Canadians – when the municipalities buy Treasuries to defease their issues, they don’t really care (too much) about the price. They have their list of things to buy which, while not carved in stone, is pretty inflexible: too much mismatch with their bond liabilities and the assets won’t pass muster. So they’ll go on the Street and sweep up whichever Treasuries they need.

Very often, they’ll buy more than is available, with the dealers shorting the issues to them. The end result is often that firstly the issue trades well off the yield curve AND goes special in the repo market (when you borrow bonds, you collateralize with cash. The bond lender pays interest on this cash at the “GC”, “General Collateral” rate. If the particular bond issue is scarce on the repo market, the bond lender can get away with paying less than the GC rate, which is referred to as going special).

This state of affairs affects off-the-run Treasuries in the under-three-year term. And the moral of the story is … don’t invent bond strategies that assume all short treasuries can be borrowed at the GC rate, because very often they can’t!

Related to the US Municipals story is MBIA – in the news again today with one investor placing a big bet:

Third Avenue Management LLC’s flagship mutual fund purchased 10.6 million of MBIA’s common shares at $12.15 each in February, Whitman said in a letter to shareholders released this week. New York-based Third Avenue, which Whitman founded in 1986, also bought $197 million of MBIA surplus notes.

This follows disclosure of long-term restructuring plans:

A plan to split MBIA’s structured-finance business from its municipal insurance operation in the next five years will make the Armonk, New York-based company more transparent, Chief Executive Officer Jay Brown said in an interview today on Bloomberg Television.

It’s an interesting story to watch!

Getting back to municipals for a moment, there is at least one indication that the market is – slowly – normalizing:

California, the largest borrower in the U.S. municipal market, sold $1.75 billion of bonds after attracting record demand from individuals amid the highest tax- exempt yields in more than three years.

The state got orders from more than 4,000 investors equal to over 72 percent of the bonds available, said Tom Dresslar, spokesman for California Treasurer Bill Lockyer. Officials, who were to complete the sale tomorrow, were able to wrap it up a day early after selling the rest of the debt to institutions.

… which just goes to show ya … ignore the headlines … behave sensibly … you’ll do fine.

On the other hand, though, there’s one market that’s getting sillier. Naked Capitalism brings to my attention the fact that real yields on 5-Year TIPS are negative:

Yields on five-year Treasury Inflation-Protected Securities fell below zero for a third day on investor speculation that inflation will quicken as the U.S. economy slows.

Yields on the securities, known as TIPS, dropped to minus 0.036 percent on Feb. 29, according to Barclays Capital Inc., the biggest dealer of the securities. It was the first foray below zero since five-year TIPS were first sold in 1997, according to the firm, one of the 20 primary dealers that trade directly with the Federal Reserve.

It brings to mind one of my favourite factoids …. at times during the Great Depression, T-Bills traded above par. This doesn’t make a lot of sense until you consider the alternatives … put your cash in the bank and the bank fails … keep your cash under your mattress and get robbed. I can’t find hard proof of this factoid, however … anybody who can help me will deserve my most earnest thanks. 

Speaking of interest rates, how about that Bank of Canada, eh? Scotia has announced prime of 5.25% effective 3/5; so has TD and National and CIBC and BMO. I don’t see anything for RBC yet, but it’s a pretty good bet! Oddly, each of the three Prime-Rate-Dependent HIMIPref™ indices was up on the day. Well, I find it odd, anyway! Were traders of these shares pricing in a bigger cut? Are they now looking forward to faster hikes sooner? Is it just random chaos? Somebody tell me, because I don’t know.

TD announced today that the new issue greenshoe was fully exercised, indicating that the underwriting did very well, even as the preferred market went down (which might indicate indigestion). Will other issuers find the situation encouraging or not? The Shadow knows!

The market was weak, but the volume was up … maybe the Technical Analysis guys will short whatever they can get on this news. That’s fine … I’ll sell em some liquidity!

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

All the problems with Municipal Auction Rate Securities lead one to the not terribly difficult conclusion that the issuers, where possible, will redeem them and replace them with fixed-rate debt … unfortunately, that highway looks gridlocked:

U.S. states and local governments may extend the worst slump in municipal bonds on record as they replace as much as $166 billion of auction-rate securities.

California, Boston’s biggest hospital and Duke Energy Corp. are converting their bonds to other types of tax-exempt debt after auction failures drove rates as high as 20 percent. The potential supply equals almost 40 percent of the municipal securities sold last year, overwhelming a market that tumbled 4.9 percent last month, according to indexes maintained by Merrill Lynch & Co., which began compiling market data in 1989.

This prompted Naked Capitalism to launch another vitriolic attack on the Credit Rating Agencies:

Now the New York Times piece, on page one, is no doubt intended for a broad audience, so it explains (without giving comparative default rates, which would have been useful), that rating agencies grade muni bonds more harshly than corporates:

At every rating, municipal bonds default less often than similarly rated corporate bonds, according to Moody’s. In fact, since 1970, A-rated municipal bonds have defaulted far less frequently than corporate bonds with top triple-A ratings. Furthermore, when municipalities do default, investors usually receive some — or even all — of their money back, unlike in most corporate bankruptcies….. Moody’s estimates that more than half of the market would be rated triple A or double A using the corporate scale. Triple-A securities are considered nearly as safe as Treasury bonds issued by the federal government.

However, the piece notes rather blandly the central conflict of interest: that rating agencies have good reason to have established and perpetuated this double standard. When less than AAA municipalities go to buy bond insurance, they are paid again to issue the second rating.

Naked Capitalism does not explain why all fault lies with the Credit Rating Agencies and not with the issuers and investors; nor does he speculate why Moody’s, for instance, would choose to publish explanations of their municipal rating scale if it’s such a big secret.

There’s a thread on Financial Webring Forum discussing long-term equity premia. It is clear that the long term equity premium will vary, moving marginally up and down in response to transient mispricing – this was discussed in a paper by Campbell, Diamond & Shoven, presented to the (American) Social Security Advisory Board in August 2001 (quoted with a different author for each paragraph):

The yield on long-term inflation-indexed Treasury securities (TIPS) is about 3.5%, while shortterm real interest rates have recently averaged about 3%. Thus 3% to 3.5% would be a reasonable guess for safe real interest rates in the future, implying a long-run average equity premium of 1.5% to 2.5% in geometric terms or about 3% to 4% in arithmetic terms.

In evaluating proposals for reforming Social Security that involve stock investments, the Office of the Chief Actuary (OCACT) has generally used a 7.0 percent real return for stocks. The 1994-96 Advisory Council specified that OCACT should use that return in making its 75-year projections of investment-based reform proposals. The assumed ultimate real return on Treasury bonds of 3.0 percent implies a long-run equity premium of 4.0 percent. There are two equitypremium concepts: the realized equity premium, which is measured by the actual rates of return; and the required equity premium, which investors expect to receive for being willing to hold available stocks and bonds. Over the past two centuries, the realized premium was 3.5 percent on average, but 5.2 percent for 1926 to 1998.

My own estimate for the long-run real return to equities looking forward is 6 to 6.5 percent. I come to that using roughly the parameters chosen above. If the P-E ratio fluctuates around 20, the cash payouts to shareholders should range from 3 to 3.5 percent. I am relatively optimistic about the possible steady-state growth rate of GDP and would choose 3 percent for that number.

Note that the paper was written near the height of the tech-bubble; the authors agreed that the market was over-valued at time of writing. 

However, there seems to be a belief by some that long-term GDP growth caps the equity premium, which is nonsense. Long-term GDP growth may well cap corporate revenue, but not equity returns. A corporation that has grown (at 10% p.a., say) until it has reached the limits to growth (revenue of some percentage of GDP) can then pay dividends comprised of the earnings it doesn’t need to retain. Alternatively but almost equivalently, it may choose to buy back stock – presumably, the choice would be made according to whether the market price of the stock was considered cheap or expensive on a long-term basis.

Corporations will pay dividends and buy back stock in order to maximize returns on equity while at the same time providing themselves with enough cushion to survive a downturn. Investors will demand a premium to compensate for the chance they’ll have to sell during one of those downturns. There is no mathematical limit to the size of the equity premium; the practical limit historically has been about 5%.

Taxation muddles matters, of course, but this debate has implications for preferred share investors, since the equity premium should set a cap on preferred spreads. How much of the equity premium can be captured, vs. how much equity risk is inherent in prefs? Now, me, I don’t think this is a topic doing a LOT of work on with respect to asset allocation, given standard market chaos, but is something to keep an eye on!

The big preferred share news today was the long-anticipated (by me, anyway!) new issue – an issuer finally looked at the recent improvement in the market and decided to test the market. It was TD 5.60% perps – and I understand the offering of $200-million went very well.

This knocked the market down considerably, but volume was nothing special … the rest of the week will be interesting … will other issuers attempt to jam in their own issues while the window’s open? Regardless of whether they do or not, is today’s price action an automatic and transient response to a new issue, or a sign of saturation? Stay tuned!

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