PrefBlog

Matt Levine of Bloomberg passes on the latest legal wrinkle in the CDS field:

And when a bank needs rescuing, holders of its most senior stuff — the deposits, the secured debt — tend to be fully and seamlessly made whole, while holders of its most junior stuff — common stock, AT1 capital securities — tend to get instantaneously zeroed.
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But in modern legal systems there is a problem with these hierarchies, which is that everyone who buys a junior claim on a bank and then sees that claim wiped out also automatically gets a lawsuit. If your junior claim is wiped out, you can sue someone — probably the bank, or whoever acquired the bank — claiming that your junior claim was wiped out unfairly: The proper procedures weren’t followed, or the bank wasn’t really insolvent when it was rescued, or it was really insolvent much earlier and its disclosures were wrong, or you were tricked into buying the junior claim by misrepresentations about its safety, or whatever. And you sue, and if you win, you have a senior claim: When a company loses a lawsuit, it actually has to pay up, making that claim unlike junior capital securities with perpetual maturity and long deferral periods.

This is just sort of weird. Here is a story about how Banco Popular Espanol SA’s credit default swaps are a mess, which is a small symptom of that larger weirdness:

Credit derivatives written against the failed Spanish lender’s junior debt were triggered in a matter of days and, given that these bonds were now worthless, it seemed self-evident to many that owners of the CDS would get paid in full.

But now a row has broken out over whether the potential value of legal claims bondholders are pursuing over Banco Popular’s collapse should be considered when determining any compensation, clouding the first payout on credit derivatives linked to a European bank since the rules were rewritten to iron out major flaws in 2014.

Lazy balance sheets at US utilities have been a point of corporate interest for well over a year now:

Led by massive acquisitions from pipeline companies Enbridge and TransCanada, six domestic businesses spent approximately $87-billion in the past 12 months snapping up U.S. firms.
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Why are the Canadians suddenly stepping up? And can domestic CEOs in other sectors, all of whom aspire to grow internationally, steal a page from the utilities?

On the first question, the starting point for takeovers is this concept of lazy balance sheets south of the border. Executives at capital-hungry companies such as utilities are always conscious of their credit ratings. This is especially true of CEOs and boards at U.S. pipelines: Enron’s meltdown and the near-death experience of the global financial crisis made top-notch ratings a priority. As a result, many U.S. utilities carry relatively little debt. That’s “lazy” in the sense that the company could easily borrow more money, while continuing to be judged as investment grade by the likes of S&P and Moody’s.

While utility executives might care about ratings, the credit market stopped paying much attention last year. In the spring of 2016, borrowing costs began to fall for any investment grade-rated company. At the same time, the spread or gap narrowed between the interest rates paid by a blue-chip double-A-rated borrower and a still-respectable but more leveraged triple B-rated business. And credit markets opened up – massive loans and bond sales were possible.

And so today we learned:

Ontario utility Hydro One Ltd. moved into the U.S. natural gas and electrical transmission business Wednesday by acquiring Washington-based Avista Corp. for $4.4-billion.

Toronto-based Hydro One, which was privatized by the Ontario government in 2015, is making its first foray outside the province by buying a utility that supplies electricity to 379,000 customers and gas to 342,000 clients across five western U.S. states. Hydro One has 1.3 million customers in Ontario.

Hydro One is the latest in a series of Canadian utilities to acquire an American rival, with six domestic companies collectively committing $87-billion to U.S. takeovers over the past 18 months.

But S&P was not impressed:

• •On July 19, 2017, Toronto-based Hydro One Ltd. (HOL) announced the C$6.7 billion (US$5.3 billion) proposed acquisition of Avista Corp., a U.S.-based electricity and gas utility.
• •We are revising our outlook on HOL and subsidiary Hydro One Inc. (HOI) to negative from stable.
• •We are also affirming our ratings on HOL and HOI, including our ‘A’ long-term corporate credit rating on both.
• •The outlook revision reflects the shift in HOL’s business strategy, as well as the slightly weakened business risk from the acquisition

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Historically, HOL’s focus on Ontario provided the company with incremental business strength based on a favorable market position, regulation, and operational history. With the Avista acquisition, we believe HOL’s business risk has eroded slightly. Furthermore, the additional leverage that the transaction introduces also eroded HOL’s credit metrics and financial risk.

The negative outlook on HOL reflects our view that the Avista acquisition signals a shift in HOL’s business strategy, which will align the company with its global peers removing the historical rationale for a one-notch rating uplift. The negative outlook also reflects the execution and financing risk inherent in any large acquisition. We recognize that the use of the convertible debentures will create a temporary impact on credit metrics, with AFFO-to-debt forecast at about 9% until conversion. However, we expect the debentures will be converted to equity in full.

As as for Avista:

• •Toronto, Ontario-based utility Hydro One Ltd. (HOL) has entered into an agreement to acquire U.S.-based Avista Corp. (Avista) for C$6.7 billion in an all-cash transaction.
• •We are affirming our ratings on Avista, including the ‘BBB’ issuer credit rating, and revising the outlook to positive from stable.
• •The positive outlook reflects the potential for higher ratings on Avista if the acquisition is completed as proposed.

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S&P Global Ratings today said it affirmed its ratings, including the ‘BBB’ issuer credit rating, on Avista Corp. and revised the outlook to positive from stable.

The outlook revision on Avista reflects the potential for higher ratings upon the completion of the acquisition by Hydro One Ltd. (HOL). Post-acquisition, we will view Avista as a highly strategic subsidiary of HOL. Our assessment is based on our view that Avista will be an important member of the HOL group, highly unlikely to be sold, and integral to overall group strategy and operations. Avista will be a significant cash flow contributor to the group, making up about 22% of consolidated EBITDA.

So Avista is already BBB, but according to their 2016 Annual Report, about $1.2-billion of their $1.6-billion total long-term debt matures in and after 2022 and carries an average interest rate of 5.09%, compared to an average coupon of 5.2% on US long term corporates. Maybe it’s Hydro 1 that should be regarded as having the lazy balance sheet, if this is an issue in this acquisition!

PerpetualDiscounts now yield 5.28%, equivalent to 6.86% interest at the standard equivalency factor of 1.3x. Long corporates now yield a little more than 3.80%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 305bp, a slight (and perhaps spurious) widening from the 300bp reported July 12.

I’m always happy when somebody agrees with me:

The report, released Thursday by the School of Public Policy at the University of Calgary1 and authored by Henri-Paul Rousseau, examines the option of banning embedded sales commissions for Canadian financial advisers and the broader, public-interest issues arising from such a ban.
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According to Mr. Rousseau, the ban on these commissions would create a number of public policy issues. Firstly, it would likely create an advice gap in Canada, due to households being averse to paying up front for an advice fee. Secondly, it will likely cause a loss of choice for Canadians who have varying needs and preferences. The report says that smaller and independent product manufacturers and distributors would be squeezed out, creating a market concentration in the hands of the bigger financial-advice players, as well as a loss in pricing transparency for clients.

The full report is titled WHY BANNING EMBEDDED SALES COMMISSIONS IS A PUBLIC POLICY ISSUE: A commentary adapted from notes for the concluding panel of “The New Paradigm of Financial Advice” conference, held in Toronto on March 31, 2017:

The U.K. provides an example which should not be followed. Regulators there have banned embedded commissions, forcing clients to pay directly for financial advice. The result is that modest-income clients have decided not to seek financial advice, even though that decision will likely negatively affect their portfolios.

The dangers of this “advice gap” are being downplayed by those who believe that robo-advisors and banks can fill the need instead. In fact, robo-advisors and banks are mostly not equipped to step into the gamma role of coaching their clients.

A ban would also mean less choice in the market for a service that needs to be competitive and innovative to serve the broad spectrum of clients’ circumstances, risk appetites and needs. In addition, smaller and independent product manufacturers and distributors would be squeezed out, creating a market concentration in the hands of
the bigger players.

The second paragraph quoted above is incomplete, it seems to me, with respect to the role of robo-advisors. That channel seems best suited for ‘those who know not and know that they know not’. Those are the guys who earnestly seek out an advisor and are greatly impressed when he repeats that morning’s headlines from the Wall Street Journal, together with commentary on what “Janet” and “Stephen” are going to do with “interest rates” in the next six months, but they’re not really all that interested. ‘Get me invested and don’t bother me’ is their motto and a robo-advisor can scratch that itch really well.

The problem is with ‘those who know not and know not that they know not’. These are the people with a profound disinterest in financial markets. They’re the people who, unless they happen to know somebody in the business, will go to the bank and ask for something “safe”, so the friendly banker will put them into a grossly unsuitable portfolio of GICs that are immensely profitable for the bank. What we should want, as a matter of public policy, is for them to know that Charlie down at the club ‘does something with stocks and bonds’, so they go to Charlie. I will agree that Charlie is probably not the greatest advisor around, but he knows more than a bank teller and has access to a wider range of investments. Sure, he takes his half-point cut on the deal. It’s worth it. Not because his advice, considered objectively, is so wonderful, but because his advice has given his new clients confidence and because – in most, although certainly not all, cases – the portfolio his clients end up with is reasonable. Not great, not particularly cheap, but reasonable.

Banks? My attention was drawn recently to the RBC Managed Payout Solution. My God. How can anybody offer up that marketing strategy without blushing? I just about had a coronary.

So maybe the economy’s not so good:

Employers created an average of 11,000 new jobs a month for the first five months of the year, according to Statistics Canada’s Survey of Employment, Payrolls and Hours (SEPH) for May, released on Thursday.

The weak jobs data suggest that “paid employment creation so far this year is the worst since the 2009 recession,” said Krishen Rangasamy, senior economist with National Bank of Canada.

The payroll survey results stand in sharp contrast to Statscan’s other labour report, the Labour Force Survey (LFS), which has exceeded expectations for months and paints a much rosier picture of the country’s job market. The difference in the numbers reported by the two employment surveys is not unusual because the SEPH report is based on payroll data from Canada Revenue Agency, while the LFS relies on people providing information about their wages and job status to data collectors. The SEPH numbers are considered more reliable; the labour force survey is volatile and not as dependable given that it has a huge margin of error.

LIBOR is on its way out:

The U.K. Financial Conduct Authority will phase out the key interest-rate indicator by the end of 2021 after it became clear there wasn’t enough meaningful data to sustain the benchmark that underpins more than $350 trillion in securities, Andrew Bailey, the head of the regulator, said in a speech Thursday at Bloomberg’s London office.
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But the 58-year-old Bailey said the market supporting Libor — where banks provide each other with unsecured lending — was no longer “sufficiently active” to determine a reliable rate and alternatives must be found. For one currency and lending period there were only 15 transactions in 2016, he said.
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The FCA only started regulating Libor in 2013, the same year legislation was passed making it a criminal offense to take any misleading action in relation to financial benchmarks.

Some timely commentary from Pew Research:

Manufacturing jobs in the United States have declined considerably over the past several decades, even as manufacturing output – the value of goods and products manufactured in the U.S. – has grown strongly. But while most Americans are aware of the decline in employment, relatively few know about the increase in output, according to a new Pew Research Center survey.

Four of every five Americans (81%) know that the total number of manufacturing jobs in the U.S. has decreased over the past three decades, according to the survey of 4,135 adults from Pew Research Center’s nationally representative American Trends Panel. But just 35% know that the nation’s manufacturing output has risen over the same time span, versus 47% who say output has decreased and 17% who say it’s stayed about the same. Only 26% of those surveyed got both questions right.

Click for Big

But the news of the day was the FOMC statement:

Information received since the Federal Open Market Committee met in June indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have been solid, on average, since the beginning of the year, and the unemployment rate has declined. Household spending and business fixed investment have continued to expand. On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.
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In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.
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For the time being, the Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee expects to begin implementing its balance sheet normalization program relatively soon, provided that the economy evolves broadly as anticipated; this program is described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; and Jerome H. Powell.

No dissent! And in the States that means something – not like in Canada, where the very idea of two people disagreeing is considered to be too embarrassing for words.

There was an immediate reaction on the FX markets:

The Bloomberg Dollar Spot Index fell to the lowest in more than a year, while the 10-year Treasury yield slipped back below 2.3 percent after the Fed held rates steady and indicated it would start unwinding its balance sheet “relatively soon.”

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… but Treasuries regained most of the ground lost yesterday:

• •The yield on 10-year Treasuries fell five basis points to 2.29 percent.

PerpetualDiscounts now yield 5.28%, equivalent to 6.86% interest at the standard equivalency factor of 1.3x. Long corporates now yield a little under 3.95%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 295bp, a significant narrowing from the 305bp reported July 19.

The SEC says cryptocurrencies are securities (link to full report added):

The Securities and Exchange Commission issued an investigative report today cautioning market participants that offers and sales of digital assets by “virtual” organizations are subject to the requirements of the federal securities laws. Such offers and sales, conducted by organizations using distributed ledger or blockchain technology, have been referred to, among other things, as “Initial Coin Offerings” or “Token Sales.” Whether a particular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction.

The SEC’s Report of Investigation found that tokens offered and sold by a “virtual” organization known as “The DAO” were securities and therefore subject to the federal securities laws. The Report confirms that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies. Those participating in unregistered offerings also may be liable for violations of the securities laws. Additionally, securities exchanges providing for trading in these securities must register unless they are exempt. The purpose of the registration provisions of the federal securities laws is to ensure that investors are sold investments that include all the proper disclosures and are subject to regulatory scrutiny for investors’ protection.
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The SEC’s Office of Investor Education and Advocacy today issued an investor bulletin educating investors about ICOs.

The Ontario government’s pension fund manager has opened for business:

Toronto-based Investment Management Corporation of Ontario (IMCO) begins managing the $60-billion on behalf of its first two clients, Workplace Safety and Insurance Board (WSIB) and the Ontario Pension Board (OPB), on Monday after a lengthy integration process. IMCO hopes to add other small public-sector plans over time by offering them access to a broader range of asset classes at lower fees.
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IMCO has roots in a 2012 report on what might be gained by pooling Ontario’s fragmented public-sector pension funds. It was penned by Bill Morneau, who was then president of Morneau Shepell and a pension investment adviser to Ontario’s Minister of Finance. His review suggested that size does matter in investing, that grouping these funds together would be a more efficient investment method and that plans might collectively save more than $75-million each year.
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When the initial build out of IMCO’s investment teams is completed more than a year from now, he will need to be able to make a compelling argument to potential future clients that the improved returns and lower costs will lead to better results than what they would be able to source on their own. Otherwise, there’s no incentive for a prospective client to join the voluntary IMCO group.

But the model already has a strong track record in Western Canada. Alberta Investment Management Corp., known as AIMCo, manages more than $90-billion of assets for 26 pension, endowment and government funds in its province. British Columbia Investment Management Corp., or BCIMC, is even larger, managing $135-billion for more than 30 institutional clients.

Like its Western cousins, IMCO will also look to manage more of its money in house, rather than buying investments in asset through other fund managers.

It will not have escaped the intelligent and assiduous reader that, in the context of a $60-billion portfolio, $75-million in projected fee savings is only slightly greater than the square root of fuck-all. I don’t want to issue any doom-filled forecasts here, but as I have pointed out in the past:

I don’t think there’s anything wrong with the Yale model, but there are definitely problems with the implementation – as I told one guy recently, just because I believe the “Warren Buffet style” of investment CAN work, doesn’t mean I think YOU can do it.

The field is filled with ignoramuses and charlatans and institutional boards aren’t any better at picking winners than any other retail investor who handles his investments as a part-time job. Hiring a small group of specialists to farm out the work to third party firms just makes matters worse, because then allocations are made on the basis of two salesmen talking to each other.

For an institution to outperform, I believe that you have to have most, if not all, of the investment expertise in-house. ‘You don’t need to sell anything, guys, you just have to outperform on a rolling four year basis or you’re fired.’ This is the Teachers/OMERS model – and it works.

So, I will direct readers’ attention to the assertion in today’s Globe article: he will need to be able to make a compelling argument to potential future clients that the improved returns and lower costs will lead to better results. That is to say, sales. It must be remembered that, in government as in business, the guys in charge of pension plans are not professional investors and don’t have any more expertise in investing than any other accountant with a $200,000 RRSP. So they’re susceptible to just as much stockbroker flim-flam as any other member of the gullible investing public.

So you get investment decisions being made on the basis of how well it can be explained to an uninformed client and that view becomes pervasive throughout the organization; with people’s bonuses being paid not for performance, but for Assets Under Management. In the worst case scenario, people start brown-nosing the government of the day instead of asking themselves how, exactly, do I put more actual money into my actual clients’ actual pockets:

It’s a black day for the professionalism of the Canadian investment management industry, such as it is. It looks like the OTPP’s foray into politics (sneered at on October 7) comes straight from the top:

Ontario’s proposal to create a voluntary disclosure rule to boost women on boards is unlikely to cause much improvement and will likely have to be turned into a quota, warns the head of Ontario Teachers’ Pension Plan.

Speaking at a public forum Wednesday hosted by the Ontario Securities Commission, Jim Leech said Canada has a smaller proportion of women on corporate boards than countries like Turkey and Poland. He said voluntary disclosure rules can be tried for three or four years, but will probably end up being rejected as inadequate.

“Let’s skip this intermediate step we don’t think is going to work,” Mr. Leech proposed.

Teachers has urged regulators to instead require all public company boards to have at least three women directors.

Maybe Leech is sucking political arse in hopes of a position with the proposed Ontario Pension Plan.

So, let’s hope. And particularly, let us hope that the new entity looks more like HOOPP, one of the best organizations I know of and not so much like Honest Jimmy’s Best Mutual Funds:

Never let it be said that I never say anything nice on this blog! For instance, on March 25, 2009 and again on April 17, 2012, I said nice things about the Hospitals of Ontario Pension Plan (HOOPP). And now there are more nice things to say:

The Healthcare of Ontario Pension Plan (HOOPP) has posted returns for 2012 of 17.1 per cent, which boosted the pension plan for Ontario healthcare workers to a record $47.4 billion in assets, compared to $40.3 billion at the end of 2011. This strong double-digit return increased HOOPP’s 10-year average rate of return to more than 10 per cent, one of the best long-term records among pension plans worldwide.

At the end of 2012, HOOPP was 104 per cent funded – this fully funded status means the Plan has sufficient assets to pay for every promised member’s pension benefit, with no shortfall.

“HOOPP had a very strong year in 2012 – with our best investment results in more than a decade,” says HOOPP President & CEO Jim Keohane. “This was a year when all of our investment strategies worked. We were firing on all cylinders, with positive returns from every type of investment,” he said. HOOPP’s liability driven investment (LDI) strategy continues to contribute to HOOPP’s success, Keohane added.

“Liability Driven Investment” is the cool way of saying “paying attention to your client’s needs”. HOOPP is in a good position to do this, because they have exactly one client and aren’t looking for new ones, despite idiotic initiatives from Premier Dad’s office that would encourage large plans to stock up on salesmen and get rid of those dreary nerds. That’s the real secret – a focus on return made possible by a complete absence of pressure for sales. Then you can fire the moron whose sole useful attribute is being buddies with a large client; then you can do all kinds of things. In an interview with the Star, though, president and CEO Jim Keohane emphasized scale, which is probably more diplomatic.

It was a tough day for global bonds:

Markets took a risk-on tone Tuesday as generally positive earnings and economic data bolstered confidence in the strength of the global economy. The data come as the Fed will weigh robust global growth against feeble inflation and mixed U.S. economic data. Expectations are for policy makers to keep rates on hold; clues to the fate of its balance sheet will be key.

• •The yield on 10-year Treasuries rose seven basis points to 2.33 percent, the most in a month.
• •Germany’s 10-year yield rose six basis points to 0.566 percent.
• •Britain’s 10-year yield rose seven basis points to 1.258 percent, the highest in more than a week.
• •France’s 10-year yield rose seven basis points to 0.812 percent, the first advance in more than a week.

In Canada the five-year yield popped up to 1.63% and the ten-year rose to 2.02%.