January 17, 2008

Prof. Hamilton’s use of the unadjusted 10-year Nominal/TIpS spread, mentioned here yesterday, attracted some criticism in the comments to his post. The Cleveland Fed adjusts the raw data for (a) the inflation risk premium, and (b) liquidity premium.

The naive method of pricing real return bonds is:

Nominal Yield = Real Yield + Inflation Expectations (Wrong!)

If this were the actual equation, there would be no incentive for the issuers to issue the bonds; they would just go with nominals. However, the correct equation:

Nominal Yield = Real Yield + Inflation Expectations + Inflation Risk Premium (Right!)

adds a term. A buyer of nominals must not only forecast inflation, but (if he’s prudent) add a little bit extra just in case his expectations are wrong. By issuing real return bonds, the issuer can capture that Inflation Risk Premium for itself.

The liquidity premium doesn’t need a lot of explanation – especially in this environment, where the liquidity premium on some issues – especially US financials – is enormous. When you buy treasuries – or Canadas, to a lesser extent – you can trade a boatload of them without moving the price. Want a quote on 10-years, $50-million a side? The quote will come back at you with a ten cent spread. Why not? The dealer’s ‘phone is always ringing, he can keep turning over his inventory and earning the spread with ease, and he can alter the directional bias of his trades by shading his quote a few pennies one way or the other.

This is – ahem! – not the case with instruments of lesser liquidity. Therefore, you are willing to pay less for instruments of low liquidity (which increases the yield required) to compensate for the risk that you’re going to want to – or have to – sell them prior to maturity anyway and be subject to the tender mercies of the dealers and their book of inventory.

I have added a link to the Cleveland Fed’s calculations at the sidebar. Curious readers will see that the adjusted series is volatile and has been sharply increasing in recent months.

The implosion of the weaker monolines, Ambac and MBIA, continued today.

Michael Woodford of Columbia University wrote an interesting piece on the ideal methodology of central bank communication with investors:

All of the big-3 central banks (the Fed, Bank of Japan and the ECB) have experimented over recent years with more explicit forward guidance through their official communications. Generally it is through the use of “code words,” such as removal of policy accommodation at a “measured pace,” or the exercise of “strong vigilance” toward inflation risks.

I suspect that other central banks are becoming more cautious as well about the use of code words that are taken to directly indicate future interest-rate decisions, under the current rapidly changeable conditions in financial markets.

He suggests that the use of fan charts would be preferable. To my chagrin I have been unable to find a linkable example of a fan chart, but the name should be self explanatory. Draw your projection of … whatever … into the future. Draw in confidence limits at, say, 50%, 75% and 95% confidence. Colour them in. Voila! See, for example, Chart#3 in the Norges Bank 2006-03 Inflation Report.

At a 2006 Bank of Canada conference, such fan charts were lauded:

The Reserve Bank of New Zealand is the pioneer not only in inflation targeting but also in introducing and publishing explicit instrument-rate paths that can be interpreted as optimal instrument-rate plans. The bank has done so since 1998 (Archer 2004, 2005; Svensson 2001a). The Reserve Bank has for many years been alone in taking this bold step. However, Norges Bank, an enthusiastic and competent newcomer to the inflation-targeting camp, has recently started to publish explicitly optimal instrument-rate paths with uncertainty bands, together with criteria for optimal inflation and output-gap projections and other innovations in transparent monetary policy (Norges Bank 2005; Qvigstad 2005). This should be an example to other central banks.

There was a bit more speculation about BCE today:

Shares of BCE Inc. Canada’s biggest telecom company, continue to trade well below the offer price in its $34.8-billion buyout as investors remain worried the deal may be repriced, abandoned or face further delays.

The buyer group, which includes the Ontario Teachers’ Pension Plan, Providence Equity Partners, Madison Dearborn Partners and Merrill Lynch Global Private Equity, has offered $42.75 a share to take the company private.

However, its shares were at $36, down $1.01, on the Toronto Stock Exchange on Thursday afternoon, despite repeated assurances from both BCE and Teachers’ that the deal remains on track.

A BCE spokesman said on Thursday the company is still “looking forward to closing the deal” in the second quarter.

A Teachers’ spokeswoman was not immediately available for comment.

My guess is that the Teachers’ spokeswoman was in the Ladies’, throwing up. But what do I know?

Today’s response in the preferred market to the new BNS 5.60% Perpetual certainly makes my “frothy” correspondent of January 7 and January 8 look like a genius! The correspondent now feels that (a) long-term, prefs are a buy; (b) short term, it might be better to wait; and (c) if another issue comes out before the new issue settles, take the day off and buy a bottle of something tasty. 

Volume, rather surprisingly, was good, but by no means heavy. Make of that what you will.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 5.80% 5.91% 56,321 14.24 2 -5.9367% 1,000.0
Fixed-Floater 4.98% 5.48% 75,869 14.90 9 -1.2704% 1,026.4
Floater 5.23% 5.27% 89,853 15.09 3 -0.4934% 842.8
Op. Retract 4.84% 2.99% 82,956 3.20 15 -0.4098% 1,040.9
Split-Share 5.30% 5.55% 101,382 4.30 15 -0.8796% 1,035.4
Interest Bearing 6.28% 6.36% 60,620 3.63 4 +0.0769% 1,073.3
Perpetual-Premium 5.79% 5.51% 65,233 6.37 12 -0.2933% 1,020.1
Perpetual-Discount 5.54% 5.58% 334,527 14.53 54 -2.1830% 924.7
Major Price Changes
Issue Index Change Notes
BCE.PR.B Ratchet -12.89% Shoot the market maker. This is the same thing that happened January 7.
BCE.PR.G FixFloat -5.1546% Closed at 23.00-24.17. Excellent market making, eh?
HSB.PR.D PerpetualDiscount -4.9145% Now with a pre-tax bid-YTW of 5.67% based on a bid of 22.25 and a limitMaturity.
POW.PR.D PerpetualDiscount -4.4915% Now with a pre-tax bid-YTW of 5.58% based on a bid of 22.54 and a limitMaturity.
SLF.PR.A PerpetualDiscount -4.2544% Now with a pre-tax bid-YTW of 5.49% based on a bid of 21.83 and a limitMaturity.
SLF.PR.B PerpetualDiscount -3.9703% Now with a pre-tax bid-YTW of 5.50% based on a bid of 22.01 and a limitMaturity.
BNS.PR.L PerpetualDiscount -3.8497% Now with a pre-tax bid-YTW of 5.45% based on a bid of 20.73 and a limitMaturity.
MFC.PR.C PerpetualDiscount -3.8271% Now with a pre-tax bid-YTW of 5.33% based on a bid of 21.36 and a limitMaturity.
BMO.PR.J PerpetualDiscount -3.7963% Now with a pre-tax bid-YTW of 5.50% based on a bid of 20.78 and a limitMaturity.
RY.PR.G PerpetualDiscount -3.6917% Now with a pre-tax bid-YTW of 5.48% based on a bid of 20.87 and a limitMaturity.
PWF.PR.L PerpetualDiscount -3.6447% Now with a pre-tax bid-YTW of 5.56% based on a bid of 23.00 and a limitMaturity.
ELF.PR.G PerpetualDiscount -3.4826% Now with a pre-tax bid-YTW of 6.17% based on a bid of 19.40 and a limitMaturity.
BNS.PR.K PerpetualDiscount -3.4752% Now with a pre-tax bid-YTW of 5.42% based on a bid of 22.22 and a limitMaturity.
BNS.PR.M PerpetualDiscount -3.3411% Now with a pre-tax bid-YTW of 5.43% based on a bid of 20.83 and a limitMaturity.
RY.PR.F PerpetualDiscount -3.1856% Now with a pre-tax bid-YTW of 5.40% based on a bid of 20.97 and a limitMaturity.
BNS.PR.J PerpetualDiscount -3.0961% Now with a pre-tax bid-YTW of 5.40% based on a bid of 24.10 and a limitMaturity.
BNS.PR.N PerpetualDiscount -3.0291% Now with a pre-tax bid-YTW of 5.48% based on a bid of 24.01 and a limitMaturity.
GWO.PR.I PerpetualDiscount -2.9698% Now with a pre-tax bid-YTW of 5.43% based on a bid of 20.91 and a limitMaturity.
PWF.PR.K PerpetualDiscount -2.8746% Now with a pre-tax bid-YTW of 5.57% based on a bid of 22.30 and a limitMaturity.
CM.PR.H PerpetualDiscount -2.8046% Now with a pre-tax bid-YTW of 5.71% based on a bid of 21.14 and a limitMaturity.
ELF.PR.F PerpetualDiscount -2.7447% Now with a pre-tax bid-YTW of 6.28% based on a bid of 21.26 and a limitMaturity.
SLF.PR.D PerpetualDiscount -2.7179% Now with a pre-tax bid-YTW of 5.41% based on a bid of 20.76 and a limitMaturity.
POW.PR.B PerpetualDiscount -2.6520% Now with a pre-tax bid-YTW of 5.63% based on a bid of 23.86 and a limitMaturity.
RY.PR.A PerpetualDiscount -2.6328% Now with a pre-tax bid-YTW of 5.37% based on a bid of 21.08 and a limitMaturity.
GWO.PR.H PerpetualDiscount -2.6304% Now with a pre-tax bid-YTW of 5.51% based on a bid of 22.21 and a limitMaturity.
RY.PR.D PerpetualDiscount -2.5475% Now with a pre-tax bid-YTW of 5.44% based on a bid of 21.04 and a limitMaturity.
BNA.PR.B SplitShare -2.4933% Now with a pre-tax bid-YTW of 7.11% based on a bid of 21.90 and a hardMaturity 2016-3-25 at 25.00.
BMO.PR.K PerpetualDiscount -2.4930% Now with a pre-tax bid-YTW of 5.54% based on a bid of 24.25 and a limitMaturity.
BCE.PR.C FixFloat -2.4184%  
CM.PR.I PerpetualDiscount -2.3091% Now with a pre-tax bid-YTW of 5.70% based on a bid of 20.73 and a limitMaturity.
BAM.PR.H SplitShare -2.3056% Now with a pre-tax bid-YTW of 5.86% based on a bid of 25.00 and a softMaturity 2012-3-30 at 25.00.
RY.PR.C PerpetualDiscount -2.2472% Now with a pre-tax bid-YTW of 5.37% based on a bid of 21.75 and a limitMaturity.
RY.PR.E PerpetualDiscount -2.2181% Now with a pre-tax bid-YTW of 5.41% based on a bid of 21.16 and a limitMaturity.
SLF.PR.E PerpetualDiscount -2.1375% Now with a pre-tax bid-YTW of 5.39% based on a bid of 21.06 and a limitMaturity.
CM.PR.G PerpetualDiscount -2.0994% Now with a pre-tax bid-YTW of 5.93% based on a bid of 22.85 and a limitMaturity.
TD.PR.P PerpetualDiscount -2.0548% Now with a pre-tax bid-YTW of 5.41% based on a bid of 24.31 and a limitMaturity.
BNA.PR.C SplitShare -2.0237% Now with a pre-tax bid-YTW of 7.20% based on a bid of 19.85 and a limitMaturity.
SLF.PR.C PerpetualDiscount -2.0207% Now with a pre-tax bid-YTW of 5.39% based on a bid of 20.85 and a limitMaturity.
CM.PR.E PerpetualDiscount -1.9876% Now with a pre-tax bid-YTW of 5.93% based on a bid of 23.67 and a limitMaturity.
RY.PR.B PerpetualDiscount -1.9859% Now with a pre-tax bid-YTW of 5.37% based on a bid of 22.21 and a limitMaturity.
DFN.PR.A SplitShare -1.9324% Now with a pre-tax bid-YTW of 5.06% based on a bid of 10.15 and a hardMaturity 2014-12-1 at 10.00.
IAG.PR.A PerpetualDiscount -1.7241% Now with a pre-tax bid-YTW of 5.34% based on a bid of 21.66 and a limitMaturity.
PWF.PR.E PerpetualDiscount -1.6586% Now with a pre-tax bid-YTW of 5.60% based on a bid of 24.31 and a limitMaturity.
FTU.PR.A SplitShare -1.6546% Now with a pre-tax bid-YTW of 6.53% based on a bid of 9.51 and a hardMaturity 2012-12-1 at 10.00.
GWO.PR.G PerpetualDiscount -1.6082% Now with a pre-tax bid-YTW of 5.49% based on a bid of 23.86 and a limitMaturity.
BMO.PR.H PerpetualDiscount -1.5873% Now with a pre-tax bid-YTW of 5.33% based on a bid of 24.80 and a limitMaturity.
PWF.PR.F PerpetualDiscount -1.5548% Now with a pre-tax bid-YTW of 5.46% based on a bid of 24.06 and a limitMaturity.
NA.PR.L PerpetualDiscount -1.5315% Now with a pre-tax bid-YTW of 5.55% based on a bid of 21.86 and a limitMaturity.
TD.PR.M OpRet -1.4313% Now with a pre-tax bid-YTW of 3.78% based on a bid of 26.17 and a softMaturity 2013-10-30 at 25.00.
CM.PR.J PerpetualDiscount -1.4272% Now with a pre-tax bid-YTW of 5.64% based on a bid of 20.03 and a limitMaturity.
RY.PR.W PerpetualDiscount -1.3091% Now with a pre-tax bid-YTW of 5.32% based on a bid of 23.37 and a limitMaturity.
MFC.PR.B PerpetualDiscount -1.2291% Now with a pre-tax bid-YTW of 5.22% based on a bid of 22.50 and a limitMaturity.
PIC.PR.A SplitShare -1.0731% Now with a pre-tax bid-YTW of 6.37% based on a bid of 14.75 and a hardMaturity 2010-11-1 at 15.00.
BAM.PR.K Floater -1.0718%  
BAM.PR.G Floater -1.0495%  
WFS.PR.A SplitShare -1.0050% Now with a pre-tax bid-YTW of 5.85% based on a bid of 9.85 and a hardMaturity 2011-6-30 at 10.00.
FBS.PR.B SplitShare -1.0040% Now with a pre-tax bid-YTW of 5.31% based on a bid of 9.86 and a hardMaturity 2011-12-15 at 10.00.
Volume Highlights
Issue Index Volume Notes
MFC.PR.B PerpetualDiscount 257,805 Now with a pre-tax bid-YTW of 5.22% based on a bid of 22.50 and a limitMaturity.
CM.PR.A OpRet 205,050 Now with a pre-tax bid-YTW of 0.89% based on a bid of 25.80 and a call 2008-2-16 at 25.75.
BMO.PR.J PerpetualDiscount 51,505 Now with a pre-tax bid-YTW of 5.50% based on a bid of 20.78 and a limitMaturity.
CM.PR.J PerpetualDiscount 34,894 Now with a pre-tax bid-YTW of 5.64% based on a bid of 20.03 and a limitMaturity.
PWF.PR.G PerpetualDiscount 34,080 Now with a pre-tax bid-YTW of 5.87% based on a bid of 25.00 and a call 2011-8-16 at 25.00.

There were thirty-two other index-included $25.00-equivalent issues trading over 10,000 shares today.

5 Responses to “January 17, 2008”

  1. […] Reversal of yesterday’s nonsense. […]

  2. […] Closed at 23.70-49, 5×6. Hasn’t anybody shot the market-maker yet? He deserves it. […]

  3. […] It should be noted, however, that these data were used using the breakeven rate. Assiduous readers will remember that the Cleveland Fed attempts to adjust the breakeven rate for other factors affecting TIPS pricing. Their data is updated only once per month, on the first … we will see shortly if there is some independent confirmation! […]

  4. […] even the worst day this year for the PerpetualDiscount sector … that honour belongs to January 17. Hmmm … 17th both times, eh? I wonder what a technical analyst would make of […]

  5. […] a means of Central Bank communication by Michael Woodford of Columbia, as discussed on PrefBlog on January 17, 2008. These are used to indicate the degree of uncertainty in […]

Leave a Reply

You must be logged in to post a comment.