May 16, 2014

Here’s a straw in the wind:

This was supposed to be a tough year for fixed income. But so far it is turning out very differently. The bond bears are suffering. Global fixed income assets have returned 4.1 per cent in the year to date, compared with 2.5 per cent for global equities, according to Bank of America Merrill Lynch. And there is probably more pain in store for asset managers who are under-invested in debt.

Inflation is persistently low and central banks are determined to keep monetary policy accommodative. The European Central Bank is likely to ease in June. And the U.S. Federal Reserve and the Bank of England are proving more dovish than expected. Investors are pushing their timing for the first hike in official rates a few months further into the future.

But, as usually happens, there’s another straw in the wind:

These bond bears just won’t go away.

Some even appear to be doubling down as their losses mount.

Exhibit A: As the ProShares UltraShort 20+ Year Treasury (TBT) fund plunged 21.6 percent this year, investors have responded by plowing $525.3 million into the exchange-traded fund, which uses leverage and derivatives.

Exhibit B: Investors have boosted short wagers on Treasuries using futures contracts trading on the Chicago Board of Trade to 56 percent more than their five-year average. A few weeks ago, there were the most since March 2008.

As I mentioned on May 13, Rob Carrick recently wrote a piece titled GICs beat laddered bond ETFs, hands down, to which I took some exception; what I didn’t mention was that I repeated my remarks in the comments section and waited to see what would happen. Well, it turned out to be a long drawn-out argument with a guy who’s really swallowed the Kool-Aid: GIC ladders are always best and anybody who doesn’t agree is either stupid or paid. He referred to a Financial Post piece by a stockbroker which isn’t very interesting: it boils down to ‘Don’t time the market’, but while searching for it I stumbled across a more interesting piece by Jane Bryant Quinn, a well regarded US financial journalist who takes another view: Seven Reasons Why Bond Ladders are Bad for Investors.

1. Bond ladders deprive you of current income. The money you put into individual bonds pays you an income at a fixed rate. When rates in the marketplace go up, your income will stay the same. In a bond mutual fund, by contrast, the managers will be adding higher-rate bonds to the pool. Your interest income – and spending money – will increase.

Well, sure. A bond fund will – normally – trade more than any individual investor, both because more issues are held, because frictional costs are so much less, and because many PMs feel that if they don’t fiddle with portfolio often enough they’ll get fired. But I do not accept this as a point in favour of funds because (i) it only considers the case in which yields rise – income will be adversely affected when yields fall, and (ii) it is therefore a market-timing argument and (iii) one purpose of Fixed Income is to FIX your INCOME and volatility of income is, if anything, to be deprecated.

2. Bond ladders often force you to reinvest at lower rates. If you’re not spending the interest income you get from individual bonds, you need to reinvest it. What are you doing with that money? It might not be enough to buy more than one or two bonds, at a high commission cost. If you want that money to be readily available, you’ll siphon it into a money market fund whose interest rate is kissing zero.

In a bond mutual fund, by contrast, you can reinvest all your interest income in new shares, at the market’s current, higher yields. In other words, you’ll be buying more shares at a lower price. When interest rates decline again, the value of your bond fund shares will rise. You’ll have more shares than you started with, which means more dollars in your pocket.

I’ll agree with her on this one. I alluded to the problem when I spoke to John Heinzl about Why only millionaires should invest in bonds directly

3. Bond ladders deprive you of future capital gains. When you hold individual bonds and interest rates decline, your bonds will rise in market value. They’ll be worth more than you paid for them. But in ladders, you hold to maturity so you’ll never collect the capital gains. In a mutual fund, the manager will harvest those gains and add them to the value of your shares.

On the face of it, this is nonsensical. Assuming the only difference between the bonds is the coupon, then the yields to maturity should be the same (and this is usually basically true), therefore there’s nothing to be gained by executing the swap.

It gets more interesting when taxes are taken into consideration. I considered the case of a 6% bond maturing 2024-5-16, exactly ten years hence. At a yield of 3%, it trades at 125.753. We hold 10MM face value of these, with a book value of par, because we bought them at issue ten years ago. So, what should we do?

  • Hold them, getting $600,000 interest annually and paying tax on that? Or
  • Sell them, pay the capital gains tax, buy 12.5753MM of 3%-coupon bonds trading at 100.00, get $377,259 in interest annually and pay tax on that?

Pre-tax, the MS-Excel XIRR function returns a value of 3.01974% Internal Rate of Return for the 6% coupon and 3.01985% IRR for the 3% coupon.

After tax, the values of 0.91590% is returned for the 6% coupon and 1.38098% for the 3% coupon – so it’s clearly in the investor’s interest to execute the swap.

Purists will notice that there is a negative cash flow after tax in 2015, since there’s a tax bill of $590,511 compared to interest income of $377,259, but purists can go jump in the lake, since I’m assuming taxes are paid from other resources (i.e., by the investor, not the fund). I used tax rates of 40% for income and 20% for capital gains, by the way. Purists will also be quick to inform me that the duration of the 3% bond is significantly higher than that of the 6% bond, 8.71 vs. 7.95, so I really should be swapping into a weighted combination of Bills and the 3% (about 91% bonds, 9% bills) … purists can do their own damn calculations.

So on point (3) we’ll award Ms. Quinn part marks: she is correct, but only for taxable accounts, only if the PM actually executes the swap and only if there’s differential taxation on capital gains (when I change capital gain taxation to 40%, the same as income, the Swap Scenario yields 0.95643%, which, to be fair, is 4bp more than the Hold Scenario as long as the swap isn’t duration neutral.

4. Bond ladders carry more default risk. Individual investors might hold no more than 10 or 20 bonds. If one of them goes bad, it could take a mean slice out of your portfolio. Ladders should be built only with high-quality bonds but – in municipals, especially — you never know when a snake is hidden in the underbrush.

Mutual funds are far better diversified, owning hundreds, even thousands of bonds (Vanguard’s Intermediate-Term Tax-Exempt fund holds 4,641 of them). Like ladders, the bonds come in varying maturities, from short to long.

This is phrased badly (the default risk is the same for both the ladder and the fund; but the ladder’s default risk is more concentrated), but is true. It only applies to corporate bonds, though; there will be some who will compare only GICs and Canadas.

5. Bond ladders leave you unprepared for emergencies. Sometimes, you can’t hold individual bonds to maturity. You might have unexpected medical bills or one of your kids might need some cash. You might have inherited the bonds and want to convert them into cash. Selling bonds before maturity is more expensive than you imagine. If interest rates have risen, their market value will be down – especially for small, retail lots. The markets trade in amounts of $100,000 or more, and clip 2 to 3 percent off the price if you’re selling just 25 or 30 bonds. You pay your broker a sales commission. And, after the sale, you don’t have a ladder any more – one or more of the rungs is gone.

With a mutual fund, on the other hand, you can sell shares at any time and at no cost if you have a no-load fund. The remainder of your investment will be just as diversified as it was before.

Spot on, this is a very compelling argument against ladders. As I pointed out in my discussion in the Globe comments, an investor seeking to have $X annual liquidity out of a five year ladder must invest $5X – and even then, the funds are only available between maturity and reinvestment. There is therefore the potential where the investor could be simultaneously short of liquidity and over-invested in short-term securities. This is less important if the ladder has marketable rungs than if it’s in GICs.

6. Bond ladders are expensive. You’ll probably work with a broker to set one, paying 2 percent in markups, at retail price. The ladders have to be managed, meaning more sales commissions. A no-load mutual fund, by contrast, charges no commissions and costs only a small amount per year in management fees – at Vanguard, about 0.2 percent. Also, funds buy their bond at institutional prices, which are much lower than the price you pay in the retail market.

Ms. Quinn gets part marks for this one. Is it better to pay X% in markups on 1/N of your portfolio every year (where N is the number of rungs in your ladder)? Or is it better to pay Y% on all of your portfolio every year? This will depend on the relative values of X and Y, on the value of N, and how fussy you are about maintaining a precise ladder – if you buy corporate bonds as new issues, you’ll pay less mark-up, but you’ll be lucky to get the next rung of your ladder within three months of where you want it. And – my antagonist in the Globe’s comments section will be quick to point out – there’s no commission on GICs and those are available as new issues on demand. But I don’t recommend GICs for ladders anyway.

7. What about other kinds of ladders? Ladders built from certificates of deposit instead of bonds face many of the same drawbacks: No increase in income when interest rates rise and a penalty if you’re forced to sell before maturity. The same is true of ladders build from Treasury securities. But there’s no default risk and you don’t have to pay sales commissions (for Treasuries, you’d have to build the ladder yourself, using Treasury Direct).

No marks for this one, I consider it at best a duplication of the first six points.

Ivo Krznar and James Morsink wrote an IMF working paper titled With Great Power Comes Great Responsibility: Macroprudential Tools at Work in Canada:

The goal of this paper is to assess the effectiveness of the policy measures taken by Canadian authorities to address the housing boom. We find that the the last three rounds of macroprudential policies implemented since 2010 were associated with lower mortgage credit growth and house price growth. The international experience suggests that—in addition to tighter loan-to-value limits and longer amortization periods—lower caps on the debt-to-income ratio and higher risk weights could be effective if the housing boom were to reignite. Over the medium term, the authorities could consider structural measures to further improve the soundness of housing finance.

I have to admit to some astonishment that they are advocating increased micro-management rather than simply capping the amount of mortgage insurance offered.

Most loans are five-year fixed-rate mortgages that are rolled over into a new five-year fixed rate contract for the life of the loan (typically 25 years) with the rate renegotiated every five years. In the case of variable-rate mortgages (which are less prevalent), the monthly payment is typically fixed, but the fraction allocated to interest versus principal changes every month with fluctuations in interest rates. Longer-term fixed rates were phased out in the 1960s after lenders experienced difficulties with volatile interest rates and maturity mismatches.

I didn’t know that about the ’60’s. I consider the whole 5-year-term thing to be not just outrageous, but probably also linked to the CDIC rules on insuring deposits with a maximum term of five years. I’d like to see that increased (with an extra premium being charged to the banks for longer dated deposit insurance), but the feds seem intent on destroying the market for long-dated bank paper with the forthcoming bail-in rules.

Insured mortgage loans have lower risk weights than uninsured loans. CMHC-insured mortgages have a capital risk weight of zero under the standardized approach and an average risk weight of about 0.5 percent under the internal ratings based (IRB) approach, reflecting the fact that CMHC obligations are considered sovereign exposures.

This is an insidious and under-recognized consequence of CMHC insurance. Not only are the banks laying off their actual business risk when they insure, they’re also reducing their regulatory capital requirement.

Limits on government-backed mortgage insurance and CMHC securitization: The government has announced plans to prohibit the use of government-backed insured mortgages in non-CMHC securitization programs, plans to limit the insurance of low-LTV mortgages to those that will be used in CMHC securitization programs, and limits on CMHC securitization programs. In addition, CMHC is now required to pay the federal government a risk fee on new insurance premiums written.8 It has also announced that it will increase mortgage insurance premiums by about 15 percent on average for newly extended mortgage (for all LTV ranges), effective May 1, 2014.9

Limiting the amount issued and auctioning it off to the highest bidder would be way too simple. A very major shortcoming of this paper is that they do not examine, or even list, the growth in CMHC outstanding (although they do show the growth rate from 2006 on).

Over the long run, the authorities could consider the possibility of eliminating the government’s extensive role in mortgage insurance. In this regard, Australia’s experience is relevant. Australia’s mortgage insurance system before 1998 was similar in important respects to Canada’s current system. A government-owned mortgage insurance company, the Home Loan Insurance Corporation (HLIC), was created in 1965. By the early 1990s, HLIC had a market share of about 55 percent.28 The mortgage market was operating efficiently and private sector mortgage insurance was well established, competitive, and available at reasonable cost. In December 1997, the government decided that it was no longer necessary for the government to play a direct role in mortgage insurance and passed legislation to allow for the privatization of HLIC. GE Capital (now Genworth) subsequently purchased the company and entered the Australian mortgage insurance market. Australia provides an example of the development over time of a well established private-sector mortgage insurance industry that alleviates the need for public sector involvement, with the associated risk to the government’s balance sheet stemming from the government insuring most of the mortgages in the country.

I like this idea. I didn’t know this about Australia. ┴ɥosǝ ∀nssᴉǝs oɟʇǝu ɥɐʌǝ ƃoop ᴉpǝɐs; qǝᴉuƃ ndsᴉpǝ poʍu ɯnsʇ ɥǝld ʇɥǝ ɟloʍ oɟ qloop ʇo ʇɥǝ qɹɐᴉu˙

LTV
Click for Big

RWA
Click for Big

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts down 28bp, FixedResets off 13bp, but DeemedRetractibles managed to eke out a gain of 1bp. Volatility picked up; the list is comprised entirely of losers. Volume was extremely low, presumably due to the long weekend, as those of us employed in the best-compensated industry on the planet can’t be bothered to do a full day’s work before a long weekend.

HIMIPref™ Preferred Indices
These values reflect the December 2008 revision of the HIMIPref™ Indices

Values are provisional and are finalized monthly
Index Mean
Current
Yield
(at bid)
Median
YTW
Median
Average
Trading
Value
Median
Mod Dur
(YTW)
Issues Day’s Perf. Index Value
Ratchet 0.00 % 0.00 % 0 0.00 0 0.0703 % 2,472.3
FixedFloater 4.53 % 3.77 % 33,534 17.87 1 -0.1430 % 3,786.5
Floater 2.95 % 3.07 % 51,550 19.51 4 0.0703 % 2,669.4
OpRet 4.38 % -7.55 % 34,782 0.13 2 0.0779 % 2,711.6
SplitShare 4.79 % 4.28 % 61,786 4.16 5 0.0237 % 3,099.9
Interest-Bearing 0.00 % 0.00 % 0 0.00 0 0.0779 % 2,479.5
Perpetual-Premium 5.51 % -9.72 % 98,009 0.09 15 -0.0495 % 2,404.8
Perpetual-Discount 5.30 % 5.29 % 113,076 14.91 21 -0.2781 % 2,546.9
FixedReset 4.54 % 3.48 % 203,897 4.26 75 -0.1339 % 2,557.9
Deemed-Retractible 4.97 % -4.10 % 143,410 0.11 42 0.0142 % 2,526.5
FloatingReset 2.65 % 2.35 % 139,777 4.18 6 -0.0659 % 2,493.4
Performance Highlights
Issue Index Change Notes
SLF.PR.G FixedReset -2.08 % YTW SCENARIO
Maturity Type : Hard Maturity
Maturity Date : 2025-01-31
Maturity Price : 25.00
Evaluated at bid price : 23.10
Bid-YTW : 4.14 %
MFC.PR.F FixedReset -1.87 % YTW SCENARIO
Maturity Type : Hard Maturity
Maturity Date : 2025-01-31
Maturity Price : 25.00
Evaluated at bid price : 23.60
Bid-YTW : 3.90 %
FTS.PR.F Perpetual-Discount -1.41 % YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2044-05-16
Maturity Price : 23.57
Evaluated at bid price : 23.85
Bid-YTW : 5.14 %
BAM.PR.X FixedReset -1.36 % YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2044-05-16
Maturity Price : 22.14
Evaluated at bid price : 22.55
Bid-YTW : 4.03 %
IFC.PR.A FixedReset -1.10 % YTW SCENARIO
Maturity Type : Hard Maturity
Maturity Date : 2025-01-31
Maturity Price : 25.00
Evaluated at bid price : 24.28
Bid-YTW : 4.08 %
FTS.PR.J Perpetual-Discount -1.09 % YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2044-05-16
Maturity Price : 23.26
Evaluated at bid price : 23.59
Bid-YTW : 5.03 %
Volume Highlights
Issue Index Shares
Traded
Notes
NA.PR.L Deemed-Retractible 76,970 TD crossed 75,000 at 25.35.
YTW SCENARIO
Maturity Type : Call
Maturity Date : 2014-06-15
Maturity Price : 25.00
Evaluated at bid price : 25.32
Bid-YTW : -10.21 %
ENB.PR.B FixedReset 62,579 TD crossed 37,200 at 24.68.
YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2044-05-16
Maturity Price : 23.22
Evaluated at bid price : 24.59
Bid-YTW : 4.00 %
ENB.PR.N FixedReset 33,080 YTW SCENARIO
Maturity Type : Call
Maturity Date : 2018-12-01
Maturity Price : 25.00
Evaluated at bid price : 24.98
Bid-YTW : 4.00 %
IFC.PR.C FixedReset 31,800 RBC crossed blocks of 11,100 and 11,500, both at 26.00.
YTW SCENARIO
Maturity Type : Call
Maturity Date : 2016-09-30
Maturity Price : 25.00
Evaluated at bid price : 25.82
Bid-YTW : 3.00 %
BNS.PR.Z FixedReset 29,366 TD crossed 14,000 at 24.70.
YTW SCENARIO
Maturity Type : Hard Maturity
Maturity Date : 2022-01-31
Maturity Price : 25.00
Evaluated at bid price : 24.64
Bid-YTW : 3.40 %
BNS.PR.Y FixedReset 23,442 TD sold 10,000 to anonymous at 24.50.
YTW SCENARIO
Maturity Type : Hard Maturity
Maturity Date : 2022-01-31
Maturity Price : 25.00
Evaluated at bid price : 24.40
Bid-YTW : 3.14 %
There were 11 other index-included issues trading in excess of 10,000 shares.
Wide Spread Highlights
Issue Index Quote Data and Yield Notes
BAM.PR.X FixedReset Quote: 22.55 – 22.99
Spot Rate : 0.4400
Average : 0.2658

YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2044-05-16
Maturity Price : 22.14
Evaluated at bid price : 22.55
Bid-YTW : 4.03 %

PWF.PR.A Floater Quote: 19.80 – 20.30
Spot Rate : 0.5000
Average : 0.3296

YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2044-05-16
Maturity Price : 19.80
Evaluated at bid price : 19.80
Bid-YTW : 2.66 %

SLF.PR.G FixedReset Quote: 23.10 – 23.55
Spot Rate : 0.4500
Average : 0.3001

YTW SCENARIO
Maturity Type : Hard Maturity
Maturity Date : 2025-01-31
Maturity Price : 25.00
Evaluated at bid price : 23.10
Bid-YTW : 4.14 %

MFC.PR.F FixedReset Quote: 23.60 – 23.94
Spot Rate : 0.3400
Average : 0.2192

YTW SCENARIO
Maturity Type : Hard Maturity
Maturity Date : 2025-01-31
Maturity Price : 25.00
Evaluated at bid price : 23.60
Bid-YTW : 3.90 %

IFC.PR.A FixedReset Quote: 24.28 – 24.65
Spot Rate : 0.3700
Average : 0.2528

YTW SCENARIO
Maturity Type : Hard Maturity
Maturity Date : 2025-01-31
Maturity Price : 25.00
Evaluated at bid price : 24.28
Bid-YTW : 4.08 %

BAM.PR.G FixedFloater Quote: 20.95 – 21.38
Spot Rate : 0.4300
Average : 0.3197

YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2044-05-16
Maturity Price : 21.56
Evaluated at bid price : 20.95
Bid-YTW : 3.77 %

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