Bombardier debt trading like it is investment grade again

What a difference a year makes for Bombardier’s (TSX: BBD.A, BBD.B) credit profile:

bbd

Their credit profile over the last year has improved considerably – they can now tap debt capital from the market at reasonable rates. Right now the closest comparable is the 8.5 year maturity for 8.5% yield.

The market is clearly believing that their solvency concerns are over. This would likely get cemented (and yields will compress even further) on successful deliveries of CS100/CS300 jets to their customers, of which two are already delivered and 356 are currently in the pipeline.

The more junior preferred share (TSX: BBD.PR.C) with a 6.25% coupon is trading at a current yield of 9% (eligible dividends), which should continue to go lower as confidence increases in the firm’s ability to be financially sustainable with the C-series. The rumours of the pending Learjet sale would also be an injection of capital if it did occur, but it does not appear that this is necessary, nor is the rumoured injection of capital by the Government of Canada (although this might occur to give future customers the impression that the government will not let the company fail).

The common equity remains pinned around CAD$2/share, and there is considerable overhang from the warrants issued from the two Quebec financings. I doubt that there will be cash dividends on the common shares until the turn of the next decade.

Selling volatility works, until it doesn’t

Since February, yields have compressed to the point where I am getting a bit suspicious that we are going to see some spreads widen again whenever we get some sort of credit event that will cause another round of financial distress. I am not forecasting when this will happen, but historically speaking, the lead-up to the presidential election always causes unwelcome volatility. Right now the assumption is that Hillary will win, but between now and the early November election date, things will change when the public actually starts to pay attention again to their two choices.

The markets, however, do not appear to indicate to price in much risk. Following is a chart of the VIX:

vix

The last time volatility got that low was back in the middle of 2014 (remember when oil was at US$100/barrel?).

Volatility is typically anti-correlated to positive price movement. Right now, investors that sell risk on the main index are not receiving much money for what is a piddling amount of yield – an at-the-money option sold a month out on the S&P 500 will only yield an investor about 1.1% on their at-risk amount, which is very, very, very low. Looking out nearly 5 months to mid-January, that same premium is 3.7%.

In the event of a market crash, an investment in put options not only profits due to the pricing differential between market and strike, but also due to the increase in volatility that occurs during turbulent markets. There’s probably never been a better time to invest in a potential market crash than right now, but the phrase that says markets can be calmer for longer than one can remain solvent applies.

Indeed, I am seeing many market prognosticators talk about skepticism of the existing market conditions, that the indexes (which are at all-time highs) are sputtering, that the economy recovery is long in the tooth, etc, etc. This does not bode well for crash conditions, which happen when there is stress and underlying causes to force entities to liquidate at all costs.

I can’t conceive what could cause crash conditions other than a major WMD event to the scale of a 9/11.

I still believe that a cautious approach is appropriate and that the market participants that will get the most out of the market will do so on the fixed income side. However, these opportunities I have noticed have basically vanished from the good risk/reward column to just ordinary. Ordinary valuations are good enough for me to hold onto things, but not nearly enough for me to invest in.

I was fortunate enough to fully participate in this market cycle, but in general at present, I am in a very slow liquidation mode as I do not see much worth investing in. There are a couple portfolio components (fixed income) that are trading at prices that are within 5% of me dumping it, but I am no rush for them to get there – I will keep collecting dividends, distributions and interest to pay down the very low interest margin debt. In general, I see about a maximum capital appreciation of about 15% in the remaining portfolio for still relatively low risk – even if the actual appreciation is zero, the weighted average coupon is 7.9% and I get paid to wait.

If we get some sort of spike that caused a general portfolio rise of 10%, I would have sold enough to have a healthy double-digit percentage cash balance. If this portfolio spike was 15% from present levels, the only things I’d be holding would be my bonds to maturity (unless if those too were trading ridiculously above par value). Then I would go on vacation and wait a long time.

Sometimes I am furiously active on trading, and sometimes there are very dull moments. The past few months have been very dull and I’ve been twiddling my thumbs. My investment strategies have been working and there will be a time to shift gears once my current strategy has run out of gas. Just not today.

An incorrect call made in the past – Whistler-Blackcomb

Everybody likes writing about their winners, but it is equally important to understand why failed predictions end up so.

Many, many, many years ago, I wrote about Whistler-Blackcomb’s (TSX: WB) IPO and about how I was quite leery about it.

With today’s acquisition offer by Vail Resorts, it should end this particular story – and was I ever wrong about the market valuation of the entity! WB went public in 2010 at $12/share, and they closed today at $36.63 a share, which would be about a 21% compounded annual gain for shareholders. I said when they got public “I might think about buying at $5.30/share”, but it never got close.

Why was I so incorrect with my projections? Putting a long story short, their resort operations ended up producing more profitable revenues than I originally anticipated, coupled with the fact that their capital expenditures remained below their ability to rake in cash flow – their net debt situation has been positive (i.e. net debt reduction) since they went public. With increasing profitability and decreasing financial leverage, I believe the partners of the Whistler-Blackcomb entity have done very well financially.

I never liked the fact that a good chunk of the publicly traded entity only represented a partial amount of the full operation – there was a huge amount of minority interest that would have siphoned a lot of economic upside. There were other residual risks (Whistler is quite developed as it is and there is significant political cost to further development in the area) that made me skeptical of the performance of the corporation. There was also the nagging feeling that the company was trying to cash out on the Vancouver 2010 Olympics.

The takeout price (a combination of roughly half cash, half stock in Vail Resorts) is higher than I would have ever expected such an offer to be. The acquisition is strategic in nature, so Vail Resorts should be able to achieve some sort of cost synergy with Whistler. That said, I’d be happy with the price received.

I have never owned nor shorted any shares of WB, and I am glad to have not!

Genworth MI Q2-2016 results review

Genworth MI (TSX: MIC) reported their 2nd quarter earnings results.

The results are reasonably positive for investors and a shade higher than what the market expectation would be.

Diluted book value per share goes to $38.23, up a dollar from the previous quarter (higher than net income minus dividends due to portfolio fluctuations).

Premiums written were $249 million, up significantly from $205 million in the Q2-2015, but this number was artificially higher due to the closing of the July 1, 2016 regulatory window for the issuance of portfolio insurance (i.e. future portfolio insurance issuances are likely to be significantly lower). Portfolio insurance written has been averaging about $24 million for the previous four quarters, but this quarter was $78 million. Transactional insurance (the type of insurance most people associate with mortgage insurance) was down 7% to $170 million.

Portfolio insurance has been quite profitable as the constituents of the loans are low loan-to-value ratio material – although the premiums received by the company are relatively low to the loans insured, these premiums are basically free money exchanged to entities so those other entities can free up the capital to make other loans. The government announced they were going to put a halt to this activity in the 2013 Budget as entities (e.g. HCG, EQB, etc.) were basically using government guarantees to increase their ability to perform higher amounts of mortgage lending. Now the lenders will have to take higher risk, which would potentially dampen the credit market for residential housing.

Other items of note include the following (quotations are from their MD&A):

The Company has reviewed the proposed methodology for calculating SCRIs and observed that Calgary, Edmonton, Toronto, Vancouver and Victoria would breach their respective prescribed SCRI thresholds at the end of the first quarter of 2016. These metropolitan areas represent approximately 35% to 40% of transactional new insurance written in the first six months of 2016.

Calgary, Edmonton and Vancouver would have been in breach of the prescribed SCRI thresholds since 2010 or earlier and are currently more than 15% above the respective SCRI threshold. The anticipated changes from the proposed new capital framework, including the proposed supplementary capital requirement may impact the regulatory capital requirements for the Company however the final impact will not be known until OSFI publishes the supplementary capital requirements. The Company expects that transactional and portfolio insurance premium rates may have to be increased for affected metropolitan areas as a result of the implementation of the new capital framework in 2017.

If the regulatory framework continues to tighten (i.e. more capital required for “hotter” markets), this would result in increased mortgage insurance rates and hence higher premiums written for future transactions – or perhaps premium surcharges for “hot” metropolitan areas. Not surprisingly, Vancouver is the epicentre of this.

During the quarter the Company entered into a $100 million senior unsecured revolving credit facility, which matures on May 20, 2019.

This was very mysterious. Genworth is solvent, their nearest debt maturity is not until June 15, 2020 ($275 million) and they have plenty of capital that they are using as a buffer until federal regulations are finalized. So why go through the bother to open up a credit facility? Odd.

(Update, August 3, 2016: Remarks were made in the conference call:

CFO: “It’s not earmarked at this time for any specific activity. It’s more in light of build-in financial flexibility to ensure that we’re nimble and whether this is core business opportunities in the MI business, for example, you saw the levels of bulk insurance as we did last quarter. If in the future other opportunities were to present themselves in our core business, and it require incremental capital, we certainly have long-term plans to fund that capital. We may use the facility for short-term need but it’s clearly not intended for a long-term portion of our capital structure.”)

The loss range for 2016 has been revised to 25% to 35%.

The company’s initial projections for losses were 25-40% for the year, but the upward range of this was lowered to 35%. For the first two quarters of the year the loss ratio averaged 22%. This is obviously a good sign for investors.

In order to help improve housing affordability, on July 25, 2016 the B.C. government introduced a four-pronged plan that includes an additional land transfer tax on foreign buyers. As of August 2nd, foreign individuals and corporations will be subject to an additional 15% land transfer tax on the purchase of residential property in Metro Vancouver. The company does not expect these changes to have a material impact on its business, as foreign borrowers are typically not eligible for high loan-to-value mortgage insurance.

I will parenthetically add that foreign buyers typically do not take out mortgages for properties either – these are cash payments as the real estate title is the vessel for storing cash offshore. Foreign investors would not have a requirement for mortgage insurance.

Also, delinquency rates have lowered from quarter-to-quarter. While Alberta and Saskatchewan have higher delinquencies, they have lowered significantly in Quebec. I would also estimate that the severity of the real estate market decrease in Alberta was less pronounced than projected.

Not everything is rosy, however. There are a couple other storm clouds worth noting:

1. The company has lost a considerable amount of money on its preferred shares. They have $49 million in unrealized losses as of the end of June on their preferred shares, which is down from $51 million at the end of March, but this is very sloppy pickings by their asset managers.

2. Private mortgage insurers are approaching a $300 billion cap:

The maximum outstanding insured exposure for all private insured mortgages permitted by the PRMHIA is $300 billion. The Company estimates, that as of March 31, 2016, the outstanding principal amount of insured mortgages under PRMHIA was $197 billion for Genworth-insured mortgages and $241 billion for all privately insured mortgages. While the federal government has increased the cap to ensure that the private sector can continue to compete with CMHC in the past as the total of the outstanding principal mortgage amounts has approached the legislative cap, there is no guarantee that this will continue. The Company estimates that the private sector will remain below the cap for the remainder of 2016 and the first half of 2017 based on the current market share of the private mortgage insurers and the forecasted size of the mortgage originations market.

The inability to capture more of the mortgage insurance market beyond $300 billion, needless to say, would be a negative – the company would have to run off the book and only acquire insurance at the rate that it expires. I am also not sure how Genworth would coordinate with the other private insurance company (Canada Guaranty) to collectively stay under the $300 billion mark. This is a line item that would need to be addressed in legislation, specifically the 2017 Budget, and I would not view the current government to be supportive of private industry in mortgage insurance markets.

Finally, I will observe that the company is unlikely to buy back shares or declare special dividends until such a point that the regulatory framework for capital holdings is solidified.

Overall, my conclusion still remains unchanged that Genworth MI appears to be somewhat undervalued at present (trading at 89% of book value, with a strong balance sheet and low loss ratios). The market is clearly pricing them lowly due to the increasing speculation of over-valuation of real estate pricing in Canada, in addition to the balance sheet issues faced by their parent company. Genworth MI appears to be very aware of the Canadian real estate issues at hand. As I have been long-since speculating, given the issues that are going on in the parent company (Genworth Financial), Genworth MI is a likely candidate to be taken over if Genworth Financial finds the correct (and willing) purchaser. The take-out price would most certainly be higher than the current market price.

Mortgage insurance concerns

The provincial government in British Columbia is trying to balance the politics of housing prices in the Greater Vancouver Regional District and the fact that housing and housing-related economic activity is our #1 source of economic activity.

The government knows that if they take policy decisions to snuff out the fire that is currently raging in real estate that they will collapse the economy into recession – our other industries (mining, forestry, oil and gas) have been withering away and this leaves real estate as our number one export.

Managing a “controlled landing” will be an interesting feat. I’m not sure whether the government can do it, but we will see!

CMHC released a report (July 27, 2016) confirming something almost anybody on the ground here knows: in real estate, there is “strong” evidence of problematic conditions in the Vancouver and Toronto regions of Canada.

This has implications for mortgage insurance. While rising prices is great for mortgage insurance (i.e. there is a much lessened chance for mortgage defaults), the residual concern is one of regression to the mean – if insurers write policies for people taking mortgages at the peak of pricing, insurers will have a considerable amount of downside exposure in the event there is a deep decrease in real estate pricing.

The last time that real estate prices fell for any significant period of time in the region was back in the early 1980’s:

June-2016-REBGV-Stats-1977-to-June-2016-Price-Chart-for-Vancouver

Interest rates at that time were in the double digits. Real estate from the beginning of 1981 to the end of 1982 dropped by about 40%, but you would never detect it by looking at the chart above – this is why stock charts use a y-axis that is logarithmic scaled, not linear like the one you see above.

Retail investment in long-dated fixed income securities

When I read headlines like the following: “Investors hungry for returns are piling in Canada long-bond ETFs at a record pace“, I’d start to get concerned if I held these instruments. Investing in long-term government debt at this time feels like return-free risk compared to just stuffing the cash underneath the mattress.

Canada 10-year government bonds are barely trading above a percent:

canada-10year

The US 30-year treasury bond exhibits a similar characteristic – yields have crashed:

tyx

The prototypical Canadian long-bond ETF is TSX:XLB and they have done reasonably well. Since long bond yields have plummeted, investors have seen capital gains.

This leaves a few questions. Will yields go negative in North America? How will pensions actually be able to realize their assumed 7-7.5% net returns when they have to maintain a bond allocation with a 1.1% YTM? How much has quantitative easing programs outside of our borders affected our bond yields? What effect will this have on our currency?

Lots of questions, but few answers. Instinctively, I’d rather want my cash in cash rather than long-term treasury bonds. This has not been a winning attitude, but unless if you’re anticipating negative yields like Western Europe, it is tough to imagine rates going lower from here on in.

US Presidential Election Update

The Republicans are having their national convention this weekend. Donald Trump will be nominated as their candidate for president, something that most pundits saw as a joke when he announced last year.

Readers should be cautioned that the national polling figures for the USA are nearly useless in determining the closeness of the presidential race. Three major states with huge populations, California, Illinois and New York, are very heavily Democratic-leaning and they will not be seriously contested during the election. These states will involve lop-sided victories and will skew the numbers.

Instead, readers should be looking at the following states (electoral votes in brackets):

Florida (29)
Pennsylvania (20)
Ohio (18)
Michigan (16)
North Carolina (15)
Arizona (11)
Wisconsin (10)
Iowa (6)


Click the map to create your own at 270toWin.com

 

Note it is very probable that Hillary Clinton requires 270 to win, while Donald Trump requires 269 to win.

I will be reverting my previous prediction of a “landslide” to a moderate victory for Donald Trump. As readers can infer from this map, the Republicans have much more “work” to do to win these swing states than the Democrats. That said, the nature of elections in Canada and the USA depend on a factor of voter turnout, something that polling does very poorly – the primary component of this assumption is that Trump has the ability to get out previous non-voters due to his non-political methods.

I will also state that I do not endorse the policies of either candidate. It is simply a prediction of what I believe will happen given what is going on in the USA political landscape. From a market investment perspective, it is likely the fruition of Donald Trump’s policies will cause considerable volatility in the markets and the markets are not sufficiently bracing for impact.

Re-examining Teekay Corp

Back in April 2016 I stated I invested in the unsecured corporate debt (January 2020) of Teekay Corp (NYSE: TK). Yields have compressed considerably since then:

tk-bonds

Part of this is due to a $100 million equity offering that was purchased by certain insiders, including the 37.7% holder Resolute Investments, Ltd. They paid US$8.32 for their shares which are trading at a market value of about $7.15 as I write this.

Teekay also significantly rectified a capital funding gap in their Teekay Offshore (NYSE: TOO) daughter entity with the issuance of preferred shares, conversion of preferred shares to common units, and other generally dilutive measures to their common unitholders. This will also involve TK with a higher ownership of TOO and the solving of TOO’s liquidity issue will serve to be positive to the payment of TK debt.

The last few trades of TK debt going on today (volume of roughly $400k par value) has been around 90 cents on the dollar, corresponding to a yield to maturity of about 12%.

What I expect to happen is the market will continue to normalize and ideally then we will see yields compress to result in above-par prices. In the meantime I get paid interest income. This is a reasonably heavy portfolio weighting.

Genworth MI update

I did not write an update to Genworth MI’s first quarter as it was relatively routine (albeit a slightly negative quarter in terms of premiums written). This decrease was due to the corporation being more conscious of what they were underwriting, in addition to slowdowns in oil-producing regions. Financially they continue to be wildly profitable, with a combined ratio of 42% and continuing to build book value (sitting at $37.23, about a 10% discount to market).

The company’s stock price has not gone anywhere over the past couple months:

mic

I look at peer companies, both in the financing and REIT domains and see nothing catastrophic occurring there.

There are a few interesting undercurrents that Genworth MI is facing, including:

1. Issues at the Genworth Financial parent company (this may result in financial pressure on their holdings – indeed, one scenario for Genworth MI is that they will be liquidated, hopefully at book or a premium to book value!);
2. The new Liberal government elected in Canada may introduce some curbs or regulatory burdens (via OFSI) which would encumber the insurance operation and/or empower CMHC;
3. Impact of oil prices and on the Alberta/Saskatchewan housing markets, although delinquencies have not risen beyond expectations to date;
4. The general insanity that can be found in the Vancouver/Toronto housing markets;
5. Provincial governments enacting curbs on transaction volumes and generally suppressing volumes that would otherwise stimulate the mortgage insurance market.

In addition, there are known regulatory changes concerning portfolio insurance transactions that were effective July 1, 2016 which would serve to decrease premiums received in what would be a fairly low-risk insurance market (such loans have loan-to-values ratios of less than 80%). Fortunately, these transactions have typically only been 10-20% of the premiums written in any single quarter.

About CMHC, they continue to deliver worse results than Genworth MI (quarterly reports for CMHC here) and their fraction of insurance covered in the Canadian market continues to decrease – a question remains whether they will attempt to take more market share, which would serve to deflate Genworth MI’s future premiums written.

With their present insurance book, as long as there is no general property market crash, they will continue to book revenues as mortgages are amortized and converge to at least book value. They also will be generating an excess of capital which management can decide to repurchase shares or declare a special dividend (which they typically do in the second half of the year). At present prices both are acceptable options although I really thought they should have bought back shares in January and February.

Genworth MI is still valued cheaply, but of course was not the screaming bargain it was when it was below $25 earlier this year. There is still capital appreciation yet to be had. In the meantime, shareholders are paid to wait.

Fixed income purchase

As alluded to in my last quarterly report, I have been looking for some fixed income securities that have relatively short durations, marginability, and with a credit risk profile of next to nothing, yet maximizing yield.

Late last month I purchased a secured corporate bond. The debt is the only issue outstanding of the issuer and it was purchased at a mild discount to par. The underlying issuer obtained a credit rating for the debt and it is in the B’s. The issuer itself has a cash balance that is about 40% higher than the amount of debt outstanding. It is also profitable, generating cash flows, and has been doing so for quite some time. There is no good reason to believe that these cash flows will materially change between now and maturity. The debt is covenant restricted, only enabling the issuer to repurchase equity linked to the amount of income it produces. Not surprisingly, the company in question has been repurchasing their debt on the open market at a discount to par.

Yield to maturity that I received on my purchase: 10.0%.

I am not sure who was asleep at the switch as I did get the bonds at the bid, in a size that was sufficient to make me happy. Quite frankly I was surprised to see the trade executing.

The funny thing here is that the capital that I am required to lock up for the next few years (the maintenance margin is approximately 50%) will actually decrease my long-term performance figures, but in terms of the risk/reward ratio, this investment is a slam dunk. I am not aiming for the best returns, I am aiming for the best risk/return ratio.