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:


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


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


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:


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:


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.

Bombardier Bond Yield Curve Update


Investors increasingly are finding the 2018 and 2019 debt maturities to be “easy money”, while the middle and long-range part of the debt curve are relatively untouched from a month and a half ago.

Preferred share yields today for floating rate preferreds (TSX: BBD.PR.B) is roughly 8%, while on the fixed-rate (TSX: BBD.PR.C and BBD.PR.D) they are roughly 9%. Yields have compressed over the last month and in the humblest of my opinions, have room to compress further.

Q2-2016 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the second quarter of 2016, the three months ended June 30, 2016 is approximately +18.3%. The year-to-date performance for the six months ended June 30, 2016 is +33%.

Portfolio Percentages

At June 30, 2016:

44% common equities
26% preferred share equities
52% corporate debt
-21% cash

Percentages do not add to 100% due to rounding.

USD exposure: 38%

Portfolio is valued in CAD;
Equities are valued at closing price;
Values include accrued corporate bond interest, but not that from Canadian exchange-traded debentures;
Corporate debt valued at last trade price.

Portfolio commentary and outlook

Back in February 11, 2016, I wrote the following:

I do have a general rule and that is whenever [financial market panic] hits the headlines of mainstream publications, it is likely closer to the 9th inning of the ballgame rather than the beginning.

The environment right now is once again reminding me of something like mid-2008 when everything is all panicky. Bargains that have good potential for double-digit appreciation are hitting the radar in huge frequency.

Just like what I did in 2008-2009, I listened to my own advice and started deploying some cash, for dramatic effect.

This quarter can only be described as insanely positive. It was a quarter where nearly everything worked. In relation to risk, the portfolio achieved returns that were far greater than anything ever done before since the 2008-2009 financial crisis (recall that 2009 was a year where I made +104% on my portfolio, an achievement that is not likely to be surpassed in my lifetime, but in my rational estimate there was more risk taken to achieve that return).

When everything is working, there are a couple attitudes:

1) Why change direction? Why not stick with a proven strategy?
2) Keep cautious, as something that works in the markets during one time period may not work in another time frame.

I am always of the #2 mentality, but apply discretion to “let winners run”. And indeed, I am letting my portfolio run.

The actual risk exposure of the portfolio is significantly less than what the asset allocation fractions above would suggest. The corporate equity portfolio consists entirely of companies that are trading under tangible book value and all of those entities are producing positive cash flows (with the exception of Genworth Financial (NYSE: GNW), where their LTC portfolio is going to be a huge negative cash drain, but financial challenge is to calculate how much of their asset base will go out the window to pay for future claims). GNW is a small equity holding.

I would not expect to liquidate any of these equity securities until they have appreciated further than present, but even then, I only like to sell when they are above my fair value band rather than at fair value.

The preferred share securities and corporate debt securities are higher up on the capital structure and for each and every of these investments I am expecting to be paid dividends or interest. In the case of the debt, my credit risk is mitigated with either security or functional first-in-line subordination status (i.e. little in the way of further senior or secured liabilities). There are a couple long-shot, distressed debt securities in the portfolio, but these have been kept to less than 1% position limits.

A notable debt highlight is Pinetree Capital (TSX: PNP) had their senior secured debentures mature on May 31, 2016 for cash, which ended a huge saga of the previous management’s inability to manage the balance sheet. I had actually liquidated most of these holdings at 101 cents before the rights offering was announced since my calculations showed that a cash maturity was going to be very tight (and indeed, if the rights offering did not come through that they likely would have had to go into CCAA to give them time to pay off debtholders with a mostly illiquid private asset portfolio). I wish Peter Tolnai, the new CEO and indirect 31% owner, the best of success in trying to unlock the value within the corporation’s huge pool of un-utilized capital losses. You can read the whole saga from November 2013 to May 2016 at this link. I expect things to be a lot more calm with Pinetree Capital in the future, except for them probably changing their company’s name to finally turn the page. I will disclose a very small equity holding by virtue of the January debenture redemption, which gave debtholders some shares.

For my fixed-income securities (bonds and preferreds), my yield at cost was in the low double-digits for something I consider to be between very low to low risk investments, despite the fact that such securities were trading at what I considered to be distressed price levels. The current yield of this basket of securities has decreased since purchase because of price appreciation (and will continue to drop because of rate-resets occurring over the next 12 months), but there is still room to run.

The beauty of debt securities is that I can fall into a coma and when I wake up, I very likely will have interest and principal deposited into my brokerage account. I do not have to take any action unless if I have a good reason to sell (which would likely be the securities trading above par value at a point where the call risk becomes meaningful). The preferred share securities are a different story – they have to be somewhat more actively monitored for both credit risk purposes and also if they are at a point where they have appreciated enough that their current yields are inferior to a superior alternative, measured from a risk-reward ratio. Due to the considerably low 5-year government bond rate, the rate-reset mechanisms of most preferred shares have taken their value well below the range where there is call risk so it is very likely that if I woke up from such a hypothetical coma, these shares will still be in the portfolio spinning away cash.

I do not have a good feel for the intermediate interest rate environment other than that there is continued downward pressure from the capital that is awash out there as a result of central bank liquidity. Let’s pretend you were given a trillion dollars with the provisio that you’ll have to pay it back in a decade – the easiest no-brainer is to dump it into US treasury securities and skim a few bucks of interest income. Enough players doing this will depress yields and then eventually pensions and institutions become so risk-adverse to the equity side that they invest in negative-yield securities like they are doing in Europe. Something is terribly amiss in the finance world, but it is tough to tell how this will play out.

It is ironic, however, with negative yields that a real cheap way for governments to pay down their sovereign debts is by issuing more negative yield debt. Forget about inflation for now!

Economics Sermon

The following few paragraphs are some of my opinions on economics. Please realize that I did not take more economics classes than Economics 100 when I was in university.

With all of these bits of paper (dollars and Euros) floating around, eventually it needs to be spent on something in order to realize their value – currency is about trading a unit of economic storage (dollars, gold coins, sea shells, bitcoins or whatever) into something tangible (planes, trains, automobiles, or the servitude of lawyers, accountants, engineers and management consultants). Optionally, if you don’t want to spend it on something today, you can put it into future claims (stocks, bonds) where you can then buy the tangible goods. This explains the rise in asset values, but not why we haven’t seen general inflation increases in tangible products.

Presently, the world is finding it quite difficult to spend money on the products, but is finding it much easier to spend on the entertainment components – explaining why service prices and the cost of specialized labour is going up much more than product prices – a product can be mass-produced a billion times over with reasonable economies of scale, but services that cannot be automated are ultimately supply-constrained by those that can practice it – and the price of this is skyrocketing above the ambient inflation rate.

So when published reports of GDP come out, it is important to distinguish between “stuff” and “non-stuff” components.

My general theory is that it will take some sort of world war, or massive natural disaster to spur “stuff-related” (i.e. physical production) related inflation. The big exception is the price of energy – while being eroded away by significant technological advances in solar power, I still do not see fossil fuels being displaced until well into the middle to end of the 21st century. The basic story is that people can only consume so much garbage and we are exceptionally efficient at mass-producing garbage, well beyond our ability to consume it. Just take a look inside a Walmart or Costco.

That ends my economic sermon for the quarter.

Quarterly Transactions

This quarter was also very bi-polar in terms of trading – most of the transactions were performed in April, while May was dormant and June had a couple transactions – one was a significant addition of an existing portfolio component, while the other was a new position in a corporate bond that should be an “easy” 10% yield to maturity.

Another bond purchase that happened earlier was my purchase of Teekay Corporation unsecured debt (maturing January 2020), which was purchased at a significant discount to par (link to article here). At my cost level, this will most likely provide the portfolio with a near 20% yield to maturity with a lot of bad news that would have to occur in order for a payout to not happen.

There were some other transactions that took place, but I do not feel like disclosing them at present.

Cash and Margin

The portfolio right now is utilizing a large amount of margin for the first time in many years. The cost of capital is extremely cheap, and is collateralized by certain fixed-income investments that give off increased cash flows than the floating rate interest expense.

On paper, it makes logical sense – invest at something with a 10% yield, and if this is financed with a 2%, 1.5% or 1% margin loan, you can skim the yield, earning 8%, 8.5% or 9% pre-tax yields, respectively. With most equities you can get at least 2:1 leverage (i.e. put up $10k to purchase $20k of stock) and bonds that have any sort of credit rating can be purchased with leverage.

It is finance 101 speaking: To convert a 5% yield into a 5%+X return on equity, you just need to use leverage that costs less than your yield. The bigger the differential between your yield and your cost of leverage, the less leverage you need to employ. Indeed, an investment that offers a “guaranteed” 5% yield that is financed with a 4.9% fixed rate loan can magically turn into a 10% return on equity with a hundred times of financial leverage – as long as you can find an institution willing to give you this leverage at the desired rates.

These sorts of products are structured and securitized and sold on the open market. You can even invent entire corporations that have a sole purpose of doing this in life. See (TSX: EQB) for an example. There are ETFs out there that will also employ such strategies with junk debt.

In practice, there are a few relevant issues, including doing this at an individual level:

1) The price of whatever you are investing in may fluctuate and you may be forced into a spontaneous liquidation scenario if you are too aggressively leveraged (and those sales will be at the most adverse prices). These fluctuations may happen for company-specific or general macroeconomic concerns and be well beyond your control to mitigate. The macroeconomic stuff you can’t really have control over but the company-specific concerns can be mitigated through diversification;
2) Interest rates might rise, killing the entire market. This can be mitigated somewhat with shorter duration investments, but you will have adverse impact on fixed-income streams as a result of a rise in rates;
3) Margin requirements might change, increasing the “stress point” where you get into a liquidation danger zone;
4) Leverage causes psychological stress and also by definition, does not allow you to take advantage of better price opportunities in the future (i.e. you can only take advantage of market opportunities by going further into leverage).

The most important consideration is:

5) Every single institution on this planet is trying to do the same thing and you are competing against them for exactly the same perceived low-risk, high-yield return on investment.

I am painfully aware that general funds flows are going into the corporate debt market, and this generally means that bond trading is going to get crowded. It is also very difficult to buy at the bid and sell at the ask for corporate bonds, although liquidity spreads on issues (such as Bombardier) are remarkably narrow (about a penny on average). Still, one cannot flip bonds around like one can with much more liquid equities.

In order to achieve outsized returns, one must always compete in marketplaces with less eyeballs and less capability for algorithimic investors to do their magic – and I do find that there have been some opportunities in the bond space as of late.

I will not go overboard doing this, however. The investment climate is not stressed enough and I generally prefer to make my investments in times of stress, such as what prevailed earlier this year and during Brexit.

Most of the retail market (at least locally here in the Greater Vancouver region) is getting into this game in the form of residential real estate – banks will give you money at 2.5%, you go buy a house with 20% down, and voila – you’ve leveraged yourself 4:1 on an asset. As long as your piece of real estate appreciates higher than 2.5% a year net of (not insignificant) carrying costs, you’re golden.

The leverage game usually (but not always) ends badly – the 2006-2008 blowup in the US residential real estate market was a great example. But a more modern example is with oil and gas producers that simply tried to squeeze too much juice out of their balance sheets – LINN Energy, Ultra Petroleum, Magnum Hunter, Sandridge Energy, etc. On the Canadian end we have a bunch of others, including some that are in the palliative care unit (best example is the company formerly known as PetroBakken, Lightstream Resources (TSX: LTS)). A lot of these oil companies are profitable, but they just ended up leveraging too deeply and financing brought them down.

Canadian Dollar vs. US Dollar thoughts

My USD allocation has crept up somewhat, but this due to appreciation of US-denominated holdings relative to the Canadian holdings. There were some minor purchases of US currency in the quarter which also added to the percentage. My policy with currency is to not pay too much attention to it other than keeping it at a band roughly between 30-70% CAD/USD. Appreciating Canadian dollars from the beginning of the year dragged portfolio performance somewhat, but this quarter the Canadian dollar was about the same. I have no big prognostications on the fate of the Canadian dollar and consider a 50/50 equilibrium to be perfectly satisfactory. I may change my opinion if the currency swings beyond 70 or 90 cents.

Anticipated future returns

In terms of future returns, I do not anticipate that my portfolio will achieve anywhere close to the returns that were achieved in the first half of this year – a stunning 33% year to date, most it achieved from March onwards. Still, if the prices of the assets in the portfolio march up to what I consider to be a fair value, there is a double-digit percentage that can still be realized and hence I am not particularly inclined to rapidly hit the sell button. Indeed, even if asset prices went nowhere over the quarter, the current yield alone would represent a passive gain of about 8% annualized with low risk, a lot better than sticking it in a zero-risk, 1% GIC.

Portfolio - 2016-Q2 - Historical Performance

Performance and TSX Composite is measured in CAD$; S&P 500 is measured in US$. Total returns indices are with dividends reinvested at time of receipt.
YearDivestor PortfolioS&P 500 (Price Return)S&P 500
(Total Return)
TSX Comp. (Price Return)TSX Comp.
(Total Return)
10.5 Years (CAGR):+16.47%+5.07%+7.26%+2.13%+5.09%

Brexit – Impact

Market volatility has been high leading up to and including after the Brexit referendum results. The VIX has climbed up to around the 25 level which is above the average ambient temperature of 15, but not ridiculously high (last August, for example, there was a spike up to 50 and I’m struggling to remember what calamity was the order of that day).

The UK exiting from the EU causes uncertainty in the minds of money managers. Whenever uncertainty is high, the natural desire is to raise cash and reduce portfolio risk, so futures get sold. This triggers automatic liquidations of underlying equities and debt portfolios, which leads to broad-based asset price decreases as the liquidations occur. There also may be some margin liquidation going on for more over-leveraged players.

Eventually this vicious cycle ends – the trick is anticipating when the vicious cycle ends. I believe it will be sooner than later, although the choppyness of the market will continue to confuse most market participants into believing that we are either entering into the new dark ages, or a golden era of economic productivity when neither seems to be the case.

Canadian Preferred Share price appreciation nearly done

Preferred share spreads (in relation to government) have compressed significantly since last February and it appears that the macro side of the preferred share market has mostly normalized and accounted for the incredible drop of dividends on the 5-year rate reset shares due to the 5-year government bond rate plummeting (0.62% at present with short-term interest rate futures not projecting rate increases until at least 2018).

We are still seeing significant dividend decreases as rates continue to be reset.

I have looked at the universe of Canadian preferred shares (Scotiabank produces a relatively good automated screen) and further appreciation in capital is likely to be achieved through credit improvement (e.g. speculation that Bombardier will actually be able to generate cash indefinitely) concerns rather than overall compression in yields.

As such, one should most certainly not extrapolate the previous three months of performance into the future. Future returns are likely to primarily consist of yields as opposed to capital appreciation.

While investment in preferred shares, in most cases, is better than holding zero-yielding cash (in addition to dividends being tax-preferred), one can also speculate whether there will be some sort of credit crisis in the intermediate future that would cause yield spreads to widen again. If your financial crystal ball is able to give you such dates, you can continue picking up your quarterly dividends in front of the steamroller, but inevitably there will always be times where it is better to cash out and then re-invest when everything is trading at a (1%, 2%, 3%, etc.) higher yield.

I am also finding the same slim pickings in the Canadian debenture marketplace.

Valuations have turned into such that while I’m not rapidly hitting the sell button, I’m not adding anything either and will continue to collect cash yields until such a time one can re-deploy capital at a proper risk/reward ratio. If I do see continued compression on yields I will be much more prone to start raising significant fractions of cash again. Things are very different in 2016 compared to 2015 in this respect – in 2015 I averaged about 40% cash, while in 2016 I have deployed most of it.

Small re-inspection of Bombardier

The on-again, off-again rumours regarding a billion-dollar injection with the Canadian government is purely negotiation strategies on both parts. The government wants to invest, but they also want to do it in a manner that allows them to save face. Conversely, the controlling shareholders of Bombardier want the money (it will indirectly end up in their pockets), but they also do not want to lose control over the gravy machine.

There will be a happy equilibrium where the taxpayers of Canada will transfer wealth to the owners of Bombardier, but the structure of the arrangement is up for debate. My suspicion is that some sort of arrangement will be made as long as they keep a certain number of jobs in Quebec, the Class A share owners will not be compelled to convert into Class B shares.

The credit market has been much more kinder to Bombardier, to the point where they can raise capital at a very reasonable rate:

The Class B equity has been hovering at $2/share, with the control premium (Class A shares) being around 10% of late.

Floating rate preferred shares (TSX: BBD.PR.B) has been hovering around 8.4% yield, while fixed-rate with conversion risk (TSX: BBD.PR.C) has been hovering around 9.9% of late.

As I alluded to earlier, investors must make a distinction between revenues and profit, and Bombardier is focussed on revenues at the moment. They will continue to service their debt and preferred shareholders, but I do not believe equity holders will be receiving dividends anytime soon. There is also a significant overhang with the two Quebec deals, with a significant number of warrants outstanding at US$1.66 level – although these warrants are held by institutional owners (Quebec), this will be a valuation overhang which will serve to depress the maximum upside of the common shares. If it ever gets to the point where these warrants are exercised, it would buffer the serviceability of debt and preferred share dividends.

I am of the general belief that if Bombardier plods along and returns to a profitability at a level that is somewhat less than what they have touted in their 2020 vision, and that their C-series jet clearly has a “runway” of perpetual orders keeping the assembly lines busy, that BBD.PR.C would trade around the 8% level (or roughly $19.50/share). The credit markets are indeed pointing toward this direction.

Now the corporation just has to make money.

I am still long their preferred shares, but under the belief that a good quantity of upside has been realized by investors in relation to previous trading prices. I went long on preferred shares less than a year ago when there was a lot more gloom and doom, and having been called a “brave soul” by national media for doing so.