Canadian interest rate futures

There are three Bank of Canada announcements concerning interest rates for the rest of the year: September 6, October 25 and December 6.

Right now 3-month Banker’s Acceptance rates are 1.2%.

The BAX futures are signalling that there is a better than 50/50 chance that rates will increase 0.25% in the September 6 cycle, and that there is a slight chance of two 0.25% rate increases by the end of the year:

Month Bid price Ask price Settl. price Net change Open int. Vol.
Open interest: 942,178 Volume: 86,058
August 2017 0 0 98.765 0 0 0
September 2017 98.655 98.660 98.645 0.010 137,868 7,160
October 2017 0 0 98.615 0 0 0
December 2017 98.500 98.505 98.490 0.010 224,303 15,544
March 2018 98.395 98.400 98.375 0.020 163,606 19,552
June 2018 98.330 98.335 98.305 0.025 112,558 15,558
September 2018 98.270 98.280 98.250 0.030 120,395 10,055
December 2018 98.210 98.220 98.200 0.020 102,302 9,439
March 2019 98.160 98.170 98.140 0.020 45,030 5,208
June 2019 98.090 98.100 98.080 0.020 17,655 1,763
September 2019 98.010 98.030 98.010 0.010 10,774 827
December 2019 97.940 97.960 97.940 0.010 5,193 646
March 2020 97.860 97.870 97.870 0 2,199 198
June 2020 97.780 97.800 97.800 -0.010 295 108

Guessing the impact of these short-term interest rate changes I will leave as an exercise to the reader for now. The one salient fact, however, is that when short-term financing rates increase, the incentive to leveraging decreases and so marginal investments will be less viable. Parking cash in a rising-rate environment is best done with cash rather than using any debt instruments with duration (I wish I had stuck to this – my cash parked in VSB.TO has decidedly unperformed zero-yield cash!).

Teekay / Teekay Offshore / Brookfield financing

Brookfield Business Partners (TSX: BBU.UN) announced a $750 million investment (Brookfield’s release) (Teekay’s release) in Teekay Offshore (NYSE: TOO).

I’ve written extensively about Teekay Offshore and thought they would cut their distributions to zero and likely cutting their preferred unit distributions because of impending financing issues. This prediction turned out to be mostly incorrect – they are cutting their common unit distribution to 1 penny per quarter (down from 11 cents), and maintaining their preferred distributions.

In general, my expectations for the outcome for this pending recapitalization transaction have been worse than what materialized.

Not surprisingly, Offshore’s preferred units are trading considerably higher in the markets – up about 28%.

Teekay (parent) unsecured debt traded up to 98.5 cents on the dollar today – I am happy regarding this transaction – it is likely to mature at par (January 2020) or earlier via a call option. Offshore debt holders have even more reason to be happy – theirs are up from 82 cents to 97 cents, with a 7% yield to maturity. (On a side note, I notice somebody was asleep at the switch at 5:00am today – there was a $100k bond trade for 90.8 cents on TK unsecured, which was a steal for the buy-side – NEVER leave those GTC orders out in the open unless if you’re willing to scan the news before the market opens!).

Summary thoughts (apologies in advance for this not being in a more professional manner, I am not writing from my usual location):

The first chart is from their today’s presentation, while the second chart was from an early 2016 presentation. Compare the two:

1. With this equity injection, Offshore buys itself a couple years of time (which is what they desperately needed) – however, their debt leverage goes from “very high” to “above average” – slide 9 is considerably above what they were anticipating in their 2016 slide when they initially recognized the pending financial crisis. Pay attention to the Y-Axis of those charts!
2. Teekay dumps its $200 million loan to Brookfield for $140 million cash and 11 million warrants in Offshore;
3. It’s not entirely clear what the terms of these warrants are, or how Brookfield picks up 51% control of the GP (they get 49% of it right now);
4. Offshore’s financial metrics (cash flows through vessel operations) should start to improve, but I suspect there will be upcoming challenges as long as the oil price environment is not supportive (thinking counterparty risk, potential future contract renewals, pricing pressure, etc. – examining Diamond Offshore, TransOcean, etc., although not strictly in the same market as TOO, leads one to believe that the present environment is also not favorable to maintenance offshore oil production expenditures);
5. Teekay also liquidated their preferred unit holding in Offshore, and this is functionally a sell-off to Brookfield.
6. The creation of a “ShuttleCo” subsidiary of Offshore will create some more financial complexity in the operation – they probably want to spin this out for valuation and/or leverage purposes (as this division apparently is doing reasonably well).
7. Offshore’s operational challenges and risks are still not going away with this equity injection, but Teekay has more or less divested as much as they could from them.
8. Teekay also get relieved of guarantees from Offshore, which will improve its financial position dramatically in the event of insolvency (this is huge for Teekay unsecured debt holders). Teekay is functionally at this point a play on their LNG daughter entity, while having some minority economic participation in offshore.
9. Teekay’s cash flows through Offshore will obviously be curtailed significantly, they have their own vessel operations which are cash neutral, so they will be solely reliant on either equity distributions of Offshore (if they decide to fully liquidate) or LNG’s distributions.

If I was an investor in the preferred shares or debt of Offshore, I’d be taking gains right now and going elsewhere.

I remain long TK unsecured debt and do not have any intentions to sell – I took a full position back in them last year. I’m not keen on any of the equity.

Worst-performing portfolio components

The biggest hits my portfolio has taken this year has been with the appreciation of the Canadian dollar and the cash-parking vehicle of VSB.TO. Sadly (not including monthly distributions, which is about 5 cents a month) they’re down about 40 cents over the past couple months, due to the short-term rate curve rising considerably.

I take solace knowing that the increased Canadian dollar gives me larger purchasing power parity and the increase in interest rates in theory should make credit-sensitive assets cheaper to purchase.

KCG, it was good knowing you (Eulogy)

The merger closed yesterday and I received proceeds from the equity and debt today.

The equity I had purchases between $9-11/share. My first stake in the company was back in Q4-2012!

From my debt purchase at 90.5 at the end of June 2016 to 13 months later, resulted in a capital gain of 13.1% plus the 7.6% current yield, made for a 20.7% CAGR investment on a senior secured debt, first in line, on a cash flow positive entity. I’ll miss you.

The perils of indexing

Horizon Kinetics has been writing about the flaws of passive index investing, and their latest quarterly report hits the nail on the head.

It reminds me of when Nortel was at one point 40% of the TSX60 index.

A solid investment screen begins with discarding the top 3 quartiles of the S&P 500 or Nasdaq 100 – or anything ascending. Due to the passive mechanism of re-balancing, stocks that gain capitalization have a momentum effect because of their higher weighting.

Genworth MI – Q1-2017 and Q2-2017 preview

(Update, July 20, 2017: FYI, Genworth MI reports the next quarter on August 1, 2017)

While Home Capital was going through their issues, I had neglected to report on Genworth MI’s Q1-2017 report.

It was a quarter for the company that was about as good as it gets – their reported loss ratio was significantly lower than expected (15%) and well below expectations. The number of delinquent loans creeped up slightly (2,070 to 2,082) but the loss ratio was the highlight for the quarter. Most of the increase in delinquencies occurred in Nova Scotia and Manitoba.

Portfolio insurance written was also higher than I would have expected ($38 million), but this was due to the completion of paperwork received at the end of Q4-2016. I would not expect this to continue in future quarters.

The geographical split of insurance has not changed that much – Ontario continues to be 48% of the business, while BC/AB is 31% and QC is 13%. Half of the transactional insurance business continues to be at the 5% down-payment level.

Book value continues to creep up, now to $40.42/share. Minimum capital test ratio is 162%, slightly above management’s 157% holding level, and as long as this number is between 160%-165%, management is not going to take any capital actions (i.e. special dividends or share buybacks), although I will note some insiders did purchase shares earlier in the quarter.

The market reaction to the quarterly report was initially very good, but I suspect short sellers decided it was a good time to continue putting pressure on the stock. It got all the way down to $30.50 before spiking up to $38 and now has moderated to $34.70/share, which is a 14% discount to book.

Looking ahead to Q2’s report, my expectations are a more moderate outlook – the loss ratio should creep up to 25% again, and management should be noting that Ontario’s actions to curb foreign property speculation have had an impact on the local residential market. In relation to mortgage insurance, however, if people continue paying their mortgages (they are employed), ultimately real estate pricing does not matter. I think a lot of market participants have failed to make that distinction.

The other question is the impact of increasing interest rates – this will certainly have an impact on the short-term investment portfolio of MIC – including small unrealized capital losses on short-term debt. This will more than likely be offset by gains in their preferred share portfolio, which totalled $456 million on March 31, 2017.

Price-wise, the company is currently too cheap to sell and too expensive to buy. I’ll continue collecting my dividends.

Bombardier Yield Curve and Preferred Shares

The yield curve of Bombardier continues to compress:

Despite all of the negative press concerning their trade war with Boeing for the C-Series jets, it appears that the credit market is thinking that the credit side of Bombardier is quite secure – offering less than 7% for 8-year money. The company can easily raise capital with its current yield curve.

The preferred shares have had some interesting action lately, and this is because of the repricing of the BBD.PR.D dividend – because of (from the company’s perspective) an ill-timed rapid increase of the 5-year Government of Canada yield curve, their BBD.PR.D series will be giving out 3.983% on a $25 par value of dividends. Around July 10th when the market was blissfully unaware of the dividend adjustment (as they apparently didn’t read press releases), this would have translated into a 10.8% eligible dividend yield.

It is because of this that the BBD.PR.C series has traded down – there is obvious arbitrage between the C-yields and the D-yields. They were originally trading a full 200 basis points away from each other but this has now converged to about 50 basis points which is more reasonable (BBD.PR.C is worth more if you plan on interest rates to decrease, while the D’s are better if you expect them to rise in 4.9 years).

In relation to Bombardier’s bond yield curve, the preferred shares looked extremely cheap (especially the BBD.PR.D series at 10.8% yield!). Now it is around 9.3%.

Disclosure: I own some BBD.PR.C and BBD.PR.D.

Bank of Canada raising rates to 0.75% – makes no sense

Most of Canada has heard that the Bank of Canada raised the short-term target interest rate from 0.5% to 0.75%, which was the first increase in about 5 years. The rate increase itself serves to increase a very small rate into another very small rate and is insignificant other than the fact that this sounds like it is a warning shot.

Indeed, when reading the Monetary Policy Report, I’ve come to the conclusion that there was really no justification for raising interest rates in accordance to the Bank’s mandate of maintaining inflation at a 1-3% band – their own research suggested that the economy was headed in that direction with the current monetary policy. The decision to raise interest rates appears to be completely arbitrary, or guided by other considerations that are not captured in the standard reports.

It is this scenario that makes me believe that barring any economically cataclysmic events, the Bank should probably raise again (to 1%), but for reasons that has nothing to do with maintaining a 2% CPI rate.

All in all, this policy decision by the Bank of Canada is mysterious.

KCG Holdings merger arbitrage and should I invest in Virtu?

KCG Holdings (KCG) is due to be bought out by VIRT for $20/share cash. The meeting for KCG shareholders to approve is on July 19 (which at this point is practically a done deal). Over the past two days we had the following trading:

See that spike up to $20/share at the end of yesterday’s trading? I wasn’t expecting that! It is not financially rational to purchase shares at $20 unless if you believe there will be a higher bid for the company. At this point, however, a successor bid is simply not going to be happening.

A more reasonable $19.98/share means a 2 cent premium obtained over a week, which works out to about a 5.2% simple interest rate, assuming no trading costs.

I had some July call options so I figured it was a good time to dump the remainder of my shares into the market. There was a legal complication from one of the class action lawsuits that might require the company to obtain a 2/3rds shareholder vote of all non-insider owned shares and considering the general apathy of voters these days, that is not a threshold that I would want to bet my kidneys over.

Once the merger is completed then KCG’s senior secured bonds will be called away (at 103.7 cents on the dollar, while my purchases were a shade above 90 cents) and that will conclude one of the better investments I’ve made over the past 5 years. It took a lot longer to happen than I anticipated – had it occurred at select points over the past 5 years I had even higher amounts of leveraged option positions on this company (which sadly expired).

One thing I will miss about these bonds is that the 6.875% coupon I was earning was virtually guaranteed money to maturity. I will no longer see that.

The analysis for VIRT is a little more muddy – I expect some serious integration pain to occur after the merger is finished.  In the definitive proxy statement materials, however, I was very intrigued by the following table which illustrated the financial projections of a management restructuring:

So in the above, we had management projecting a 2019 estimated free cash flow of $132 million, which appeared to be sustaining for future years. This worked out to about $2 per KCG share, which VIRT is now purchasing for 10 times earnings.

Management projections are always on the optimistic end of things, so this is not likely to materialize as presented, but it still makes one wonder whether VIRT is worth investing in or not. I do not like their corporate structure (public shareholders have no control over the company and a vast minority of the economic stake of the firm) and I am inclined against it.

Teekay – the buzz from Seeking Alpha

There has been a considerable amount of bandwidth on the future outcome of Teekay and Teekay Offshore on the Seeking Alpha channel.

When you see this much bullishness on a public forum, watch out. The “news” (if you want to call it that) has already been baked in.

There is also a material amount of mis-information in some of the analysis presented on Seeking Alpha, including the J Mintzmyer analysis which got most of the flurry of TK/TOO posting started. There’s no point for me to argue about the fine details of the analysis here.

My original post about Teekay’s 2020 unsecured bonds of April 2016 still applies today – at a current price of 90.5 cents on the dollar they are in the lower part of my price range but not a wildly good buy as there is real risk involved. My initial purchase point was below 70 cents on the dollar back in early 2016. My only update to my April 2016 post is that I have long since offloaded my Teekay Offshore equity position – my optimism back then about TOO was considerably over-stated and when my own modelling changed, my price targets subsequently changed and I bailed out.

TK’s inherent value is primarily focused on their TGP entity (Mintzmyer got this correct, but grossly over-states the value of the company). Most of the discounting of TK unsecured debt’s value is that they are likely to offer guarantees to future TOO and/or TGP financings that would make it difficult for TK unsecured debtholders to realize value in the event of a Chapter 11 equivalent event (this would involve cross-defaults between entities and be incredibly messy to resolve). There is currently cross-default potential with TOO’s debt complex, not to mention that TK has made unsecured loans to TOO to bridge TOO’s liquidity situation. My general expectation is that there is a gigantic incentive for the controlling shareholder (Resolute Investments) to avoid a default scenario and would instead opt for a dilutive recapitalization instead, which would of course render TK unsecured debt maturing at par. I still think this partial recapitalization scenario is probable.

TK and TGP have announced dividends and distributions, respectively. The TK dividend surprised me somewhat as they are obligated to pay dividends by raising an equal amount in equity capital until a certain debt is paid off. TOO has been silent and they will likely be announcing suspensions in conjunction with some financing announcement in the upcoming weeks.

My assessment at present is that the only people that will be coming out of this with money are the debt holders. Such is life when oil is at US$45/barrel.