Canadian Fixed income review – end of August 2023

I’ve been reviewing the fixed income situation in Canada. Some observations:

1. The yield curve is still heavily inverted, and the inversion has gotten even wider over the past week. The half-year bond is at around 525bps and the 10 year is at 359bps as I write this. There is a general anticipation of the rise of the short-term interest rates stopping, but this anticipation has been present now for almost half a year. Time will tell.

2. There hasn’t been a new TSX debenture issue since Fiera Capital a couple months ago, and issuance this year has been very light. Previously you would typically see companies issue new debt and call existing debt with half a year to a year left of maturity, but now they are letting debt run to near-maturity – probably because the coupons they are paying today are less than what they can roll over for, coupled with everybody and their grandmothers waiting for rates to decrease!

3. Preferred share markets are very thin, but if you do not anticipate the 5yr government bond yield changing materially for a year, there are many high-credit names that are trading at 10% rate resets. There are too numerous to mention, but for example, pretty much all of TransCanada’s (TSX: TRP) are trading above 10% at the current 5-yr rate reset value. It becomes an interesting situation for an income investor whether they want to roll the dice with equity, get a 7.6% yield currently or to play the relatively safer preferred shares and clip about 300bps more out of it. There’s even one really trashy financial issuer that has a reset yield currently north of 15% which I’ve looked at, but I value my sanity over yield at the moment.

4. Risk-free cash continues to remain extremely competitive against much out there. The only way to rationalize more speculative equity investments out there is with implied growth or implied expectations of interest rates dropping. We are not going to get this interest rate drop as long as market participants are obviously stalling for it.

The “everybody wants to be a day trader” society

I keep having this amusing thought in my mind, “Everybody wants to become a day trader”. I noted this especially during the Covid-19 era which gave the lesson to a whole cohort of individuals that the way to riches was picking off Gamestop (NYSE: GME) and YOLO-ing to millions. Since then, there has been many people wanting to get into the investing world as their second “side gig”, instead of doing something that actually adds value to society.

I have written and spoke on a past episode of Late Night Finance the fictional world of an island of 100 people, being able to produce a mild surplus of food to satisfy their needs, and then what happens is that they all want to turn into day traders – producing food is difficult work, while clicking buttons in front of a computer is so much easier!

Here is a small amusing story.

When going to Costco (something that Charlie Munger and myself share in common high regard to our appreciation for this institution), I overheard an employee and presumably one of his friends (who wasn’t wearing any name tag) having a conversation near the vegetable section. While I was casually looking at produce, I couldn’t help but overhear some very interesting words such as “limit order” and “trades”. Naturally my ears piqued and I stopped there and became very interested in inspecting the fine micro-details of the avacadoes in front of me while I listened to the conversation. Essentially the friend was talking to the employee about how you should always use limit orders and was tapping away on his Wealthsimple app on his mobile phone to show some charts of various stocks. He clearly was giving a miniature lesson on trading to the employee.

This got me thinking about a few things.

1. Financial competition is everywhere. Technically all of you readers of mine are competition as well, but I am such a sleepy trader that I’m not much of a threat, unless if we decide to all pile into the Yellow Pages (TSX: Y) at the same time (speaking of which, a valuation of an EV of 2.8x annualized operating cash flow!).

2. Maybe there are still new entrants trying to get into “the game”. Tough to believe at this point.

3. How many people would stop working in order to make their fortunes trading stocks? Why bother slogging away at Costco making $20/hr when you can potentially make $20/minute YOLO-ing Tesla or whatever?

Statistically speaking, there has to be some cohort that has tried and by virtue of getting a bunch of coin tosses correct, have removed themselves from the labour force at least temporarily. Just like somebody going to the casino and winning at slot machines, it is entirely possible to win money at the stock market without any prior knowledge. I would claim the stock market offers better odds. When a society starts to see the way to riches as a result of zero-sum extraction as opposed to actually creating wealth (farming, building, cutting people’s hair or programming software), it is no wonder why we are seeing inflation – nobody’s producing supply because they’re too busy day-trading. You get enough of this cohort in society and not only does the zero-sum extraction become more difficult for the participants involved but the cost of everything else rises because of the labour pool removal.

Interest rates controlling the key to everything

Most of the financial world tries to anticipate what actions Jerome Powell and the Federal Reserve decide to make with monetary policy.

For the past year, markets have been trying to anticipate the so-called “pivot”, i.e. the point in time where the Federal Reserve will stop raising interest rates and eventually lower them. The thinking is that lower costs of capital will usher in a new era of demand and we can party like it is 2009 with a rush of quantitative easing.

One problem, however, is there is a deeply psychological component to the inflation going on. The inflation expectation itself is a determinant of real interest rates. I’ll give a very simple example.

Let’s say the nominal interest rate is 5% and inflation is 2%. The real rate of interest is +3%.

However, if you expect inflation to be +4%, the real rate goes down to +1%.

The higher the inflation expectation, the lower the real rate.

An extreme example would be if you anticipated your currency turning into Argentinian paper, with a 50% inflation. Your real rate of interest goes very negative, very quickly and you suddenly will have a very large incentive to spend everything you can today.

We fast forward to today, where you still have the chairman of the Fed saying that inflation is too high. In Canada, Tiff Macklem more or less said as much.

There is the makings of a chaotic system. While nominal interest rates are elevated and real interest rates are still quite positive in relation to past norms, the inflation expectation (the Bank of Canada has referred to this as “entrenched expectations”) continues to render the effective real rate down, if not negative. However, market participants are anticipating a halt in the increase of nominal interest rates and the Fed Funds Futures suggests that there will be 100bps in cuts by the end of next year.

It is precisely this expectation of lower interest rates that is preventing the nominal increase of interest rates to have their desired effect by central banks. As a result, demand is still high because inflation expectations remain high – practically speaking, the real rate of interest in the minds of a lot of people is negative. When the purchasing power of your cash continues to erode, why not spend?

The chaos factor is anticipating when there will be a turnaround in expectation. Psychological whims are fickle – much more so than nominal interest rates.

To use a science analogy, the economy is feeling like a super-saturated solution – one minor intrusion away from reverting into another state of matter. I can’t anticipate when this will occur. However, when it does, it will be relatively swift. I don’t want to use the word “crash” to describe it, but there is a possibility, albeit I would not rank it as probable at the moment.

What are some defences to this scenario? Holding cash is good, although my gut instinct says it is a crowded trade. The trade is crowded enough that it will probably buffer the impact of lower prices. A scenario I see more likely is the long-term (10 year) risk-free rate rising to a point that suppresses equity valuations like a wet blanket on a campfire. Although this is hardly a scientific sample, stable royalty income trusts such as the Keg (TSX: KEG.un) have recently exhibited some degree of price contraction, likely due to the yield competition with cash. Why bother holding risky units in a steakhouse chain when you can just hold onto (TSX: CASH.to)? Is that truly worth a 250bps equity premium? It even looks worse for A&W (TSX: AW.un), which is at a 50bps premium at the moment. Maybe I should be shorting it!

Finally, let us not discount the slow impact of quantitative tightening. In Canada, we have $23.9 billion in government treasuries maturing on September 1, and another $558 million in mortgage bonds maturing on September 15. This is about 7.75% of the Bank of Canada’s balance sheet of treasuries and mortgage bonds. Funds parked at the Bank of Canada by banks remain plentiful, however – nearly $157 billion is still parked at the BoC at last glance. Credit is still available – you just have to pay a lot more for it.

BBTV – Lights out, pretty soon

Accounting is not complicated, but knowing the tricks of the trade really help when doing financial analysis.

One thing that confuses most laymen is that a company can generate net income but bleed cash like crazy.

This describes BBTV’s (TSX: BBTV) second quarter report.

They reported a $3.7 million net income, but still are bleeding cash like crazy. It is because they restructured a piece of debt for a non-cash gain:

On June 20, 2023, UFA Note had another amendment whereby UFA provides the Company with an option (the “Discounted Payout Option”) to discharge the Convertible Promissory Note at 10 cents for every dollar of outstanding principal and accrued interest if that Discounted Payout Option is exercised at the earlier of (i) September 15, 2023 and (ii) 5 business days following the closing of any financing that provides the Company with the option to exercise the Discounted Payout Option. If the Discounted Payout Option is exercised, the Company would be subject to a covenant for the next six months from the effective date of this amendment whereby the Company would need to increase the payout (the “Increased Amount”) to UFA if the Company discharges certain other financing debts at an amount that is more than 8 cents for every dollar of outstanding principal and accrued interest. The Increased Amount is calculated using a formula specified in the amendment, subject to various limitations. This amendment is considered a substantial modification under IFRS, resulting in a gain of debt modification of $18,337 for the period ended June 30, 2023.

… essentially they want the company to suck up blood from a stone and try to suck up as much cash as possible while they can.

Also you do not want to be reading this paragraph on Note 1 of the financial statements:

As at June 30, 2023, the Company had a working capital deficiency of $44,303 compared to a working capital deficiency of $44,876 as at December 31, 2022. For the six months ended June 30, 2023, the Company incurred a loss of $10,757 (June 30, 2022: $26,783) and used cash in operations of $14,738 (June 30, 2022: $14,365). As part of the Company’s working capital and cash flow management, the Company has a receivables purchase agreement as described in Note 5. On February 14, 2023 the Company obtained additional loan financing of CAD$21,485 and received proceeds of CAD$20,926 (net of transaction costs). Immediately after the closing of this loan financing, the Company used part of the proceeds to pay off the balance in its overdraft facility and subsequently, the aforementioned overdraft facility was terminated. The loan financing arrangement includes an earnings performance target covenant for the six months ended June 30, 2023 and as a result of the Company not meeting this performance target, it is required to repay US$6,000 to the lender originally by August 18, 2023 and subsequently extended to August 31, 2023. The Company is in discussions about further extending the timing of the US$6,000 payment until such time that it can be settled in accordance with a signed non-binding proposal from a new third party investor. The Company presently remains in good standing with the Term Loan (Note 8). Subsequent to the quarter end, the Company received a shareholder loan of $4,000 (Note 22).

Needless to say, the balance sheet is in need of restructuring and I can’t see an escape route considering they can’t seem to stem the cash bleeding – about $15 million gone in the first half of this year. Even the most elementary of financial statement analysis, current assets over current liabilities, indicates that with $28.9 million of current assets, over $73.2 million in current liabilities, at 39% this is just not good news for shareholders. Most of the liabilities consist of payments to content creators – and if your business is about content creation and if you’re not paying them, they’re not that likely to stick around!

New Flyer Industries (NFI)

I will make a claim that companies that make “stuff in demand” will do reasonably OK in an inflationary environment, providing that they can actually price their contracts properly in anticipation of such inflation. The key operationally is that they need to be able to ensure their physical inputs, but also be able to retain their expertise and know-how in the staff – one of the huge competitive disadvantages that most Canadian cities have is that most people that actually do the work can’t afford to live at the wages being offered.

Part of my examination of industries producing “stuff in demand” involved a re-examination of New Flyer Industries (now rebranded NFI with the same TSX ticker symbol) and I have been eyeballing this one for many, many years. I’ve never owned it. They are one of the top (if not the top) manufacturer of busses in North America. Financially speaking, however, they have not been doing very well over the past few years. While one can claim that Covid-19 was an absolute killer for public transportation, the historical income statements show a huge varying history of income generation – with the peak being in 2017 (the stock was trading over $40 at this time and peaked around $50 in 2018). Just before Covid, however, the 2019 year reported net income, but the cash flow statement shows a company with working capital management issues, coupled with spending $327 million on an acquisition. 2019 ended with negative tangible equity of about $430 million and $1.2 billion in debt. NFI was sliding before Covid hit.

Post-Covid, they have really struggled to stay afloat, especially with their bank covenants.

On July 29, 2022, NFI renegotiated their debt covenants. Part of the new covenants was that they would earn a minimum adjusted EBITDA of $45 million after the 4th quarter. A few months later, they subsequently projected a NEGATIVE 40 to 60 million. It was less than three months since they re-negotiated their debt covenants and blew it, and not by a small amount either – they missed by a mile. The dividend was also cut to zero at this point (it should have never been paid out in the first place given their balance sheet situations).

Nearly half a year after that, they announced they were receiving short-term government bailout money from Export Development Canada (a Canadian crown operation) and the Government of Manitoba.

Much to my surprise on May 2023, they announced they reached an agreement with their creditors to raise equity financing, and also additional secured financing. Later that month they also issued more equity – both equity raises were deeply under the market price of NFI traded shares (CAD$8.25/share). The primary equity investor, Coliseum Capital Management, raised its effective stake in the company from 12% to 27%.

On July 25, 2023, they indicated that a $200 million tranche of Second Lien Debt includes “an annual coupon at the higher end of the previously disclosed expected range of 12% to 15%, payable semi-annually, with a maturity of 5 years.”. Today (August 16) when they announced their quarterly result, they raised another $50 million gross (5 million shares at $10.10/share, about a 15% discount to market) with a reduction in the Second Lien Debt to $180 million.

The August release stated “Based on the expected proceeds from the August Private Placement, NFI intends to lower the gross proceeds from its proposed second lien debt financing from $200 million to approximately $180 million. This is expected to generate annual interest savings of up to $2.9 million per annum.”

Pulling out my calculator, $2.9 million divided by $20 million gives an interest rate of 14.5%.

NFI also claimed the following in their release:

I am not sure how credible this guidance is, but going from $50 to $275 million in EBITDA in a year is quite a leap. Operationally, this company is effectively producing larger pure electric vehicles and should this not result in a Ford or GM-type valuation?

The big surprise to me, however, is how or why the stock is holding up so well despite this huge financial mess that has been going on over the past few years. Despite having nearly a billion dollars of debt further ahead in rank, the most junior tranche of debt, the 5% convertible debentures maturing January 2027 (TSX: NFI.DB) trade at around 82 cents, a 12% yield to maturity. The second quarter report had a negative $40 million free cash flow. All of this suggests that the equity is priced for absolute perfection. It is no wonder why the company is so eager to issue shares, even at a steep discount to market.