Volatility spike

TSX down 12%, S&P down 9.5%, and VIX reached 75 today, holy crap:

This is not predictive, but it is at the level that was experienced during the 2008-2009 financial crisis:

Again, VIX is not predictive, but suffice to say this is one of those “six sigma” events that are supposed to happen once in a million years, but instead takes 12 years apart to realize. Who knows, it might head to 100.

Just as a reminder, VIX is a measurement of what traders expect is the annualized implied volatility of the S&P 500 over an average of 30 days. The word “volatility” in everyday language implies down, but mathematically it implies movement in either direction.

Dividend cuts

Those cash-flowing equities with yields are going to cut dividends simply because there’s no other outlet. If you’re depending on a stock for their yield, one must have a good grip on whether they can sustain it from a balance sheet perspective.

I won’t even cover the oil and gas sector – those that had dividends will surely lower or eliminate them (SU and CNQ may be exceptions here, but everybody else – good luck!). In Canada, nobody will make money with WCS at US$20/barrel. Interestingly enough, in the gas world, AECO/Dawn/Henry Hub are holding steady.

Chemtrade Logistics (TSX: CHE.UN) announced they are dropping their distribution from $1.20 to $0.60/unit per year. This wasn’t surprising to me since even at the current rate they are still questionable.

Melcor (TSX: MRD) decreased their quarterly payment from $0.12 to $0.10/share; as their property portfolio is entirely Alberta-centric they are secondary roadkill in the oil/gas slaughter.

Anything in the equity markets that are trading at double-digit yields – give the balance sheets a very careful look, and ask whether the cash flow, accounting for a decrease in the economic landscape, will be able to provide sufficient coverage.

There will be a few equities with double digit yields that will recover and maintain their dividends, but it will be few and far between. However, if you do manage to snag them, and the overall economy recovers, you will be the recipient of a yield compression and continue receiving distributions at your original (low) cost basis. High risk, high reward.

Canadian Preferred shares are getting killed

The rest of the stock market is getting killed by the Coronavirus as well, but Canadian preferred shares are not much of an escape valve.

James Hymas reported today that:

It is noteworthy that the Total Return version of TXPR closed at 1,304.43 today. I will note that the value of this index on September 30, 2010 was 1320.92, so total return has been negative over the past NINE YEARS AND FIVE MONTHS and a little bit. That’s before fees and expenses. Remember those charts I published in the post MAPF Performance : August 2019 illustrating the downturn to date, comparing it to the Credit Crunch and remarking that there had been zero total return for seven years and four months? Well, those charts are now out of date.

The two major ETFs which trade in Canadian preferred shares are ZPR and CPD, and they both have been murdered in the past two weeks, roughly 17%:

A negative total return of 9 years and 5 months can be contrasted against the TSX total return of about +4.5% (compounded annually) in the same period. In theory, preferred shares are safer investment vehicles than common shares, but clearly as the 5-year rate reset preferred share came to dominate the market, as 5-year interest rates have declined, they have also taken down the capital return of the preferred shares, resulting in very lacklustre long term performance.

This can only be considered to be a total washout that is going on.

One reason is perhaps that leveraged players are being forced to cash out. A retail example is in this reddit post, where the poster very thoughtfully constructed a diversified portfolio of preferred shares, and who is certainly underwater on this trade.

The math was pretty simple: Choose a “stable” preferred share (e.g. BAM.PR.Z) (4.7% and a rate reset of 5yr+2.96%, which presumably would be ‘stable’ since obviously the five year government bond will hover near 1.7% and you won’t get ripped off on the rate reset!). You borrow money at 3.3% from a proper brokerage firm, and leverage $100k of equity to buy $200k of stock, and voila. At the beginning of 2020, the shares would yield 5.9%, and your net would be 2.6%, minting a cool tax-preferred $2,600 in the process per $100k equity.

The problem is today, those BAM.PR.Z shares are worth $160,000, your net equity is down to $59,175 (had to pay the interest expense) and the only thing you will be receiving in this procedure is a first dividend payment of $2,928 tomorrow (which will correspond with a drop in the price of the preferred shares, so this is a push). Your margin level has gone from 50% to 37%, and this is precariously close to the 30% level which is allowed by the IIROC list of securities eligible for reduced margin and the brokerage firm.

Surely these preferred shares couldn’t go down further, to the point where you’re going to be forced to clear out your account? Can you take the risk being so close to the brink of a margin call?

This is part of what is going on. The other aspect is that the market is pricing in the reduced dividend rate that will inevitably occur with the rate reset. At a 5 year government of Canada bond rate of 0.55%, that BAM.PR.Z yield, after the reset, will go from 5.9% to 4.4% on original cost, which cuts heavily into the original intention of the trade, which was to skim a leveraged return off the dividend. The only solace is that the short term interest rate (that you would pay for margin) also decreases, but then your capital is impaired – you can realize the capital loss today, or wait patiently and hope for better times and hope things don’t get worse to where you will face that margin call.

These two factors I suspect are driving the push down in preferred shares. What will be even more fascinating is if we enter into a negative yield environment – preferred shares will look even uglier then.

Even the preferred shares with minimum rate guarantees (e.g. TRP.PR.J – 5.5%, reset at 4.69% with a minimum of 550bps) have not been immune to selling – although you are guaranteed a 5.5% coupon payment (and traded at a 4% premium to par for this minimum rate privilege to yield 5.3%), this series has been sold down in the past few weeks to 91.5 cents of par, or a minimum yield of 6.01%. Fascinating times.

Fortunately a couple weeks ago I sold all of my preferred shares short of a 2% position in something which I’m still not happy at myself for not unloading when I saw the proper bid for it.

Finally, the only solace for the rate reset preferred shares that are resetting at the end of March is that five years ago, the five-year government bond rate was 0.93%. I bet the people receiving that rate never thought they’d be getting a lower rate at the end of this month.

Mid-stream oil and gas

Low oil prices hurt producers for obvious reasons.

They also are hurting the mid-stream, but this is for less obvious reasons – low prices means curtailment of capital expenditures, which typically mean lower volumes, which means less money for midstream producers. Volume is the dominant variable for the mid-stream, not prices.

The flip side of this equation is lower prices stimulates consumption, which means higher oil prices, which means higher capital expenditures… you get the picture. There is an equilibrium factor that depends on mutually dependent factors in order to “solve the equation”. In Excel, this would typically be a circular equation, but when applied in real life, the input variables are much more fuzzy, and thus it makes the output chaotic and difficult to predict where the true “landing spot” is (which never exists – it is always ever-moving).

The other clear factor is that when oil and gas companies are not making profits, there is an element of counterparty risk.

One broad-brushed way of investing in the US mid-stream sector is through the Alerian MLP ETF (AMLP) which got killed yesterday. The constituent companies are fairly stodgy oil and gas pipeline MLPs which give out most of their income in the form of distributions. Normally MLPs are very adversely taxed for Canadians, but the AMLP structure is a corporation. It distributes its income mostly in the form of a return on capital, but for tax purposes, it is equivalent to foreign income. However, in a registered account, this is a non-factor. At the low of $4.14/unit, it was trading at a yield of 18% and even when factoring in the inevitable decline of shale production in the USA, seems to be a reasonable risk-reward proposition as investors seek yield.

To a lesser degree, Canadians can also invest in Enbridge (TSX: ENB), TransCanada (TSX: TRP), Pembina (TSX: PPL), and for those interested in Albertan intra-provincial pipelines, Inter-Pipeline (TSX: IPL). However, the income to price disparity is not nearly as present as the American analogs (including Kinder Morgan, Williams, etc.).

Pembina, in particular, has gotten killed simply because it faces a risk that the Trans-Mountain pipeline is not going to be constructed, especially with the crash in oil prices and the general incompetency of our Trudeau-led federal government. The assets they picked up from the old Kinder Morgan Canada were quite good. Enbridge and TransCanada should also do well – the big loser going ahead will probably be the oil-by-rail trade – if production slows down, this volume will be the first to get scrapped, not the pipelines.

The new market paradigm

Longer term interest rates have gone to nearly zero.

I won’t quote the yield curve but suffice to say at the March 17-18 Federal Reserve meeting, they will drop the federal funds rate another half point to a target of 0.50% to 0.75%, or perhaps even to 0.25% to 0.5%.

Either way, this is close enough to zero.

After the 2009 economic crisis the yield curve more or less did the same thing (except yields were slightly higher). The name of the game was the following: Anything with a yield is an eligible investment. Anything without a yield is trash.

The trick, as always, is to ensure that the companies that you’re investing in have the organic cash generation capability to give out those yields.

Those that can buy sustainable yield will do well. Those companies that don’t give out yield will probably trade at a discount to those that do, except for those that are of speculative value (the Teslas and the like).

Finally, using my “Coronaproxy” stock, Alpha Pro Tech (NYSE: APT), it looks like the hysteria is dissipating. Be warned that I’ve been so wrong on the psychological impact that this flu has had on society that I don’t blame the readers of this site for using me as a contrary indicator.