Canadian preferred share indexes hammered

The Canadian 5-year government bond rate has compressed significantly:

As most Canadian preferred shares are linked to this rate, we are seeing a huge selloff (which interestingly took place about a month before 5-year interest rates really started to drop):

ZPR is a BMO ETF tracking preferred shares. CPD is an ETF tracking a preferred share index holding most of the investment grade preferred shares trading on the TSX (mostly concentrated in Financials and Energy). Holders in these “safe” funds will have had around 13-14% of their capital value evaporate over the past two months of trading.

It is indeed ironic how the equity components of the preferred share indexes have fared generally better – as an example, Toronto-Dominion equity has declined about 10% in the same period of time.

So much for preferred shares being a safer vehicle to invest in!

The big difference this time around is that a lot of the rate-reset preferred shares have already had their yields reduced to a minimum due to the 5-year Canadian bond rate being so low for an extended period of time. Subsequent rate rises will have less impact on the dividend rates paid for preferred shares.

It remains to be seen whether this will continue or not. Back in February 2016, we had seen double-digit dividend yields on very credit-worthy issuers, but this was also when the 5-year bond rate was trading at around 100 basis points.

I’ve also been doing some research on preferred shares that are not held by these two funds. I would suspect that less liquid preferred share series on the main two ETF indexes would be more prone to auto-selloff algorithms when people inevitably decide to panic and try to liquidate everything.

Very often, people hold cash in their portfolios for too long and then get itchy. They then instead think of investing in “safe” preferred shares, or an index, thinking that the 5-6% yield they realize is adequate compensation for the risk in lieu of holding cash.

It is these situations where they rethink this notion and decide to liquidate. Eventually the capital losses become too much to bear.

It is very difficult to time when the maximum moment of panic is, but doing so will result in outsized risk/reward ratios, which is why I’ve been paying careful attention in these very volatile couple months.

Doing a portfolio check on a heavy down day

As I write this the S&P 500 is down over 3% for the day. The TSX is down 1.4% which isn’t so bad by comparison.

An index is simply a collection of stocks. For the two indexes above, companies that have higher market capitalization are weighted high in the index. When an index gets sold off heavily, there is a high probability that the higher capitalization stocks in the index will also be sold off.

When there is heavy market volatility it is usually wise to look at what is going down by the averages, what is going down more than the average and which stocks are holding steady or even rising, especially those stocks that are not included in a major index. It gives you some hints as to which sectors are and are not popular for the day.

Institutional investors are usually required to keep specific ranges of portfolio fractions (i.e. an allocation between equities, bonds and other asset classes). Typically when broad equities drop, managers will dump bonds in order to buy equities to rebalance the portfolio.

Today, contrary to what the market has been doing a few months ago, a selloff in equities is once again correlated to an increase in risk-free bond securities – I note that the 10-year treasury bond yield is down some 70 basis points – which means that what we are seeing in the markets today is a flight to less risky positions. The yield curve continues to flatten – there is a 10 basis point difference between 2-year and 10-year treasuries now.

If equities fall enough, collateral values will also decline to the point where portfolio managers will have to liquidate assets in order to maintain sufficient collateral – i.e. a margin call situation. If enough of this happens, you will start to see significant opportunities appearing on the equity side.

It’s more probable than not that the upcoming December meeting of the Federal Reserve will be the last quarter point interest rate hike before they take an extended pause. If interest rates stop rising, then the next market focus will be back for finding yield.

Another observation is that gold is doing reasonably well. It is a shame for most investors that most gold mining companies are poorly managed.

I’ve still got a lot of dry powder in the portfolio and I’m waiting for worse times. There will be a time to pounce but not yet.

There is one other observation I will make – robo-investing and index investors that choose allocations of various low-cost ETFs are dooming themselves to sub-par returns. Every time I hear people investing in whatever index fund that pledges market diversity (e.g. VGRO is quite popular) I just think to myself if they are truly prepared to earn low single digit returns with the real risk of them seeing 25% peak-to-trough downdrafts.

It was about 10 years ago when the economic crisis was clearly in full swing – Bear Stearns went bust, Lehman Brothers went bust, and anything financial was imploding. The S&P 500 was still at around 870 at this time. It wasn’t for another 3 months before the S&P 500 reached its low (the value being “666” appropriately enough) – you would have still seen a 23% decline in value.

This time around, how much of a value loss can index investors take before the perception of an unlimited wealth creation vehicle evaporates? Today, we are at 8% below the peak of the S&P 500. Canadian investors (via the TSX) have seen a 9% drop from peak-to-trough in the index high.

“This is just another buying opportunity to buy shares cheaply”. Or is it?

As my last note, I will point out that General Electric (NYSE: GE) is down 6.66% today. How symbolic.

Zargon Oil and Gas – debenture offer

I haven’t written about Zargon Oil and Gas (TSX: ZAR) as they are a very obscure small oil and gas producer with some small producing properties in Alberta and North Dakota. They have been trying to sell themselves for years as they have admitted they are not at the scale where they should be a viable standalone entity.

They did manage to successfully sell off an asset a couple years ago, and in conjunction with that reduced their bank debt to zero and extended their 8% convertible debenture (TSX: ZAR.DB.A) to the future.

In this case, the future meant December 2019.

Financially, Zargon is not in completely awful shape (by virtue of the prior asset sale) but even before the collapse in Western Canadian Select oil pricing, they were barely treading water on their income statement. They are now burning cash when factoring in capital expenditures and the interest bite on the debentures. Their only major debt on the balance sheet was their convertible debenture, approximately $42 million face value. They also have a large provision for asset retirement (which suffice to say, they will not be executing on given the lack of money they have to perform such a function – reassuringly, they expect to pay for this over the next 55 years according to their financial statements!).

Because they had no other viable sources of financing, on November 2, 2018 they were forced to borrow US$3.5 million of secured debt financing at the rate of 11% to conduct a drilling operation on the North Dakota side.

I had previously took a speculative and very small (emphasis on VERY) position in Zargon debt which I eliminated immediately after reading the November 2 press release, taking a small loss.

Recently, on November 21, 2018 Zargon proposed an offer to their debenture holders to convert them at the equity price of 10 cents per share. The debenture holders would have to approve it in a special meeting.

I cannot figure out why the debt holders would agree to such a proposal, especially given the shares of Zargon are now trading at half of the proposed amount (5 cents per share). I know clearly the reason why management wants to do this – to wash their hands of a huge debt and pray that they keep control.

Unlike most of these convertible debenture offerings where the company can choose to equitize the debt, Zargon gave away that privilege in their early 2017 debt extension – Zargon does not even have the right to redeem the debentures into stock unless if Zargon equity is trading at 125% above the $1.25 conversion price, which they are nowhere close to.

Zargon is forced to pay debenture holders the 8% coupon between now and maturity. Zargon management cannot compel the debenture holders to redeem their debt for equity.

This has a Twin Butte Energy saga written all over it – if Zargon doesn’t offer the debenture holders a better deal, I can’t see this arrangement passing. They will likely threaten CCAA proceedings, but that will simply accelerate the realization of value (or whatever is left) in the subsequent bankruptcy liquidation.

The question is how much these producing assets would fetch in a fire sale in relation to the amount of debentures outstanding, net of the liabilities of the company. My suspicion is that it is more than the current implied value of CAD$16 million, but the actual realization of this would take quite some time and be somewhat dependent on a recovery in the oil markets (who knows how long that will take, if ever).

The obvious safety valve for management and the company is to sweeten the offer and change the conversion price to 4 cents a share. Instead of getting 93% of the company, debenture holders would get 97%. I am still not sure whether the debenture holders would go for this, although there is a reasonable chance they could realize more value with a flat-out CCAA proceeding, this would be more riskier than what happened with Twin Butte debenture holders compared to Zargon debt holders owning virtually the whole company if they went with a sweetened proposal.

The collapse of the asset bubble

If you haven’t picked up a (digitally – free!) copy of Ray Dalio’s Big Debt Crises, I would recommend you do so since what you are seeing right now is a playbook describing exactly what is happening right now. This book contains various examples of market reactions of historical debt crises which made for some very fascinating reading.

For the quarter, the TSX is down 9% and the S&P 500 is down 10% as I am writing this. These sorts of markets will be punctuated with higher volatility – rallies, in particular, will serve to draw cash from the market from people that are fearing “missing out”.

What’s happening is the cost of capital has risen to a point, coupled with the reversal of quantitative easing, where you are starting to see assets dragged into cash. Cash is starting to return a relevant yield again (e.g. 2-year US treasuries are yielding 280bps which is about 200bps more than it was a couple years ago). Yield proxies are no longer as attractive because cash is such an alluring alternative. It is a slow squeeze of a financial vice that will continue to reverse the inflation of asset prices and encourage demand for cash – “The phases of a classic deflationary debt cycle” is listed early in this book and what is happening in the USA is precisely this.

This means that the equity end of debt-heavy operations will be especially vulnerable. The last thing to hit in this part of the market cycle will be defaults as liquidity becomes much more valuable. One canary in the coalmine is General Electric – there is a very real valuation case to be made that they will go to zero unless if management is especially astute at managing the psychology of the marketplace. When reading articles like this (Reuters), hearing about “urgent” asset sales, especially in today’s market environment, smacks of desperation.

I won’t get into the malaise that Canadian oil producers are facing – putting it mildly, the damage done with the current Western Canadian Crude pricing situation, compounded with the general drop in West Texas Crude, coupled with overall financial market liquidity drying up (as most of the producers are heavily indebted) is going to cost a lot of people a lot of money. In these situations, timing the bottom is the key to making a lot of money, but I do not see signs of a bottom presently.

2019 target maturity ETF solutions

I’ve been doing some minor work analyzing low-risk cash parking options in both USD and CAD currency. My underlying assumption is we will see a couple more (quarter point) rate hikes in 2019 if the economy doesn’t crash and we will see nothing happening on rates if the economy does decide to slow down. If interest rates are projected to be less than market expectations, it would make sense to buy a constant-maturity ETF (in particular, NYSE: SHY looks attractive – YTM of 2.85%, duration 1.86 yrs, MER of 0.15%). The following option are fixed-maturity ETFs, which remove most of the duration risk (although in the case of SHY, a duration of 1.86 yrs is not exactly gambling on the direction of interest rates either).

Canadian currency: TSX: RQG – portfolio of high-grade corporate debt, YTM 2.67%, duration about 9 months, MER 0.28%, maturity November 2019.

US currency: Nasdaq: IBDK – portfolio of high-grade corporate debt, YTM 3.05%, duration 0.56 yrs, MER 0.10%, maturity December 15, 2019
Nasdaq: BSCJ – portfolio of high-grade corporate debt, YTM 3.05%, duration 0.58 yrs, MER 0.10%, maturity December 31, 2019

I would deem these ETFs to be relatively low risk – even if there was a meltdown in the corporate bond market. The US ETFs are trading above NAV but market fluctuations should render an execution at par or even a mild discount.

I would, however, avoid the high-yield corporate bond market. Not only will rising risk-free rates damage yields in this sector, but the ultimate risk of investing in high-yield is defaults and it has been quite some time that we have seen the entire junk bond market get hit.

It is also reasonable to construct your own ETF by purchasing the underlying bonds directly. As an example, Shaw and Rogers October/November 2019 debt is roughly 2.7% yield to maturity. All of the ETF names above trade in an efficient and liquid market and it is a lot easier to just trade them instead of the underlying bonds.