More market silliness in the Trust Preferred marketplace

Looking at the whole exchange-traded bond market, there is nothing ordinary going on – some up, some down, most of them less than a percentage point. It looks like a typical slow end of summer day – and indeed, this week no significant decisions will be made since a lot of decision-makers out there, including the President of the United States, are on holiday.

However, there is one significant blip on my radar, and considering up until today, I held onto them, was a trust preferred issue which is backed by March 2033 senior debt of Limited Brands, trading as NYSE: PZB. Already (at 12:30 Pacific, or 30 minutes to closing), 60,000 units have been traded, the highest volume day since July 8, 2009 (which was an unremarkable day).

Unlike back in July, today there was a clear and pronounced price increase, up 5.9% to 22.5 (90 cents to par value).

Why the price spike? I am not sure, but I suspect the trust preferred made it onto some newsletter or recommendation list.

Unlike the underlying debt which has a 6.95% coupon, PZB has a 6.7% coupon, which means it should trade below the bond price (which is currently 91 cents on TRACE). At 90 cents on the dollar, an investor in PZB would receive a 7.44% current yield, with a 0.47% implied capital gain if held and redeemed at maturity 22.5 years from now. An investor in the 6.95% senior bonds at 91 cents would receive a current yield of 7.64%, and an implied capital gain of 0.42% at maturity.

In my efforts to reduce duration and long-term corporate debt exposure, I have expunged my small position in PZB. It is a difficult decision, knowing that you are trading something with a decent and relatively secure yield for something that is giving you nearly nothing (cash interest), but keeping liquid is the name of the game – you will have ammunition to strike when the real opportunities start arising, whenever it may be. Having the discipline to holding onto substantial portions of cash is a crucial skill to survive in the markets.

Is that it for the rise in long term bonds?

Attached is a chart of the 30-year treasury bond yield, and please observe that lower yields mean higher bond prices:

There are probably a lot of speculators out there with long positions in the bond, wanting to take profits. There are probably a lot of speculators out there with long positions that want to see even greater amounts of profits.

Ben Bernanke’s statements today was obviously a catalyst for the downward price movement in bonds. When reading the speech, I generally do not take the media’s perception that he was saying anything new with respect to inflation or any future use of monetary policy. I am forced to conclude that this was a technical correction of expectations rather than any reaction to pricing in future policy decisions from the Federal Reserve.

Traders that have used increases in bond yields to add to their long positions have profited handsomely over the past 4 months; will it be the case here? Time will tell. Every technical analyst out there will point out the slope implied by the chart, and see that the y-intercept at the right hand side of the chart is around 4.0%. The question is whether the market will take it there or not.

This has always been one of my big beefs about technical analysis – its ability to predict the future is not good, it is always in retrospect you can construct these “trends”, “resistances” and “support” levels. Does four months of downward yields mean the next four months will be the same? What about two months of data? Or six? What would signal a trend reversal? One month of rising yields? Two? Two days of trading? Again, it is always much easier to answer these questions in retrospect, which is why I do not have a lot of respect for technical analysts, although there is some value in the process because other people think there is value in it.

Finally, if long bond yields are truly rising again, it should affect the corporate long term debt market. I am continuing to liquidate my long term corporate debt positions and there are some other issues in my portfolio that are tantalizingly and/or frustratingly close to liquidation prices. Hopefully there will be a flood of retailers that will be bidding up these products for one final push before they collapse again in price.

A basic guide on how to do Canadian equity research

Whenever I hear of a publicly traded company, I follow a fairly standard methodology to do some basic research on the firm.

In a perfect world, you try to do research before looking at the share price of the company. The whole idea of the research methodology is to pin down a valuation for the equity (or in some cases, debt) and seeing a stock price contaminates what should be an unbiased analysis. You want to come up with your own valuation, rather than looking at the market’s valuation and then thinking of ways to rationalize the stock price. Unfortunately 9 times out of 10, the first thing I do is pull up the stock quote. I’ve been trying to train myself to no longer do this, but it is really, really difficult to not see a quote attached to an article.

Once I am ready to research, I pull off these documents from SEDAR in this order:

1. If the “nearest” financial report is an interim statement, I pull down the interim financial statements and MD&A document and read them. Doing analysis on this alone is time-consuming, and you look for tidbits in the statement, get an idea of how the company is capitalized and look at the cash situation. If the “nearest” report is an annual one, I read that and the MD&A.

2. Then I read the management information circular, and look at executive compensation scheme, insider ownership, and executive biographies and get a “feel” for who is running the firm, and who is on the board.

Usually by this point, you can come up with a ballpark number and then it becomes irresistible to look at the share price and hence valuation. Which then leaves:

3. Pulling up the stock chart, and then looking at any significant price moves, and then connecting those price moves to various news releases of the company;

4. Reading every news release of the company over the past X years, chronologically, and then looking at the reaction of the stock to what is significant news;

5. Reading the latest annual report (not the glossy version, the dry financial version) with its MD&A, and/or the Annual Information Form, which is also a good document that has information that is not contained in the interim statements;

6. Insider trading is available on SEDI and can influence a decision. While insider selling is not necessarily a negative signal, whenever you see insider buying it gets your attention much more.

7. The company’s website.

Usually by this point you spent many hours of reading and synthesizing information, and should have a pretty good idea as to what makes the company “tick”. Then the next step is to have a sector-wide comprehension and start investigating competitors, and firms up and down the supply chain to get a feel for the economic variables at stake. This is a never-ending process and eventually at some point you cut it off and then make a buy/sell/leave alone decision.

Learning to prune investment candidates at stage #2 is a very good skill to have – I usually set price triggers on those companies, and when the triggers are hit, I get an email and this triggers me to take a second look at the company to see if anything has changed. In the second half of 2008, so many companies were triggering low price alerts that I had a very, very difficult time keeping up with what was literally an avalanche of securities. I probably could have performed better in 2008 had I had more time to look at all the securities that were flashing at me.

Today, there is hardly anything that triggers my low price alerts, so I am using different screens to put some companies on the research queue.

Cursory scan of mortgage markets

As 5 and 10-year yields plunge, they have had a corresponding impact on mortgage interest rates.

The best variable rates I can find are prime minus 0.75% for a 3-year variable mortgage, or prime minus 0.7% for a 5-year variable mortgage. Prime currently is 2.75%. This is still the dirt-cheap option and is preferential compared to the best available 5-year fixed rate, which is currently 3.75%.

Assuming the Bank of Canada raises rates 0.25% this September (which is not a certainty, but is a likely action) then the break-even proposition, in terms of net interest paid over a 5-year fixed period, is quite unlikely. An example of a breakeven calculation would be, on a 25-year amortization mortgage, a 0.25% rate increase every half-year in order for the 5-year fixed rate to be breakeven with the variable rate. This would correspond with a 2.5% rate increase over 5 years which seems to be unlikely given that the futures currently indicate that rates will go up by about 0.69% over the next 2.75 years.

That said, the current interest rates are historically low, and interest rates are not very predictable – it sometimes feels like one is reading tea leaves in order to get glimpses of the economic future.

As there is a real estate implication to mortgage rates, it should be noted that even though the USA has record low financing rates for mortgages, it is not sparking their real estate market.

General Market Commentary

Very little going on in the day-to-day action in the marketplace, hence very little to write about. If there was a story to write about, it would be at the extremely low yields of the US treasury market and how it continues to induce others to chase yield. Forcing people to invest in assets for income when they do not receive a fair risk-adjusted return of capital (opposed to return on capital) means making such investment decisions is a tricky endeavour.

Spot gold continues to swim at the US$1,200/Oz mark; spot crude continues to wobble between US$70 and US$85/barrel. Natural gas has been wobbling around $4.5/mmBtu, which is still quite divergent with the energy content implied with the crude contract – Natural gas has considerably lagged crude, presumably due to the implementation of cheap shale gas drilling (so-called hydraulic fracturing, or “fracking” in short).

3-month banker’s acceptance futures have also shifted slightly downward, implying less of a chance that the Bank of Canada will raise interest rates on their September 8th meeting. Three-month corporate paper is trading at a 0.91% yield. This change in the future projected rates also had the effect of taking down the Canadian dollar from roughly 97 cents to 95 cents, but this could just be white noise. The currency diversification is an interesting and separate topic, but I am happy with my mix of Canadian and US-based portfolio components.

There’s not a lot to be writing about, which gives me some time to research individual issues on my research queue. Also, since the last two weeks of August are the most heavily booked vacation days before the kids go back to school, the markets should also be relatively quiet in volume, but not necessarily price! However, at least Monday was a calm day.

I have been noticing some of my income trusts creeping up in price; if they go much higher, I might consider a partial liquidation.