Modern Finance – The risking of the risk-free rate

There will be a huge quantum shift coming in the financial markets, and this is mostly inspired by the fiscal mess that countries such as the United Kingdom and the United States will be facing in the medium term future.

It has to do with the concept of the “risk-free rate”. Most formulas in finance reference the US government bond or Eurodollar (essentially an interbank short term interest rate) as the “risk-free rate”, where all other financial securities are referenced from. So if the 5-year US government bond is trading at a 2.5% yield and General Electric issues 5-year debt at 3.2%, typically the financial literature would state that the bonds were sold at 70 basis points over. The spread of yield, rather than the absolute yield itself has typically been the market benchmark in determining how creditworthy a corporate issue is.

This is going to change, mainly because the risks inherent in the reference securities will be significant to the point that it will start to distort the concept of the spread.

It is very unlikely that the US government will default on their debt; instead, the road to their fiscal recovery will lie upon debasing their currency. An investor in General Electric would still face the same inflation risk as an investor in US government securities; however, the big difference in modern finance is that an investor can hedge their currency risk and solely take on the default risk of the security.

As a result, it will increasingly be seen that corporate bonds will be trading at lower yields than their government counterparts under the belief that the market thinks the corporation is more likely to pay off its investors than the government.

Thus, the finance variable of the risk-free rate must not be solely relied upon – just as how Newton’s Laws become unreliable when dealing with objects that are close to the speed of light, the risk-free rate becomes unreliable when sovereign defaults start becoming non-zero possibilities.

Quantitative traders that fail to adjust for this in their models will end up losing a lot of money for their clients.

Paying attention to debt call features

Rogers Sugar Income Fund announced yesterday a bought deal – they were issuing $50M in convertible debt. The salient part of their press release was the following:

The net proceeds of the offering will be used to redeem all of the outstanding $50 million principal amount 6.0% convertible unsecured subordinated debentures of the Fund due June 29, 2012. The redemption is intended to take place on or about June 29, 2010.

The $50M currently outstanding trades as RSI.DB.A. It had a maturity of June 2012, coupon of 6% and a conversion feature at $5.30/unit – before this announcement, the debt was trading very thinly at a price of 103-104. This implies a 4.1-4.5% yield, plus the option premium on conversion. The proper valuation of the debt actually is not a trivial issue considering you have to make some complex calculations with respect to the convertible option – Black Scholes will not cut it in this case.

In any event, Rogers Sugar refinanced the debt. The June 2012 debt also contains a call option, where the company can call the debt, as per the prospectus:

On or after June 29, 2010, the Debentures will be redeemable prior to Maturity in whole or in part from time to time at the option of the Fund on not more than 60 days and not less than 30 days prior notice at a price equal to the principal amount thereof plus accrued and unpaid interest.

So in other words, debt that was trading between 103-104 on March 18, 2010 will be redeemed at a price of 100 by the company on June 29, 2010.

Not surprisingly, the debt now is trading with a bid/ask of 101.75/102.00 and the only reason why this is above 100 is purely due to the value of a three month option with a strike price of $5.30/unit embedded in the debt. Debt purchased at 102 actually has a negative 0.5% yield when you factor in the call that will occur on June 29, 2010.

Investors would be very well to take note of any embedded call features in the debentures they purchase – especially if they are purchasing the debt for over par value.

The new debt issue of Rogers Sugar has a 7 year maturity and is 2.7% above government bond rates (coupon 5.7%; government 7-year benchmark is 2.96%), which is represents a rather cheap medium-term financing for the company. The $6.50/unit call premium is about 35% above market value and thus would minimize any dilution in the unlikely event that Rogers Sugar actually trades that high and thus the coupon cost is lower. I would have preferred that management lower the conversion rate to about $6.00/unit and have a smaller coupon on the debt, however.

Vancouver Real Estate – Cultural Factors

Just reading this post out of the Vancouver Real Estate Anecdote Archive:

Vancouver has the highest percentage of young adults by government definitions (18-30) living at home in Canada. Much of this is cultural, where members in certain communities (Asian, East Indian just like Greeks and Italians in Toronto) do not leave home until they are married as renting is a huge waste of money in their eyes. When you leave at home for a couple years, it is very easy to accumulate a large DP when you have no expenses (someone making 30k living at home is much better off than someone making 60K having to rent). Factor in that 40% of the city is made up of primarily two ethnic minorities, and that people are getting married later, you have a situation where FTBS come to the table with very very large DPS that more than offset the high cost of houses. The do not need massive salaries to afford their homes…

[DP = Down payment, FTB = First Time Buyer]

I referred to the “Cultural Factor” as being a relevant determinant in terms of the expensive Vancouver real estate market.

I don’t think it is the “live at home” factor that accounts for a latent demand factor in Vancouver Real Estate valuations – looking at the demographic bulge would suggest that there are relatively less people of the domestic 18-30 year bracket that would be moving into their own dwellings, compared to the people coming in (immigration factor).

I do think that having a very heavy Chinese ethnic component in the Lower Mainland is a significant cultural demand component – I don’t think any other culture values real estate and education as highly as people having Chinese origins. Combine this with the perception of price stability (compared to the amount of money lost in the stock market) and it creates demand for an asset class that is perceived to be a “sure thing”.

My rational framework (which is not at all supposed to model real life reality) suggests Vancouver real estate is over-valued around 40%. But the famous quote, “the market’s ability to remain irrational longer than your ability to remain solvent” always applies, especially with real estate.

Stocks and Politics – TennIndependent

I am linking to some fellow named TennIndependent, who resides in Brentwood, Tennessee, USA.

He seemingly has a portfolio that has a billion stocks in it, but his writings are strangely both coherent and incoherent at the same time, but I like his scatter-brained logic and how he knows he writes as such (which he equates to his “left brain” and “right brain”).

Most notably is that he is probably one of the few amateurs on the internet that I know of that invests in Trust Preferreds.

First Uranium raises expensive capital

The financial soap opera continues at First Uranium. On Friday morning they announced they have agreed to a private placement of between $125 to $150 million of senior secured notes. There are a bunch of stakeholders that are getting into this offer, including the major shareholder, Simmer and Jack, and also Gold Wheaton, who has a stake in the gold production of First Uranium.

The notes are convertible at $1.30/share and this will represent a substantial amount of dilution for existing equity holders, assuming conversion – about 48% dilution.

I was informed that the notes will have a 7% coupon attached to them.

Also in the announcement is that the CEO, Gordon Miller, will depart and be replaced by another CEO, Deon van der Mescht, who is currently the CEO of Simmer and Jack.

A relevant quotation is the following:

In addition, the Company is relying upon exemptions from the minority approval and valuation requirements of Multilateral Instrument 61-101 – Protection of Minority Security Holders in Special Transactions, on the basis of financial hardship. The Company’s current payables do not, in the Company’s estimation provide comfort to wait for 21 days to begin closing the Offering. As previously announced, the Company’s financial situation has been severely compromised by the termination of discussions regarding certain financing options as a result of the decision to withdraw and subsequently reinstate the Company’s environmental authorization for the new Tailings Storage Facility designed to accommodate future tailings deposition at the Company’s Mine Waste Solutions tailings recovery project.

First Uranium, therefore, is very close to bankruptcy. If this deal falls through, then bankruptcy is guaranteed. There would be a process where creditors (including the debentureholders) will be able to make their claim on the assets in accordance with Canadian law. Simmer and Jack’s investment would have been completely destroyed in the process, which is why they had to take this very unpalatable deal in order to save their interest in the company – which by all means should be able to produce a substantial amount of revenues once the core operation commences.

If you are holding equity in First Uranium, you have virtually lost most of your value over the past couple years. This deal should probably stop most of the blood-letting, but it is at a huge cost to shareholders.

The market, seeing certainty on the horizon, bidded up First Uranium shares 13% to $1.68. This also provides a substantial conversion cushion for the private placement component of the convertible offering to succeed.

The convertible debentures also rose 12% to 77 cents on the dollar with this news. The convertible debentures are a $150M issue, with a 4.25% coupon and maturing on June 2012. I happen to own some of these and am not afraid of dilution – in fact, I prefer dilution.

If this deal succeeds, it is more likely that I will receive payback on my investment, especially since the maturity date of this new deal is later than the existing convertibles. It is not clear, without reading some sort of prospectus statement, whether the secured nature of these new notes would interfere with the payment of the unsecured debentures.

Of note in this press release is no quotations from any officers in question – probably because this deal was entirely organized without the management of First Uranium consenting to it.