Looking at the government bond market

Every analyst that is actively tracking the market is acutely aware that the US government bond (and this also applies to Canadian government bond) yields have been dropping dramatically over the past couple months. Here is a chart of the 10-year US Treasury note yield over the past two years (the y-axis is the percent yield times 10):

What do we see?

People that loaded up on government debt four months ago are laughing right now since they have a significant profit. But should they liquidate? What is the market anticipating? (Just as a side note, I don’t apply my “August trading is not to be taken seriously” stance on the government bond market.)

Typically institutions invest in bonds if they anticipate deflation (as having a fixed income yield in a deflationary situation is ideal) or if there is a “flight to safety” or some incident that spooks the market – such as a global economic crisis that occurred in late 2008/early 2009. Bond yields went as low as around 2.0% at that point in time.

But where is the global economic crisis today? It is obvious the market is trying to say something is going to happen, and I believe the bet is on some sort of deflation.

Even though I believe the next “swing” in monetary trends will be an inflation, this will only happen when the vast quantity of money supply out there is unleashed into the economy – right now those reserves are being held by banks that are very resistant to lending them because of credit concerns. They don’t want a repeat of late 2008, so they are buffering themselves. The catalyst to lending will be confidence in the marketplace, and right now is the most business-unfriendly administration the US has ever seen in a long, long time. Until this administration is gone and replaced by a pro-business administration, investors will not have the confidence. However, that will be the catalyst for inflation.

So until then, we might be seeing a deflationary dip as government stimulus slows down and the economy comes grinding to a halt. I don’t think we will be entering into a “new depression” by any means, but economic growth is going to be slow.

What are the implications?

1. Federal funds rates will be kept at zero for a long time. December 2011 futures are trading at 0.45%. In Canada, I would expect one more rate increase of 0.25% to 1.00% in September, and that is it for now.

2. People will struggle to find yield at an acceptable price. You can’t invest in the short-end of the rate curve, since this yields almost nothing (two-year government bonds give you less than 0.5%!). This already has been happening, especially since the last four months. Gold is also popular, which is counter-intuitive since assets decline in deflationary situations – I believe the mentality is that “bond rates are low, Gold will return nothing, but it will retain its value since it is a de facto quasi-currency.” Other commodities, such as oil, copper, etc., should depreciate unless if they also have a quasi-currency perception by the marketplace. Note that America’s economy used to dominate the commodity market, but with emerging markets (e.g. China, India, Brazil in particular) taking a higher proportion of commodities, the linkage might change somewhat.

3. Companies with debt will find financing a little tricky if they are too leveraged – low interest rates are “good” since they will be able to pay less interest on debt, but this is assuming they get extended credit since their cash-generation ability will be compromised by the deflation itself.

4. In a deflationary situation, zero-yield cash also has a positive return at the rate of the deflation itself. Any savings banks that give a positive yield (e.g. Ally at 2%) is “gravy” on top.

How low will the 10-year note yield go? I have no idea. However, at current yields, 2.6% looks very pricey compared to other alternatives that are available. It takes a very brave person to be shorting these products since it is very well believable that you could see even lower yields.

I do know when this paradigm changes to the inflationary cycle that it will be very quick – like a flash forest fire.

ING Direct gets into the chequing market

In an interesting corporate strategy shift, ING Direct is now getting into the chequing and bill payment market. The salient details are similar to the local credit union that I deal with, mainly no transaction charges and a nominal fee for other basic services (ordering cheques, writing bank drafts, etc.).

ING Direct used to start off as a basic business model where you can save your money at a high rate of return – ING Direct would then use this as collateral to write mortgages, and then make the money off the spread between the mortgage rates and the savings interest paid. As their deposit base grew, they eventually morphed from giving their clients the best rates available to just giving slightly above average rates for savings. They are now out-competed by Ally and other providers.

As there is nothing preventing competition for funds, the only barrier for customers to switch banks is simply to fill in an application form. Since the interest spread between ING Direct and Ally is 0.5% on short-term savings at present, it is a $50 difference on a $10,000 deposit for a year. While this is not a gigantic amount of money, it is likely worth it for those that can spend the 20 minutes applying and getting an account.

As for the chequing account, I was assuming that the funds you leave on deposit would be earning ING Direct’s typical interest rate on savings, but it is not – apparently the first $50,000 will earn 0.25%, and the remainder will be earning more. This is far below the 1.5% that ING Direct offers.

So what is the point of opening an account? Typically the convenience of opening such a chequing account would be that it works completely in synergy with your main ING Direct account, and offering the high rate while you keep your cash idle in the account. Instead, you still have to go through the same procedure to transfer over your money from the high rate account to the lower rate chequing account, and then make the cheque or bill payment.

I don’t think this is going to attract the type of clients that ING Direct wants, mainly those that keep large amounts of deposits in the account.

It is also interesting how most banks probably take a loss processing these accounts – the big money maker on the retail end are for mortgages, loans and credit card interest debt.

Potash – Corporate takeover bid

Many years ago, the first time I heard the word Potash, I thought somebody was referring to a narcotic. I quickly educated myself (Wikipedia is a good primer) and nodded, and didn’t think about it otherwise. Potassium compounds aren’t exactly rare, nor are they terribly exciting – you can use potassium chloride instead of sodium chloride to replace your table salt, and more importantly, its usage as a fertilizer.

Canada apparently has the majority of potash reserves, and the major corporation is Potash Corp (TSE: POT). Never in my wildest imagination did I think back then that it would result in a triple over the past 5 years, but apparently agricultural fertilizer is in such demand that companies with potash reserves have been bidded through the roof.

Yesterday, Potash Corp received a hostile takeover bid for US$130/share, while the day before the takeover trading closed at US$112. After the takeover was announced, trading closed at US$143/share, which likely means that the takeover bid will fail at the present price.

Potash has about 297M shares outstanding (304M diluted), which implies that the price paid is around CAD$40 billion for the equity, plus CAD$4 billion in debt for a total price of around CAD$44 billion. The balance sheet has about $6.5 billion in equity, so there is a takeover premium of about $38 billion over book value. Presumably this is because of the embedded value of their resource reserves, but I skimmed their annual report and couldn’t find any clean quantitative data – it has to exist somewhere, but I couldn’t find it when wading through the many pages for a minute.

Apparently 2008 was a banner year for the company, where high prices allowed the company to mint about 11 dollars per share in earnings. 2009 was a more moderate year, with $3.25/share of earnings. The first two quarters of 2010 have an EPS of $3.02/share, so strictly from a backward looking P/E ratio, it looks expensive. Even if you assume every year is like 2008 from here on in, the CAD$44 billion valuation (roughly CAD$145/share) appears to be “average”.

Because of my investment laziness, combined with a lack of knowledge of the dynamics of the potash industry, I wouldn’t make a firm statement on the valuation of the merger. I don’t plan on touching this stock without doing a lot more research (which I am not going to do). Just strictly looking at the financial statements, it looks like the party willing to pay $44 billion for the company is over-paying, while the board of directors that are recommending the rejection of the takeover are likely playing for more money from their potential suitor.

Still, the general lesson here is that when you learn about some obscure compound or mineral, it might pay to look a little more carefully at it and see if it is plausible whether it will be an in-demand commodity in the future. Everybody knows about petroleum and potash, but what is next? Uranium already had its hype period in 2007, while “rare earths” and lithium are making the headlines currently – what’s next? Antimatter?

Investing in structured products

After alluding to disposing of a long corporate bond position, I received some comments as to what the exact ticker is of the issue in question. There were enough hints in the post to figure out the product, but I will be more explicit in this post.

Now that I have completely disposed of the position today, the ticker in question is (NYSE: HJR). This is one (of many, many) examples of an exchange-traded structured product. The specific structure is a trust that has a single asset – corporate senior bonds of Limited Brands (6.95% coupon, maturing March 1, 2033). The trust’s mission in life is to distribute income coming out of that bond. The trust itself has $25,340,000 worth of 6.95% corporate bonds and the distribution is at a 7.00% rate.

You can read the exact specification of the trust by reading its prospectus.

Effectively you are investing in a corporate bond that is exchange-traded. The payout times are identical to the bond, with the exception of the coupon (7.00% on the trust vs. 6.95% with the corporate bond) and that trades do not incur interest expense/revenue for a purchase/sale of securities. An investor purchasing one unit of HJR will receive a $0.875 payout every March 1 and September 1 until March 2033, where they will receive a $25.875 payout.

At the current transaction price of $24.40, an investor has a 7.2% current yield on investment, or about a 7.5% yield to maturity for a 22.6 year term.

There are slightly different risks involved with the structured product. The largest change is that the structured products have a “call provision” where the unitholder, if held in sufficient quantity, can redeem the trust in exchange for the underlying bond. This call provision ensures that there is an effective cap on the unit price, even if the underlying bond trades at a premium.

There are a couple hundred of these products trading on the exchanges – some are extremely illiquid, and in the example of HJR, it is lucky to have $50,000 par value traded daily. The spread is typically 40 cents.

As I have indicated before, I have recently liquidated my entire position in HJR as I do not feel the risk/reward ratio is right for my portfolio. Other investors that are looking for a stable 7.2% yield on a senior corporate security could consider HJR. It is still a far, far more inferior option at present than buying the actual corporate debt, which is priced at around 90 cents. Since HJR is trading around 97 cents on the dollar, I am very puzzled at the high price and hence sold my position. The bid is obviously from an irrational retail source.

There are other structured products carrying the exact same bond as collateral, and they are trading at more reasonable prices. If the products were marginable, there would be an obvious arbitrage opportunity.

Exchange-traded structured products are very research-intense. Although most of them have standardized provisions, there are some that have odd-ball provisions that require you to look at the prospectus of each and every security that you are considering. Once you have cleared the research hurdle, however, they are worth looking at. In late 2008 and early 2009, these products were being thrown out the windows of financial intuitions. At the depth of the financial crisis, HJR was trading for $8.40 (33.6 cents to par) and suffice to say, I thought this was one of the greatest opportunities the market was offering especially in consideration with the risk taken (the seniority of the bond ranks you ahead of common shareholders).

Although you would have done slightly better with an equity investment at the same time, you earned your capital gain with a significantly lower level of risk, in addition to having the luxury of having a well-defined exit point (at the lastest, the maturity date). You were also being paid a handsome sum of money to wait.

In the case of HJR, and in the case of a lot of other asset-backed securities that give out a yield, it is close to the time where it is worth liquidating the positions. As the 10-year bond yield is heading toward record lows, chasing yield will become more and more dangerous.

Spam filters

I notice that Larry MacDonald has had some issues with the Akismet spam filter, which has been over-zealous in filtering his comments on other people’s websites.

I notice that on this site, he had three comments which I had to fetch out of the spam filter.

Spam is really all about economics – you can produce enough of it for such a low cost that even with a microscopic payback rate, it still is profitable. It does cause a lot of pollution on the internet, but with some Bayesian filtering you can weed out most of it and have an acceptable false positive rate.

Spam is also about game theory – a cat-and-mouse type game. The new game is that spammers are trying to increase their “credibility scores” by making innocent-sounding comments and posts in the hopes that human operators will “approve” them and then they will be able to deliver their payloads more effectively elsewhere.

Akismet has been good at picking up comments like “Like your site, keep up the good work” and other such spam comments that were socially engineered to let site owners keep them on their site. Filtering techniques are quite effective at weeding out these types of comments, such as using the IP address of the comment origin, and the submitted name and/or email address included with the comment.

However, if filtering gets too hyper-aggressive such that it begins to block out legitimate comments (called false-positives), it undermines the entire system.

Imagine a cellular phone network taking 5% of your incoming phone calls and/or text messages and not relaying them to you. You would consider this unacceptable. In the comment world, the acceptable false positive rate is likely higher, but for emails, it has to be one in a thousand in order for the system to be effective.

If spammers are able to increase the false positive rate, it will also be a victory for them since it undermines confidence in the spam detection system.

Unfortunately for Larry, it is likely that Akismet has somehow flagged his online signature as spam. Not sure how that happened, but at least on this site, I have taken three of his comments out of the spam bucket.