Bank of Canada raises rates 0.25%

As I was speculating, the Bank of Canada has raised interest rates by 0.25%, which is a change from 0.75% to 1.00%.

The key guiding paragraph to determine future rate hikes is in the last paragraph. From the July 20 statement:

Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments.

From the September 8 statement:

Any further reduction in monetary policy stimulus would need to be carefully considered in light of the unusual uncertainty surrounding the outlook.

The phraseology of changing “would have to be weighed” with “would need to be carefully considered” suggests that the Bank of Canada is not necessarily totally done raising rates, but it is not out of the question if data warrants so.

The next Bank of Canada scheduled announcement is October 19, 2010 and the last one for the year is December 7, 2010.

3-month Bankers’ Acceptance Futures are at 1.24% for September and 1.3% for December. Both are trading about 0.15% up from yesterday as a reaction of today’s news. The futures imply there is roughly a 20% chance of a rate increase between now and years’ end.

Canadian Interest Rate Futures

At 9am (eastern time) on September 8th, the Bank of Canada will make an announcement regarding the overnight target interest rate, which is currently 0.75%. The 3-month Bankers’ Acceptance futures market currently has the following quotations:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 SE 98.895 98.900 98.890 0.000 16669
+ 10 OC 0.000 0.000 98.795 0.020 0
+ 10 NO 0.000 0.000 98.785 0.020 0
+ 10 DE 98.850 98.870 98.850 0.010 19389
+ 11 MR 98.760 98.770 98.750 0.010 12911
+ 11 JN 98.670 98.690 98.650 0.020 6078
+ 11 SE 98.550 98.570 98.530 0.020 3172
+ 11 DE 98.400 98.430 98.400 0.110 363
+ 12 MR 98.270 98.310 98.270 0.100 262

A September and December contract at around 98.85-98.9 is projecting that there is a higher than average chance of a 0.25% rate increase this upcoming meeting, and then no further rate increases for the rest of 2010.

The market is likely going to be correct with this – I anticipate a statement that will state that domestic growth in Canada is quite good, but there remains significant risks outside the country that might affect Canada’s domestic economy.  A 1% short term rate, historically, is still very stimulative.

3-month corporate paper is yielding 0.98% on September 7th and 3-month T-Bills are yielding 0.78%.

In the last decade, the previous low bank rates were 2.25% in early 2002 and in the middle of 2004.

The main impact of the sum of these interest rate increase decisions is that the yield curve will be slightly less steep – traditionally banks make money by borrowing short and lending long.  So when rates were at 0.25%, they could borrow money at that rate, and then lend it out (the ultimate risk-free loan would be to the Government of Canada, which has a 10-year bond yield currently of 2.95%).  You would then skim the difference (2.7%) as profit, which is nearly risk-free.

By increasing interest rates, spreads shrink somewhat.  Assuming the Bank of Canada does raise rates to 1%, the spread will shrink to 1.95% for 10-year money which is still profitable, but not quite as profitable as it was at lower rates.

People with sensitivity to short-term rates (e.g. variable rate mortgages, margin balances in margin accounts) will feel the impact of this increase most directly.

Clearwater Seafoods facing debt crunch

Clearwater Seafoods Income Fund (TSX: CLR-UN.TO) is a financially distressed entity. The fund has an equity interest in a limited partnership. The limited partnership is the operating business that sells seafood. The units are trading at around 80 cents, with a market capitalization of about $23 million. The trust has stopped paying distributions since 2007 and is not likely to pay distributions for a long, long time.

Whenever investing in an income trust, they typically have more complicated ownership structures than corporations. You can usually get a summary of the structure in the first few pages of the annual information form. I have extracted a diagram which illustrates the relationship between the fund and the operating entity:

Whenever I see something like this, I think negatively since usually such structures exist to give certain (usually founding) entities control over the operating assets, but to distribute the economic interests to other parties that is not in proportion to voting interests. In this case, the unitholders of Clearwater Seafoods Income Fund are simply there for the ride by virtue of having a 54% voting interest in a very indirect say as to what goes on at the operating level. As a result, an investor would need extra compensation (i.e. higher reward) for the extra risk that they are taking (the risk that their interests are not going to be in alignment with the people holding the puppet strings).

Clearwater also has a debt problem – as of June 30, 2010 the operating entity has about $218 million in debt outstanding, and of this debt, the trust has lent the operating entity $45 million in exchange for partnership units (they have also done this in other instances with different terms and maturity dates). This loan matures in December 31, 2010. The operating entity also does not generate enough cash, nor are there other assets readily available to pay off the debt. As a result, the company will have to find external financing or find some method to recapitalize the debt.

There is also another $11.3 million loan that is due in September 2010.

In the management discussion and analysis, we have the following paragraph:

In December 2010 Clearwater Seafoods Income Fund has $45 million of convertible debentures that come due. These funds were invested by the Fund in Class C Units issued by Clearwater with similar terms and conditions, including maturity in December 2010. Clearwater also has approximately 1.3 billion in ISK denominated bonds, including CPI and accrued interest that come due in September 2010 (approximately Canadian $11.3 million at July 3, 2010). Clearwater is currently investigating refinancing alternatives and plans to refinance both before the respective maturity dates.

When we look at the market for the $45 million debenture, we see it is trading at 88.5 cents on the dollar. So the market is heavily betting that the debt will be refinanced at relatively favourable terms to debt investors. Recapitalization, however, appears to be out of the question since it would require relinquishing control to the debtholders and the current market value of the units is far too low to make a direct conversion worthwhile. Going into bankruptcy protection might occur if the debtholders and trustees cannot come to a mutually equitable arrangement.

Given the lackluster cash flow from operations, the complexity of the trust and underlying operating entities, and obvious credit risk, I will be watching this one purely from the sidelines to see how this mess gets resolved. My cursory look at the situation would suggest that the debt and equity are both overvalued.

Headlines that get your attention

Being an investor requires you to be part rational analyst, part number cruncher, and part armchair psychologist (and a lot of other parts as well). On the armchair psychologist side, you have to determine what other investors are thinking and determine whether this sentiment has reached a local maximum or minimum with respect to the expectations that are implied in market pricing.

So when I see a headline like “Equities are dead, long live bonds” it gets my attention. Not because there is any information in the headline, but rather that it is an indicator of sentiment. Although a single news article is never enough to give a definitive indication of sentiment, multiple articles over a short period of time spread across all sorts of non-specialized ‘conventional’ media tend to send signals.

While mining for this information is difficult without realizing that retrospective analysis is 20/20, recent memories such as the tech/internet mania in the late 90’s and early 00’s come to mind. Also, in the early 80’s when gold was bidded up to the moon, and the US currency was widely known as future toilet paper (along with those 15% 30-year government bond yields) made a sell gold / buy bonds trade to be the trade of that particular decade.

Trying to mine this information for future use, rather than historical use, might be impossible task. Who knows. Sometimes the masses are right.

Week ends with some bond selling

The 30-year US treasury bond had a significant sell-off over the past few days.  It will be interesting to see whether this is a start of a larger sell-off in the autumn, or whether this is just a simple profit-taking exercise:

I had another trade execution in an issue, but probably the most frustrating thing on the planet is when you have your order in, the price gets touched, and you get a fill in for 100 shares and then the market backs away from your price. It is more annoying that this happens than if the order was never touched at all. Hopefully the market will be a little more generous next week.