How to survive a high interest rate environment

Things in the real economy are going to get a lot worse. You will see this with a lot of lagging indicators, especially unemployment. Come January and February 2023, the unemployment rate will rise a lot higher than the reported 5.4% for August.

The financial economy tries to predict these changes in advance and indeed, some of this has been already priced in. There are typically two areas where the market does not anticipate very well – when it over-extrapolates a trend, and also the failure to predict second and third order impacts of economic developments. The ability to predict these contributes to a lot of alpha for portfolio managers – worthy of a separate post.

At the end of the day, however, equity markets have some semblance of valuation on the basis of residual profits of the various entities which are given to shareholders. There is never an equilibrium price achieved, it is always fluid and subject to anticipation of changes.

When the so-called “risk-free” rate increases like it has, the comparisons become more competitive as there is always a risk premium between risk-free and risk-taking.

A concrete example of this is looking at a relatively stable equity versus a government bond.

We will use A&W Revenue Royalties Income Fund (TSX: AW.UN) as our example. It is nearly a universally recognized entity in Canada. The business is stable. The debt leverage employed is not ridiculous. While there are some complexities (the controlling interests have somewhat of a conflict with the unitholder trust), all you need to know for the purpose of this post is that the business skims 3% of the revenues of all A&W franchise sales across Canada. After interest expenses and taxes, the cash is passed to unitholders.

Right now this trust yields unitholders 5.4%.

Contrast that with a 1 year government bond, yielding about 4%, or a 10 year government bond yielding 3.1%. If you’re dealing with retail amounts of money and want to put it into a GIC, a 1-year GIC earns 4.53%, while a 5-year GIC earns a cool 5% – that’s a larger rate of interest than it has been for a very, very long time. Savers are finally getting rewarded for a change.

In contrast with units of A&W, you’re not receiving a lot of compensation for your risk. As a royalty business, you are less concerned about profitability and more about gross sales – your incentive is that the business operate rather than thrive. For some reason, the market warrants the risk spread (to government debt) of about 1.4 to 2.3%, depending on time horizon, is deemed to be sufficient. One can argue this is too high or too low, but right now it is what it is.

If interest rates continue to rise from here, it is only logical that the equity risk premium rise as well. In other words, if 1 year rates go to 5%, and 10 year rates go to 4.1%, then all things being equal, the equity should be priced around 6.4% – or the equity should take a 15% price haircut from the current point.

The equity risk taken is absurd especially in light of other perpetual investments that offer a seemingly higher margin of safety than A&W. An example would be in preferred shares of Pembina Pipeline, say PPL.PR.A, which gives you around a current 6.9% eligible dividend (much better tax treatment than royalty income) with a gigantic margin of safety. However, in rising rate environments, many of these entities are extremely leveraged with debt, which may result in credit risk deflating the value of your shares.

There is also the overall market liquidity risk – when liquidity continues to decline (central banks are tightening up the vice with QT as we speak), valuations across the entire market will compress as the marginal dollar does not have the ability to sustain high asset prices.

So how does one survive as an investor in a rising interest rate environment? There are very few escape valves.

One is cash, or very short-term cash equivalents. While you take the inflation hit, your principal will be safe. You will also be the recipient of rising rates when you rollover your debt investments into the like.

However, many do not have the luxury of holding cash (funds are restricted from holding over a certain amount).

Preferred shares in selected companies are another possible escape route. While they do not offer great returns, many of these firms that obviously will be solvent and paying entities are trading at reasonable yields. Your opportunity for capital appreciation is likely to be very limited, but at least you’ll be generating a positive and tax-advantaged return. (I will once again lament the upcoming redemption of Birchcliff Energy’s preferred shares (BIR.PR.C) as being the last redeemable preferred share left on the Canadian marketplace (R.I.P.).)

However, many do not have the luxury of holding fixed income products.

So say there is a gun pointed to your head and you are forced to wade into the equity markets.

The problem is that anything with a yield is sensitive to increasing interest rates. Companies trading at high multiples will have P/E compression and this will kill your equity value.

The formula is that you need to invest in a company generating cash at a very low multiple (well beyond a 2-3% spread from the risk-free rate), the cash flows are sustainable, AND the company can either repurchase its shares at such a low multiple or give out cash to shareholders at a yield well beyond the risk-free rate.

There are not many companies like this that trade. Ideally one day you would find a royalty company trading at a 15% yield. Then you would pounce on it with full force.

There are very few moments where you see this happen, and when it does, it can be very profitable. February 2009, Q1-2016, Christmas 2018, and March 2020 were some recent times where you had a gigantic rush for liquidity in various names.

Execution on the trading is also not easy – before a royalty company reaches a 15% yield, it will have to trade through 8%, 10%, 12%, etc. At these valuation points, it will increasingly look more and more attractive. Back during the economic crisis of 2008/2009, I remember purchasing long-dated corporate debt in Sprint (the telecom) for a 20% yield to maturity and feeling a bit resentful when at one point it was trading at 25% YTM before it slowly made its way back to the upper single digits YTM a couple years later. A similar situation with equities and some distressed debt will likely happen over the next 12 months, so plan accordingly to reduce resentment of not catching the absolute bottom – markets are most volatile at their bottoms and tops. I do not think we are at all close to seeing the peak in volatility for this cycle yet, which is surely a ‘down’ cycle.

Diversification

There are events that you just can’t predict, such as having to deal with malware on your web server.

This week has been full of them, and it is only Wednesday.

Teck (TSX: TECK.B) announced on the evening of September 20 that their Elkview coal plant (their major metallurgical coal operation) had a failure of their plant conveyor belt and it would be out of commission for one to two months. If out for two months, this would result in a loss of 1.5 million tonnes of coal. Considering that they can get around US$400/tonne for their product, and very generously they can mine it for US$100, this is a huge hit. Not helping is that one export terminal (Westshore (TSX: WTE)) is going on strike, but fortunately Teck managed to diversify from this operation last year with their own coal loading terminal!

Cenovus (TSX: CVE) owns 50% of a refinery in Toledo, Ohio. BP owns the other half, and they are the operating partner. There was a story how a fire at the plant resulted in the deaths of two workers, and the refinery has been shut down to investigate. Making this more complicated is that on August 8, 2022, Cenovus announced they will be acquiring the other 50% of the refinery for US$300 million in cash. Ironically in the release, it is stated “The Toledo Refinery recently completed a major, once in five years turnaround. Funded through the joint venture, the turnaround will improve operational reliability.”

Given the elevated level of crack spreads and the 150,000 barrel/day throughput of the refinery, the cost of this fire will not be trivial, and quite possibly will involve an adjustment to the closing price.

The point of these two stories is that there can be some one shot, company-specific event that can potentially affect your holdings – if there are other options in the sector you’re interested in investing in, definitely explore them and take appropriate action. Teck and Cenovus are very well diversified firms, but if you own an operation that has heavy reliance on a single asset (a good example would be when MEG Energy’s Christina Lake upgrade did not go as expected a few months ago), be really careful as to your concentration risk of such assets.

On a side note, have any of you noticed that many, many elevators are out of commission in publicly-accessible buildings? It’s like expertise in anything specialized is simply disappearing – it makes you wonder whether the maintenance operations of the above companies (and many others not listed in this post) are being run by inexperienced staff.

Site is back online

It appears that due to some stale installations of WordPress on my web hosting account, somebody managed to inject a whole bunch of garbage into the server that is running this website.

From what I can tell the initial intrusion happened in late August, while the thing that caused the site to go down happened on the morning of September 19th.

The script that ran on the machine injected files across practically every available directory on the server. It wasn’t a very subtle hack. It allowed the host to act as a ‘pass through’ – if you ever wonder why hacks these days are almost impossible to geo-locate, it is because they are almost always done through infected servers and this makes things incredibly difficult to trace after the fact.

Anyway, after many hours of polishing off my ancient UNIX skills, I’ve managed to restore this site from my backups and things should be back to normal again.

Divestor is back online – for now!

I could not imagine how anybody that doesn’t know how to navigate within an SSH session could solve this without getting external assistance (read: $$$$). Things are getting really complicated these days.

Cash ETFs

I’m sitting on some relatively heavy losses (0.7%) in my investment in the Canadian Short Term Bond Index ETF (TSX: XSB). The loss was a result of speculating that an average 3-year yield would perform better than a short-term cash account. Needless to say, it is annoying that had I just kept the cash in the account (even earning zero-yield, as Questrade generously offers on cash) I would have done a lot better.

Now that the Bank of Canada has cranked up short-term interest rates even further, the yield curve is flatter and spot yields are about 70bps lower than 1-year yields. The compensation for duration is quite low.

So while I contemplate flip-flopping to even shorter maturities than 3.11 years in exchange for a boost-up of about 100bps on spot rates, we look at the cash ETF options (alphabetical order by ticker symbol):

(TSX: CASH) – info – gross yield 378bps – MER 13bps
(TSX: CSAV) – info – gross yield 296bps (pre-BoC 75bps increase on Sept 7) – MER 16bps
(TSX: HSAV) – info – gross yield 375bps – MER 12bps
(TSX: PSA) – info – net yield 359bps – MER 17bps

All four of the above trade with penny spreads on the TSX in sufficient liquidity volumes.

For comparison, Interactive Brokers offers 276bps on their CAD cash yields. The question is whether it makes sense to flip cash for near-cash, and for each $10,000 transaction, it would cost approximately $2 in commissions to make a trade for approximately 90bps of yield, good for a $90/year difference, or $7.50 monthly.

The question then becomes whether the structural risk of the cash ETF (What happens if the market makers decide to quit? What happens in a true market crisis where everything blows up? What happens if the “cash” investments the ETF invests in goes belly up? What happens if the custodial arrangements the ETF management has turns out to be fraudulent or defective, etc.?) becomes worth it for a $7.50/$10k monthly difference. Is it worth a 360bps difference? Likely. Is it worth a 90bps difference? Probably not.

Bank of Canada – raising rates and NOT killing kittens

Right on the front of the Bank of Canada website:

A lot of press was made about this, and the distraction phrase here is “cash”. Yes, they did not print cash, but they sure as hell injected a bunch of money into the system in the form of bank reserves!

The logic is as disingenuous as writing the following:

“#YouAskedUs if we killed kittens to finance the federal gov’t.

We didn’t.”

The original inception of the central bank is that it is supposed to perform independently of the government to fulfill its mandate (which is set by the government and is currently to maintain inflation at a level of 2%). Independence is supposed to give the central bank credibility, but since we are now in the era of the politicization of everything, the central bank is now playing politics, which certainly won’t help its credibility.

Anyway, back to the present, the Bank of Canada raised 0.75% today, largely on expectations.

Key points in the release, with my comments:

* consumption grew by about 9½% and business investment was up by close to 12%.

It is very easy for consumption to increase this level when inflation is 7.6%! This is a lagging indicator.

* Given the outlook for inflation, the Governing Council still judges that the policy interest rate will need to rise further.

October 26: 0.25% increase to 3.5% unless if something really, really terrible happens in the next seven weeks (say, a stock market crash). The non-market consensus outlook that I’m putting some probability towards is that they will continue to raise 0.25% each meeting until there is the obvious break in demand.

Implications and thoughts

It has been a very long time (about 15 years) where short term interest rates were at these levels, just before the 2008 economic crisis. The risk-free rate is a relevant parameter for most financial calculations. Right now, you can lend the Government of Canada your money for a year and receive a 3.75% guaranteed (nominal!) return. When going out to the corporate bond market, this represents an effective floor on an investment – why bother lending your money to Nortel or Shopify at 3.75% when you can just do it with the government for zero risk?

One reason could be that the corporate world will give you a return for longer than a year – and indeed, a 5-year government bond now yields 3.3%. The question of where long term interest rates go from here is a fascinating one, but if we ever return to the zero-rate environment again, a guaranteed 3% return is golden.

It is instructive to look at the progression of quantitative tightening. December 22, 2021 was the peak of Bank of Canada holdings of government bonds, approximately $435 billion. There is also a (relatively) small amount of provincial and mortgage debt on the books, but we will focus on the bonds. As of August 31, 2022 the Bank of Canada holds $381 billion ($54 billion or 12%). We have data on the “Members to Payments Canada” (bank reserves held in the Bank of Canada) – a reduction of $78 billion there. There’s a $24 billion gap there. What happened?

One factor is that the Government of Canada has been raising more money than expected. Their net cash position with the Bank of Canada rose $30 billion in the prevailing time period. On the fiscal side of things, there is much less pressure on the financial markets to raise debt capital simply because tax revenues have been skyrocketing – this is one of the effects of inflation – everything is valued with nominal dollars. This fiscal cushion gives monetary policy some extra runway before having adverse effects on the longer term interest rates. The government will continue to roll over its debt at higher rates of interest, but they have a very large cash cushion to work with, and if the indications suggest, they will be reporting a significantly lowered budget deficit when they do the fiscal update this November (just in time for more spending to “alleviate the cost of living”!).

What will this mean for the equity markets and asset markets in general? Tough times! It is much, much more difficult to make significant sums of money in a tightening monetary policy environment. Instead of the customary multiple boosts, returns (if any!) will likely be much more correlated to traditional metrics, such as net income and free cash flow, and any gains in corporate profitability will likely be offset to a degree by the P/E multiple compressing due to the risk-free rate rising. Be cautious.