Counting on the Federal government to do exactly the wrong thing, Part 2

The amount of incompetence exhibited by the current federal government is mind-blowing, but that’s what you get when political correctness is a dominant social consideration than taking proactive action. However, our incompetent government does have the legislative authority to blow over a hundred billion in borrowed money on their supporting constituencies, in addition to the levers of the Bank of Canada and others that tilt monetary policy and loan guarantees towards favoured sectors.

So let’s start with Bombardier, the poster child for government handouts. They will get a loan guarantee to ensure continuity of their operations as corporate business jets is an essential service (can’t catch Covid-19 when you’re in a private jet 35,000 feet above the skies).

Bombardier debt was selling at nearly 25% YTM, and unlike their common shares and preferred shares (where there is a good chance they will suspend dividends), they can’t suspend interest payments on their senior debt. They’ll find a way to kick the can ahead in time, even if their proposed sale of the Transportation division with Alstom fails. Alstom is still trading at 37 Euro per share and part of the BBD sale valued $550 million of Alstom stock at 47.50 Euro, so it’ll be interesting to see how this goes.

Needless to say, the Caa1 rating by Moody’s is well warranted and it is trading like a default is imminent.

Their floating rate preferred shares (BBD.PR.B) give out a yield that is the equivalent of prime, and at their current trading price, that equates to a 13% eligible dividend. So this is a rare situation where the lower risk asset, the debt, is yielding more than and is ultimately cheaper than the preferred shares. Go figure.

I’ll point out that the super-voting shares (BBD.A) are trading exceptionally higher than the small-vote (BBD.B) shares, which should be an indication that there is some sort of value in controlling the corporation. If everything was going to crap, I’d expect the A’s to trade much closer to the B’s.

I got some of Bombardier’s unsecured senior debt at nearly 25% YTM. Not a huge position, but enough of a position where when I start hearing about the inevitable bailout via loan guarantees, I can at least feel I didn’t get robbed, because the rest of the Canadian taxpayers certainly are. Keeping to my short duration policy (regarding inflation), it was the March 2022s that caught my attention. In my nominal scenario, Bombardier will put out a tender offer to repurchase these at some modest premium sometime in 2021.

I know this makes me a hypocrite since I generally suggest not having to do anything with aviation during this CoronaPanic. However, this is more of a political call than a financial one (although financially, Bombardier is not in catastrophic shape).

Since I’m talking about bonds, I’ll throw out another idea I’ve looked at but declined simply because it was beyond my horizon to evaluate but others out there might have some perspective. Taseko Mines (TSX: TKO) is financed mostly by a senior secured bond that matures on June 15, 2022. Taseko’s main producing operation is a copper mine (75% ownership) and the commodity is currently trading ever so slightly above their all-in cost to produce it (about US$2/pound while copper is hovering around US$2.20 post Covid-19). If you anticipate spot copper improving, TKO is well leveraged and they would be able to renew the debt which is secured by their operating mine. The last trade on the June 2022 debt (8.5% coupon) was 45 cents on the dollar, which needless to say is a 55% YTM. High risk, very high return. Even in the event of a CCAA or recapitalization process, I’d suspect you’d get some sort of recovery in line with the price. I don’t know much about copper, so I’m throwing this out here for you.

A few more miscellaneous market notes

4. The winning trade of the quarter in all my estimation is going to be short volatility. There’s a pretty easy way to play it – short shares of TVIX (which holds a 50/50 notional short of the CBOE VIX futures front month and second front month, cost of shorting is about 5%), or just short the futures directly (margin on this is US$30k/contract, so that’s basically like posting 60% collateral at present). Be cautioned that an ongoing trade that worked for the entirety of 2019 was to short volatility, and this continued to work until about the middle of February, where sophisticated quant funds that structured paired trading (namely taking extreme advantage of volatility/index rollovers) were absolutely crushed as a result of the Coronacrisis.

I do not frequently have macro convictions but this is one of them where I do. The justification is pretty simple – bad news stemming from Covid-19 is going to continue flowing in, and the consequences are foreseeable (death, defaults, and dysfunction). That said, the probable scenario is that liquidity injections are going to mop up volatility like a dry sponge in water, and things will calm down to the “new normal”. There will be spikes up now and then, and these spikes should be shorted – similar to how taking such a procedure with Marijuana companies over the past 18 months would have been highly profitable. Unlike marijuana companies, however, you have a much smaller cost of carry to hold a short position on volatility.

Shorting puts on the S&P 500 also will work, but why muck around with the index?

5. More macro convictions (perhaps this is a sign I am mentally losing it during the self-isolation period) – The Hong Kong dollar is close to its lower band (the band being 7.75 to 7.85) – the last trade is at 7.752, which represents the strongest the Hong Kong dollar has been in quite some time – it was at its upper band (7.85) during the protests last year (which seemed so far long ago). There’s no leveraged way to play this, but macro-wise, I’d suspect shorting HKD will net a few bucks over the next year. The carry trade is negative (i.e. HK interest rates are higher than US currently).

A few miscellaneous market notes

No April Fools jokes on this site.

1. I’ll post a more comprehensive report later, but Q1-2020 is shaping up to be around -13% -11% performance for me, while:

Index / Total Return
S&P 500: -20.0% / -19.6%
TSX: -21.6% / -20.9%

I was caught badly out of position going into this CoronaCrisis and I do not consider my relative performance to be any sort of victory at all. You can’t eat on relative performance is a good cliche to describe this. I hate losing money.

2. CannTrust (TSX: TRST), after getting busted by Health Canada in July 2019 for not being able to run a legal marijuana operation, finally bit the bullet and did CCAA yesterday. The fact that they haven’t been able to publish any financial statements since Q1-2019 should have been enough of a hint to anybody that something really bad was going on. The marijuana sector is regarded as one positive recipient of everybody that is forced to go on lockdown (and anecdotally when biking around Vancouver I get the impression a lot more people are smoking it!), but my views on the economics of the entire sector is the same – I wouldn’t be a buyer unless if you get the impression that branding will result in premium pricing power. Although I do not smoke marijuana at all, from those that do, apparently the legal stuff isn’t nearly as good. The majors (Canopy Growth, Tilray, etc.) will stay alive but that’s about it.

Speaking of Tilray, remember when they were trading at US$150/share back in October 2018? They’re now a shade under $7. Canopy’s down to about CAD$20/share and still has a $7 billion market cap. I’d expect this to depreciate. Still too expensive to short (borrow is still at 22% cost although this has gone down significantly), so sad.

3. What happens when a province goes bankrupt? Newfoundland is on the brink and only got bailed out by the rest of Canada…

4. Dividends will be cut. Do not depend on the historical dividends of any corporations. Another example is Corus (TSX: CJR.B) reported this morning and they will “review” their next quarterly dividend in June as they, along with the rest of the universe, has no idea what will happen to business going forward. Although quite cash flow positive, they are also heavily leveraged and this leverage is forcing them to be more conservative than what their P/E of 3 would otherwise indicate. Good luck raising debt financing in this environment unless if your investor is the Government of Canada!

If Canadian real estate valuations continue to drop and banks start taking baths on bad debt, I also wonder if they will be forced to cut dividends in an attempt to shore up their Tier 1 ratios. Remember how I described Genworth MI as picking up twenty dollar bills in front of a steamroller? With unemployment spiking up to double digits, we’re going to find out what happens when we get a whole bunch of credit defaults. The question is whether the market is pricing this in or not.

Start the money taps

It’s starting…

https://www.theglobeandmail.com/business/article-caisse-sets-aside-4-billion-to-finance-quebec-businesses-affected-by/: The Caisse de dépôt et placement du Québec says it’s ready to pump up to $4-billion into Quebec businesses affected by the COVID-19 pandemic.

https://pm.gc.ca/en/news/news-releases/2020/03/31/prime-minister-announces-new-partnerships-canadian-industries-fight: The Government of Canada is investing $2 billion to support diagnostic testing and to purchase ventilators and protective personal equipment, including for bulk purchases with provinces and territories. Personal protective equipment includes things like more masks and face shields, gowns, and hand sanitizer.

The Government of Canada has signed new procurement agreements with Canadian companies Thornhill Medical, Medicom, and Spartan Bioscience to purchase and boost capacity to manufacture equipment and supplies including portable ventilators, surgical masks, and rapid testing kits. The government has ordered millions of supplies to ease the pressure on health care facilities. It has also signed letters of intent with five companies – Precision Biomonitoring, Fluid Energy Group Ltd., Irving Oil, Calko Group, and Stanfield’s – to produce additional test kits, hand sanitizer, and protective apparel including masks and gowns.

(Who wants to make a bet the government is not going to be too price sensitive?)

Anybody standing in the way (by being short) on these “protected” industries had better cover.

CoronaPanic, Edition 14

Very random thoughts follow.

Throw all the rules out the window. Even though the economy is going to stall (and go into recession, if not depression), people are going to get dumb-founded when the market goes up. The explanation is pretty simple – with central banks pumping as much liquidity into the system, mostly anything that got sold due to liquidity will be brought back to life, and that liquidity will ooze back into real assets.

Dust off the 1970’s playbook because we’re going to see inflation. Not immediately but it’s coming. It will also hit quicker than what we are typically used to, just like how the Coronavirus kicked us all.

This makes bonds of any lengthy duration (let’s arbitrarily define this as more than 2 years) less profitable, in real terms, to invest in unless if you’re going to get a massive nominal return in the process. Ask yourself what will be happening to real estate when entities like Riocan can no longer borrow unsecured at 2.5% – when cap rates go up from 3% to 6%, you do not need a Ph.D in finance to realize that asset values go down, and when asset values go down, the mandated 50% or 60% loan to value that typical REITs manage themselves to will be heading down as well – previously the model was to take mark-to-market property gains, and then leverage the remaining fraction to buy more income-producing real estate, but look out what will happen when this process goes into reverse!

This should hit residential as well, although governments have a huge incentive to stem this, and you can see it when the Bank of Canada is out there busy buying residential mortgage portfolios from the financial institutions – socialized losses, privatized profits. One would also find it difficult to see the mortgages paid off when a third of your population is going to be unemployed… the nightmare scenario that Genworth MI (TSX: MIC) is prepared for is going to come to fruition – loan-to-value ratios will rise, and with this will come increased capital. Real estate valuations haven’t adjusted for this, but they will.

Will we see spot oil head below US$15/barrel? It’s possible. You just can’t hit a button and stop oil from flowing. Western Canadian Select is at US$6 today… will this go negative? It’s possible. Start digging a big hole in your backyard, and they’ll pay you to store crude.

Gold mining companies might seem like a refuge when gold commodity prices are rising, but the problem here is when somebody in a gold mine gets Covid-19 and then you have to shut down for a few months like everybody else. I don’t see gold mining equities as a refuge, but gold itself should do better. There will be a time that the inherent leverage of gold mining companies (at least the legitimate ones) will take over, but for now, the commodity is the place to be rather than the equity (short-term headlines of everybody saying “buy gold” notwithstanding).

With all this inflation, one would assume that government debt yields will rise to account for this. It will eventually.

The “confirmed cases” statistic is almost a useless figure at this point. The real figure is “how many people have Covid-19 that aren’t confirmed”, coupled with “how many deaths attributed to a trigger of Covid-19 were from individuals that did not fit into the main risk categories (age, lung/heart conditions, obesity, etc.) giving them a predisposition to dying?”.

Iceland is a fairly good laboratory, with the majority of its population in one major urban centre. It has sampled nearly 5% of its population, 2 deaths.

With all the fitness and recreational centers closed, I am forced to partake in exercise through two ways: running and cycling. Last week’s weather was unusually good for a March in Vancouver, but in the past few days it has regressed to the mostly usual overcast and grey, and today I forced myself to run 5km out in a mild drizzle at a balmy 7 degrees Celsius. I see other places in Canada today that it is still -10 outside, and will Covid-19 turn us all into couch potatoes? I did walk through the isles of the places that are still open, such as Canadian Tire, and notice that most of the exercise equipment has been cleared out. Bodes well for Nautulus (NYSE: NLS) and Peleton (NYSE: PTON) (seems to be priced in)?

How can the news get worse? Obviously we will hear about unemployment, we will hear about grossly negative GDP numbers, and we will hear about closures and lockdowns lasting months, and the general breakdown of society. Then we will hear about defaults (especially in the sectors that are heavily leveraged to begin with), and this other bad news. Barring a geopolitical invasion, I can’t see anything other than implied volatility heading down.

Finally, you’re going to see decisions that were going to be made anyway justified under the guise of Covid-19. Watch out for it. Get rid of paper cash? It’s because Covid-19 will infect paper currency and exchanging it will transmit the virus! Can’t build the Trans-Mountain Pipeline because that’s going to spread Covid-19. Shut down municipal roads and install socially-distant bike lanes, because of Covid-19! You name it, this is the time where politicians are going to do their usual thing in the name of Covid-19. Before it was climate change. The motivations have always been there, just the excuse to do it is different.