Canadian Finance, Economics and Fiscal Analysis
Everybody is on holiday this week.
Thus, yesterday, when the markets went down, it was because of “traders betting on a double dip recession”. Today, the markets are up, so therefore it is because “they are betting on an economic recovery”.
It’s advisable to just not pay attention to the headlines and instead just pay attention to individual issues that might be wildly taken up or down in low volume conditions.
Uranium One’s shareholders voted convincingly in favour of the takeover of a majority stake in the corporation by a Russian “crown” corporation SC Atomredmetzolo (“ARMZ”) with approximately 91.99% of non-ARMZ shareholders in favour of the transaction.
The salient terms of the agreement is that ARMZ will take a 51% majority stake, and pay the rest of the shareholders $1.06/share in a cash dividend. Shareholders, assuming they haven’t already sold at market value, will be in for the ride and will have to make sure that their interests are in alignment with the majority ownership.
This is almost the reverse case of Magna International, where the Stronach family is being paid a considerable sum by the corporation to relinquish its controlling stake.
Investors should always be very cautious in making sure whenever they invest in companies that have majority or near-controlling ownership stakes that their interests are in alignment with the large shareholders. While a majority stake is not necessarily an exclusion criterion to considering a potential investment, it does raise the bar considerably higher. I tend to have a high aversion to majority or near-majority controlled domestic corporations as they can abuse minority shareholders.
The debenture holders, however, should be looking good – Uranium One has a December 31, 2011 issue that has a 4.25% coupon that is a very probability candidate for maturity at par; between the bid and ask, it is trading at 98.5 cents. Once you factor in capital gains, it is a relatively low risk 5% return on investment. Uranium One has another outstanding debenture issue that matures in March 2015 and this one is muddied by the fact that the conversion privilege (at $4/share) is close to the common stock price – this issue is trading at around 105 cents.
It is not likely that the 1.3 years between now and December 31, 2011 will pose much of a credit risk for the initial debenture issue – the corporation is likely to refinance this debt. However, the 2015 debenture has more embedded risk simply due to the time between now and the March 2015 maturity – you never know how much of the company assets will get stripped out. The worst case scenario is that ARMZ will try to to repatriate the assets (mainly agreements to mine and sell Uranium, mostly from Kazakhstan) of Uranium One into some other corporation controlled by ARMZ. You then don’t have to worry about the bankruptcy of a Canadian corporation once the assets have been stripped out of it, and debenture holders and shareholders alike would be left with nothing. It is unlikely this scenario will happen by 2011, but by 2015 it becomes somewhat more likely.
Suffice to say, I won’t be touching the equity or debt of this corporation.
Looking at Banker’s Acceptance Futures, we have the following rates:
| Month / Strike | Bid Price | Ask Price | Settl. Price | Net Change | Vol. |
| + 10 SE | 98.915 | 98.930 | 98.925 | 0.000 | 16053 |
| + 10 OC | 0.000 | 0.000 | 98.830 | 0.000 | 0 |
| + 10 NO | 0.000 | 0.000 | 98.820 | 0.000 | 0 |
| + 10 DE | 98.890 | 98.900 | 98.900 | 0.000 | 27314 |
| + 11 MR | 98.820 | 98.830 | 98.830 | 0.000 | 25451 |
| + 11 JN | 98.740 | 98.750 | 98.750 | -0.010 | 8618 |
| + 11 SE | 98.600 | 98.620 | 98.610 | 0.010 | 1774 |
| + 11 DE | 98.480 | 98.520 | 98.490 | 0.020 | 1197 |
| + 12 MR | 98.360 | 98.440 | 98.370 | 0.060 | 386 |
It looks like that there will be a higher than 50/50 probability that the Bank of Canada will raise their overnight target rate by 0.25% in their September meeting, but after that, future rates in the 2011 calendar year are projected to go up by 0.25% to 0.5%.
The drop in increase expectations has likely contributed to depreciation of the Canadian currency – currently at 94 cents US to a Canadian dollar, while this was high as 98 cents earlier in August, and at parity back in April. During the depths of the economic crisis, the Canadian dollar reached 78 cents multiple times throughout the October 2008 to March 2009 period.
The bond market is pricing in an upcoming deflation. Canadian 10-year benchmark yields are at around 2.8%, which is quite close to the all-time low of 2.55% reached during the pits of the economic crisis in early 2009. Although I stated previously that the next economic cycle will be inflationary, it will only be after certain conditions have been achieved – mainly the willingness of companies and consumers to spend money. Until then (which could be years away), we will not see inflation.
If this is true, then cash is likely to be a good performing asset class, if not the best asset class.
Cash is also the least “sexiest” of asset classes. It is boring. Just imagine trying to tell your colleagues that your investment portfolio is packed full of Canadian dollars. It provides a very low return (about 2%), and no possibility of appreciation. It is ironic that it might be a good asset class by virtue of other asset classes having negative returns.
Investors of government bonds will also be profiting in a deflationary environment because the government will be guaranteeing the payment of the principal – longer durations will result in larger capital gains as yields go down.
Corporate debt and other fixed income securities will fare less well simply because in deflationary environments it becomes more difficult for companies to generate cash. Debt-issuing companies will have to repay debt in nominal dollars that will have higher real value – hence, credit risk becomes a more predominant concern of the pricing of the corporate debt. For companies that have good solvency ratios (e.g. debt-to-equity and/or debt-to-free cash flows are very good), then this becomes less of a concern and corporate debt will then appreciate. But junk debt issues or corporations that are inflation-sensitive (i.e. can’t charge as much to your customers) will not be a safe haven in such an environment.
Deflation really messes with economic intuition and if market participants cannot adapt to it, there will be inefficient pricing in the markets to take advantage of if it does materialize. It would be a virtual guarantee that the Canadian real estate market would get hit badly in an economic deflation, as the prospect of paying off higher-valued debt in the future would crush prices and trump even the low interest rates that would be offered to credit-worthy customers.
Looking at the whole exchange-traded bond market, there is nothing ordinary going on – some up, some down, most of them less than a percentage point. It looks like a typical slow end of summer day – and indeed, this week no significant decisions will be made since a lot of decision-makers out there, including the President of the United States, are on holiday.
However, there is one significant blip on my radar, and considering up until today, I held onto them, was a trust preferred issue which is backed by March 2033 senior debt of Limited Brands, trading as NYSE: PZB. Already (at 12:30 Pacific, or 30 minutes to closing), 60,000 units have been traded, the highest volume day since July 8, 2009 (which was an unremarkable day).
Unlike back in July, today there was a clear and pronounced price increase, up 5.9% to 22.5 (90 cents to par value).
Why the price spike? I am not sure, but I suspect the trust preferred made it onto some newsletter or recommendation list.
Unlike the underlying debt which has a 6.95% coupon, PZB has a 6.7% coupon, which means it should trade below the bond price (which is currently 91 cents on TRACE). At 90 cents on the dollar, an investor in PZB would receive a 7.44% current yield, with a 0.47% implied capital gain if held and redeemed at maturity 22.5 years from now. An investor in the 6.95% senior bonds at 91 cents would receive a current yield of 7.64%, and an implied capital gain of 0.42% at maturity.
In my efforts to reduce duration and long-term corporate debt exposure, I have expunged my small position in PZB. It is a difficult decision, knowing that you are trading something with a decent and relatively secure yield for something that is giving you nearly nothing (cash interest), but keeping liquid is the name of the game – you will have ammunition to strike when the real opportunities start arising, whenever it may be. Having the discipline to holding onto substantial portions of cash is a crucial skill to survive in the markets.