Category: Canada

The title says it all, but the market is again at a point where if you want a double digit return on your money, it has to come from the equity side. With equity comes risk.

Over the past year there has not been a lot of TSX-traded debenture issuance (indeed, the list of traded debentures is down to 94 and there does not appear to be much compelling value in the list – anything trading below par is doing so for what I consider to be a valid reason).

On the preferred share space, while it is easy to make a relatively stable 5% return, the risk you have to take to move up the yield chain goes higher and higher – e.g. Aimia’s preferred shares give you an extra 250bps or so based off of the 5yr reset rate, but you’re more or less investing in a hedge fund with a current market cap of half a billion.

Want less risk? Canaccord’s preferreds reset at about 100bps less than Aimia’s, have much higher revenues, but when the investment banking gravy train stops (and indeed – it will) you can be sure that people like me will be buying these preferred shares for less than half of par value, like we did back in 2016.

The surest 500bps I can find at present appears to be Pembina Pipeline’s minimum rate preferred shares that they acquired from Kinder Morgan Canada (PPL.PF.A/C/E), and in the case of the C and E series, likely to get called out in less than 2 years. Aside from a mention of Birchcliff Energy’s preferred shares, Pembina’s is probably the closest instrument that you can treat as a term GIC instrument with a ‘probable’ fixed maturity. Between now and then, however, things can always change and there could be some credit crisis that’ll blow the capital value of the stock – as witnessed during the CoronaCrisis – what trades at par value today traded at 44 cents on the dollar on “Margin Call Day”, March 23, 2020. It does an effective job of wiping out people that take out excessive leverage to buy these types of issues.

All in all, if your target is to make a 5% income stream, there is still plenty of selection (with capital risk in the event of market stress), but this is a far cry from the days of last year or in early 2016 when finding low risk double digit yields in fixed income was like the proverbial shooting fish in a barrel.

This environment is making me suspicious and indeed elevates my sense of paranoia that we are ripe for something bad to happening.

Natural gas producers are getting a spike today because of spot demand:

Just remember a couple years ago AECO was at nearly negative pricing due to the glut caused by US shale oil producers (and this resulted in a lot of associated natural gas production).

Different story today. US shale peaked at the end of 2019.

The other story will be how every piece of “clean renewable” electricity generation is going to be a stealth increase in future natural gas demand. The higher the potential volatility peaks in electricity generation, the higher the requirement will be for dispatachble sources – this comes either in the form of hydroelectric or natural gas. Ultra-large batteries are possible but they suffer from significant losses and they depreciate relatively quickly.

Hydro is pretty much tapped out – most of the good sites are built, and here in British Columbia, we’re having incredible difficulty building the 900MW Site C project (indeed, it might even be scrapped even though a few billion have been dumped into it).

The flip side of the equation will be some “demand management” applications where people will be compelled to use the bulk of their electricity generation in off-peak times (e.g. charging your electric vehicle after 9pm) and giving pricing incentives to doing so. Still, the efficiency gains to be made using demand management will be limited. Are factories going to be compelled to operate between 8pm to 6am because of electricity load factors? I don’t think so.

Until such a point where policy makers become serious about increasing base load power supplies, these sorts of problems will increase as intermittent sources become increasingly large fractions of the electric grid. You can stall the problem with using imports as buffers, but this solution only goes so far as California discovered last summer.

Similar to the concept of liquidity in the financial marketplace, intermittent electricity generation sources (wind, solar) are much more expensive than their numbers would seem because it involves a surrender of “power liquidity” – getting the power when you want it, not when it passively is received by you. Right now the cost of this liquidity is being outsourced to others, but as the value of this liquidity continues to increase, the true cost of intermittent sources becomes much more known.

From the Bank of Canada (the 10-year and 5-year government bond yield):

From the end of 2020 (0.67%) to yesterday (0.84%) the 10-year bond yield has risen.

This could just be from the “white noise” of trading. A fixed equity/debt split would surely have resulted in equity selling and fixed income purchasing which to date has not occurred, prices would appear to have done the opposite. US 10-year treasuries are also up about 15bps or so from the beginning of the year.

The impact of rising long-term interest rates have a ripple effect through the market. If the trend continues, you’ll see a dampening effect across the investment spectrum. Right now it is not a lot, but if yields continue to rise another 20bps or so (totally arbitrary guess), more people will start noticing and you’ll start to see momentum effects occur, which would likely be concentrated with price contractions of yield-based instruments (which would have the immediate impact of increasing their yields, but interest rate increases would result in the expense of their ability to borrow money at low rates). Soros’ theory on reflectivity reflexivity really applies here!

What is the difference between 0.25% and 0.1%? A 60% drop in the short term interest rates!

Apparently that is the logic of the Bank of Canada mulling a decrease in the target rate, which is currently at 0.25%.

In November, the Reserve Bank of Australia cut its policy rate by 15 basis points to 0.1%, while the Bank of England did the same last March.

While this may not seem like a lot, the mathematics of division when you get close to zero gets really fun. If your limitation is interest expense, then reducing the interest rate by 60% means you can borrow 2.5x more money!

This is a luxury that nations with their own sovereign currencies can perform. In Canada, despite the federal debt ballooning over $1 trillion this fiscal year, public debt charges peaked in 1995-1996 at nearly $50 billion. For the 2020-2021 COVID-19 fiscal year, that interest bite is expected to be about $19.5 billion (table A2.4)!

The low interest rate environment ends when the demand for currency starts to abate and one trigger to this is the onset of inflation.