Category: Debt

Competition on the mortgage front

I notice that a certain local credit union is advertising a 5-year fixed mortgage rate at 3.45%, which is a very low rate considering it is about 125bps above government benchmark bond rates. Since the overnight rate is now 1%, they will not be making much margin on the transaction. This also implies they have confidence in the price stability of the local real estate market, and being in the Greater Vancouver area, makes you wonder whether this is a valid assumption.

Something that is not easily discovered is their loan criteria – for example, if getting such a rate required a 40% down payment, then the rate might be warranted since the bank would have recourse and recovery in the event of a mortgage default.

Looking at the variable rate market, the best rate I can find is 0.85% below prime (prime is currently 3.00%), but if other institutions are over-capitalized, this discount to prime will continue to increase as they compete for loans. It makes you wonder whether consumer demand for debt has slowed down.

If you put a gun to my head and forced me to choose a mortgage that would result in the lowest interest paid over a 5 year term, I would still go for the variable rate. However, that said, 5-year mortgage rates cannot go much lower than 3.45% – maybe down to 3%, but that’s about it before you really question the sanity of financial institutions offering loans at that rate.

There is some risk of short term rates rising even further in 2011 and 2012, but it doesn’t seem like such movement would be extreme if it did occur. For financial modeling purposes, the market is saying that the 2011 increase will be 0.43%. There are scenarios where this rate could skyrocket, and also scenarios where the short term rate goes back to 0.25% again (where sitting on a prime minus 0.85% mortgage is really inexpensive!).

Relative debt pricing – Yield and Quality

Noticed that AON Corporation (NYSE: AON), which is a financially stable and large insurance broker, issued some debt to fund a $1.5 billion dollar takeover of another corporation:

Of these notes, $600 million will mature on September 30, 2015 and bear interest at a fixed annual rate of 3.50 percent; $600 million will mature on September 30, 2020 and bear interest at a fixed annual rate of 5.00 percent; and $300 million will mature on September 30, 2040 and bear interest at a fixed annual rate of 6.25 percent. The offering is expected to close on September 10, 2010.

They have a convenient 5-year, 10-year and 30-year maturity, which compared to the US treasury bond is a spread of 2.05%, 2.35% and 2.52%, respectively compared to the closing quotes in September 8, 2010. AON is receiving very cheap debt financing, and the bonds were rated BBB+, although one can see by a quick look at AON’s financial statements that despite the takeover (which is roughly a $5 billion purchase, half cash, half stock that dilutes shareholders by about 20%) they should still be generating sufficient cash to pay off the debt.

So let’s pretend you are owning some 30-year corporate debt in a less solvent entity (e.g. QWest) and have a yield to maturity of 7.5% on a similar bond. Do you trade 1.25% of yield in exchange for higher credit quality? Or do you think the macro environment (e.g. the risk-free rate) will turn hostile to long bond yields and both assets will depreciate? Very difficult to say.

Bonds are trading high

When markets move in a direction, the trend typically goes longer than most people otherwise anticipate. The Vancouver Real Estate market is a great example, or I could just be completely wrong and not realize there is some fundamental underpinnings that I am unaware of.

I believe this lasting momentum is the case for the bond market – today, I continue to unload at a pace of a trickle some of my slightly-better-than-junk debt (long-dated maturities) because the quotations just keep going higher.

Fortunately, some of it is sheltered in a registered account so I can defer the tax hit for a future time, but some of it is in the non-registered account. There is a tax timing problem in that I ideally would want to carry forward gains into the 2011 tax year, but it is better to take the bird in hand, rather than waiting 4 months. The taxes have to be paid eventually, but I’d rather want to pay them in April 2012 than April 2011.

Chances are in four months the bond party will still be going strong (especially when people dump their annual RSP contributions into the hottest bond fund they can find), but as a bond investor, I am getting very concerned as to the macro movement toward fixed income products and accordingly am continuing to leak my positions to the market as quotations go higher.

My cash balance continues to rise in the portfolio. It is at a higher level (in absolute but not percent terms) than at the end of 2008!

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.

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.