Category: Finance

Being an investor requires you to be part rational analyst, part number cruncher, and part armchair psychologist (and a lot of other parts as well). On the armchair psychologist side, you have to determine what other investors are thinking and determine whether this sentiment has reached a local maximum or minimum with respect to the expectations that are implied in market pricing.

So when I see a headline like “Equities are dead, long live bonds” it gets my attention. Not because there is any information in the headline, but rather that it is an indicator of sentiment. Although a single news article is never enough to give a definitive indication of sentiment, multiple articles over a short period of time spread across all sorts of non-specialized ‘conventional’ media tend to send signals.

While mining for this information is difficult without realizing that retrospective analysis is 20/20, recent memories such as the tech/internet mania in the late 90’s and early 00’s come to mind. Also, in the early 80’s when gold was bidded up to the moon, and the US currency was widely known as future toilet paper (along with those 15% 30-year government bond yields) made a sell gold / buy bonds trade to be the trade of that particular decade.

Trying to mine this information for future use, rather than historical use, might be impossible task. Who knows. Sometimes the masses are right.

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.

As 5 and 10-year yields plunge, they have had a corresponding impact on mortgage interest rates.

The best variable rates I can find are prime minus 0.75% for a 3-year variable mortgage, or prime minus 0.7% for a 5-year variable mortgage. Prime currently is 2.75%. This is still the dirt-cheap option and is preferential compared to the best available 5-year fixed rate, which is currently 3.75%.

Assuming the Bank of Canada raises rates 0.25% this September (which is not a certainty, but is a likely action) then the break-even proposition, in terms of net interest paid over a 5-year fixed period, is quite unlikely. An example of a breakeven calculation would be, on a 25-year amortization mortgage, a 0.25% rate increase every half-year in order for the 5-year fixed rate to be breakeven with the variable rate. This would correspond with a 2.5% rate increase over 5 years which seems to be unlikely given that the futures currently indicate that rates will go up by about 0.69% over the next 2.75 years.

That said, the current interest rates are historically low, and interest rates are not very predictable – it sometimes feels like one is reading tea leaves in order to get glimpses of the economic future.

As there is a real estate implication to mortgage rates, it should be noted that even though the USA has record low financing rates for mortgages, it is not sparking their real estate market.

Very little going on in the day-to-day action in the marketplace, hence very little to write about. If there was a story to write about, it would be at the extremely low yields of the US treasury market and how it continues to induce others to chase yield. Forcing people to invest in assets for income when they do not receive a fair risk-adjusted return of capital (opposed to return on capital) means making such investment decisions is a tricky endeavour.

Spot gold continues to swim at the US$1,200/Oz mark; spot crude continues to wobble between US$70 and US$85/barrel. Natural gas has been wobbling around $4.5/mmBtu, which is still quite divergent with the energy content implied with the crude contract – Natural gas has considerably lagged crude, presumably due to the implementation of cheap shale gas drilling (so-called hydraulic fracturing, or “fracking” in short).

3-month banker’s acceptance futures have also shifted slightly downward, implying less of a chance that the Bank of Canada will raise interest rates on their September 8th meeting. Three-month corporate paper is trading at a 0.91% yield. This change in the future projected rates also had the effect of taking down the Canadian dollar from roughly 97 cents to 95 cents, but this could just be white noise. The currency diversification is an interesting and separate topic, but I am happy with my mix of Canadian and US-based portfolio components.

There’s not a lot to be writing about, which gives me some time to research individual issues on my research queue. Also, since the last two weeks of August are the most heavily booked vacation days before the kids go back to school, the markets should also be relatively quiet in volume, but not necessarily price! However, at least Monday was a calm day.

I have been noticing some of my income trusts creeping up in price; if they go much higher, I might consider a partial liquidation.

After alluding to disposing of a long corporate bond position, I received some comments as to what the exact ticker is of the issue in question. There were enough hints in the post to figure out the product, but I will be more explicit in this post.

Now that I have completely disposed of the position today, the ticker in question is (NYSE: HJR). This is one (of many, many) examples of an exchange-traded structured product. The specific structure is a trust that has a single asset – corporate senior bonds of Limited Brands (6.95% coupon, maturing March 1, 2033). The trust’s mission in life is to distribute income coming out of that bond. The trust itself has $25,340,000 worth of 6.95% corporate bonds and the distribution is at a 7.00% rate.

You can read the exact specification of the trust by reading its prospectus.

Effectively you are investing in a corporate bond that is exchange-traded. The payout times are identical to the bond, with the exception of the coupon (7.00% on the trust vs. 6.95% with the corporate bond) and that trades do not incur interest expense/revenue for a purchase/sale of securities. An investor purchasing one unit of HJR will receive a $0.875 payout every March 1 and September 1 until March 2033, where they will receive a $25.875 payout.

At the current transaction price of $24.40, an investor has a 7.2% current yield on investment, or about a 7.5% yield to maturity for a 22.6 year term.

There are slightly different risks involved with the structured product. The largest change is that the structured products have a “call provision” where the unitholder, if held in sufficient quantity, can redeem the trust in exchange for the underlying bond. This call provision ensures that there is an effective cap on the unit price, even if the underlying bond trades at a premium.

There are a couple hundred of these products trading on the exchanges – some are extremely illiquid, and in the example of HJR, it is lucky to have $50,000 par value traded daily. The spread is typically 40 cents.

As I have indicated before, I have recently liquidated my entire position in HJR as I do not feel the risk/reward ratio is right for my portfolio. Other investors that are looking for a stable 7.2% yield on a senior corporate security could consider HJR. It is still a far, far more inferior option at present than buying the actual corporate debt, which is priced at around 90 cents. Since HJR is trading around 97 cents on the dollar, I am very puzzled at the high price and hence sold my position. The bid is obviously from an irrational retail source.

There are other structured products carrying the exact same bond as collateral, and they are trading at more reasonable prices. If the products were marginable, there would be an obvious arbitrage opportunity.

Exchange-traded structured products are very research-intense. Although most of them have standardized provisions, there are some that have odd-ball provisions that require you to look at the prospectus of each and every security that you are considering. Once you have cleared the research hurdle, however, they are worth looking at. In late 2008 and early 2009, these products were being thrown out the windows of financial intuitions. At the depth of the financial crisis, HJR was trading for $8.40 (33.6 cents to par) and suffice to say, I thought this was one of the greatest opportunities the market was offering especially in consideration with the risk taken (the seniority of the bond ranks you ahead of common shareholders).

Although you would have done slightly better with an equity investment at the same time, you earned your capital gain with a significantly lower level of risk, in addition to having the luxury of having a well-defined exit point (at the lastest, the maturity date). You were also being paid a handsome sum of money to wait.

In the case of HJR, and in the case of a lot of other asset-backed securities that give out a yield, it is close to the time where it is worth liquidating the positions. As the 10-year bond yield is heading toward record lows, chasing yield will become more and more dangerous.