Tag: AW

Reviewing the past week

The past week was relatively interesting.

The 10-year bond yield went down about 0.25% from the beginning to the end of the week. Likewise, the long part of the yield curve also dropped (prices rose) and a whole flurry of the usual interest rate sensitive subjects got taken up VERY sharply. I’ll just give a few of them, but you get the idea – these four are from very different industries:

(But also take a look at REI.un.to, CAR.un.to, etc. – also dramatically up over the past few trading days).

REITs, lumber, sugar, and fast food. All of these are yieldly and leveraged. Don’t get me started on other components of the fixed income markets either, but I’ll throw in the 30-year US treasury bond yield:

There is a cliche that in bear markets, bull trap rallies are the sharpest. This is usually the case because short sellers are a bit more skittish than in the opposite direction.

My suspicion is that the bears on the long side of the bond market got a bit too complacent.

The calculation of the risk-free rate is a very strong variable in most valuation formulas. If you can sustain a 5% perpetual risk-free rate, there is no point in owning equities that give a risky 4% return. The price of the equity must drop until its yield rises to a factor above 5% (the number above 5% which incorporates the appropriate level of risk).

So what we see here is the strong variable (risk-free rates) moving down and hence the valuation of yieldy and leveraged equities rising accordingly, coupled with some likely short squeeze pressure on the most leveraged entities.

There are likely powerful undercurrents flowing in the capital markets – the tug-of-war with the ‘higher for longer, inflation is here to stay’ crowd competing with the ‘Economy is going bust, the Fed has to lower rates!’ group.

The last chart, however, I must say was not on my bingo scorecard for 2023 – Bitcoin is up over double from what it was trading at the beginning of the year:

I should have just pulled a Michael Saylor and gone 150% on Bitcoin. Go figure.

Interest rates controlling the key to everything

Most of the financial world tries to anticipate what actions Jerome Powell and the Federal Reserve decide to make with monetary policy.

For the past year, markets have been trying to anticipate the so-called “pivot”, i.e. the point in time where the Federal Reserve will stop raising interest rates and eventually lower them. The thinking is that lower costs of capital will usher in a new era of demand and we can party like it is 2009 with a rush of quantitative easing.

One problem, however, is there is a deeply psychological component to the inflation going on. The inflation expectation itself is a determinant of real interest rates. I’ll give a very simple example.

Let’s say the nominal interest rate is 5% and inflation is 2%. The real rate of interest is +3%.

However, if you expect inflation to be +4%, the real rate goes down to +1%.

The higher the inflation expectation, the lower the real rate.

An extreme example would be if you anticipated your currency turning into Argentinian paper, with a 50% inflation. Your real rate of interest goes very negative, very quickly and you suddenly will have a very large incentive to spend everything you can today.

We fast forward to today, where you still have the chairman of the Fed saying that inflation is too high. In Canada, Tiff Macklem more or less said as much.

There is the makings of a chaotic system. While nominal interest rates are elevated and real interest rates are still quite positive in relation to past norms, the inflation expectation (the Bank of Canada has referred to this as “entrenched expectations”) continues to render the effective real rate down, if not negative. However, market participants are anticipating a halt in the increase of nominal interest rates and the Fed Funds Futures suggests that there will be 100bps in cuts by the end of next year.

It is precisely this expectation of lower interest rates that is preventing the nominal increase of interest rates to have their desired effect by central banks. As a result, demand is still high because inflation expectations remain high – practically speaking, the real rate of interest in the minds of a lot of people is negative. When the purchasing power of your cash continues to erode, why not spend?

The chaos factor is anticipating when there will be a turnaround in expectation. Psychological whims are fickle – much more so than nominal interest rates.

To use a science analogy, the economy is feeling like a super-saturated solution – one minor intrusion away from reverting into another state of matter. I can’t anticipate when this will occur. However, when it does, it will be relatively swift. I don’t want to use the word “crash” to describe it, but there is a possibility, albeit I would not rank it as probable at the moment.

What are some defences to this scenario? Holding cash is good, although my gut instinct says it is a crowded trade. The trade is crowded enough that it will probably buffer the impact of lower prices. A scenario I see more likely is the long-term (10 year) risk-free rate rising to a point that suppresses equity valuations like a wet blanket on a campfire. Although this is hardly a scientific sample, stable royalty income trusts such as the Keg (TSX: KEG.un) have recently exhibited some degree of price contraction, likely due to the yield competition with cash. Why bother holding risky units in a steakhouse chain when you can just hold onto (TSX: CASH.to)? Is that truly worth a 250bps equity premium? It even looks worse for A&W (TSX: AW.un), which is at a 50bps premium at the moment. Maybe I should be shorting it!

Finally, let us not discount the slow impact of quantitative tightening. In Canada, we have $23.9 billion in government treasuries maturing on September 1, and another $558 million in mortgage bonds maturing on September 15. This is about 7.75% of the Bank of Canada’s balance sheet of treasuries and mortgage bonds. Funds parked at the Bank of Canada by banks remain plentiful, however – nearly $157 billion is still parked at the BoC at last glance. Credit is still available – you just have to pay a lot more for it.

Chasing yield is easy until the party ends

I have successfully liquidated my debentures in Harvest Energy (series D and E) for 101.5 and 102.0, respectively. Since they are trading above the 101 that will have to be offered after the takeover, it is unlikely that investors will tender the debt. I am happy to be rid of the bonds so my capital can find some more productive areas. My opportunity cost of this transaction is giving up about a 6% yield, but there are equivalent risk instruments that the money can be parked in the interim.

I have another issue (Bellatrix Exploration, formerly True Energy Trust) that has seen its equity rise about 400% over the past four months and its bonds have correspondingly traded near par. It is very close to my liquidation point and there will be a high probability it will be sold very soon.

As such, my portfolio is starting to look cash rich. While cash is good, it is also earning a return that is less than flattering (mainly zero) and while I can shift the funds into a short term savings account for 1.2% (or 2% if I shopped around) I am always looking for a better place to put my money – something that will give a yield.

In my tax sheltered accounts, I am looking for investments that will generate income. Outside the tax sheltered accounts, I am looking for investments that can generate capital gains (taxed at half the rate) or eligible dividends (taxed significantly less depending on what income bracket you are in).

Most of the income trusts have been bidded up to yields that are not representative of the risks embedded within the company – for example, a trust that is always on my watchlist (but I never get around to purchasing) is A&W – currently yielding about 8.01%. This is not adequate compensation for a company that is distributing more cash than its distributable cash allotment. It is possible that A&W could trade higher (and yield lower) but this is essentially the equivalent of gambling and could just as easily go to 8.5% ($14.82/unit) as it could to 7.5% ($16.80/unit). I do not want to get into coin flipping competitions with the market.

Since my hurdle rate is above 8%, I am forced to lower my standards if I am to seek a home for my cash. This means either accepting higher risk, or accepting a lower rate of return.

Right now if I accepted a lower rate of return, I estimate I could generate about 10% a year with debentures, but this is still a relatively low rate of return in consideration of the risk taken.

As such, I must broaden my search to more obscure securities and companies. This will also require some research and time. It will also require appropriate market conditions when people are less confident.

Fortunately, time is on my side – while the cash is sitting there, earning nearly nothing, it will at least be there when I need it. The temptation to quickly deploy cash is one of the most destructive psychological behaviours one has while investing.