Sunday, 31 January 2016

H&R Reit, Strip Coupons vs Convertible Debentures vs Trust Units

I was searching TD's fixed income offerings on Friday and found the following strip coupon offering:

This is a March 2020 strip coupon, yielding 2.93% at TD's spread.  For almost the same duration, you can get a 300 BPS yield improvement by buying the June 2020 convertible debentures, as follows:

When I see a 300 BPS improvement, my gut tells me something must be up, and as there's no free lunch (EVER) in investing, the thought process behind buy the strip vs. buy the convert has to involve more than a simple cursory comparison of yield.

So here are my thoughts, in no particular order:

  • The strip coupon is the face value part of the Series F 4.45% senior debentures maturing March 2020 (i.e., face value matures at $100 in 2020)
  • With reference to H&R's most recent annual information form, H&R's senior unsecured debentures are "direct obligations of the REIT and rank equally and rateably with each other Senior Debenture and with all other unsecured and unsubordinated  indebtedness of the REIT"
  • Both this senior debenture issue and the June 2020 convertible debenture issue are unsecured and rank equally, so both unsecured obligations should trade similarly in terms of YTM as a whole (Par + coupons for the Series F vs. HR.DB.D YTM)
  • The difference in YTM must therefore be part attributable to the absence of PV'ing the residual series of coupons to be received under the Series F issue
  • If there is any remaining difference between YTM as a whole between the two issues, my thoughts are that the series D convertible debenture will show a higher yield to reflect the issuer's option to settle the redemption of principal in units of the REIT instead of cash at maturity
  • The next comparison is to risk free money.  I can earn a 2% yield risk free by buying 4 year GIC's, so by buying the convertible debentures of the same duration, I can earn almost 400 BPS over risk free GIC's

Here are my thoughts on possible issues which could impact H&R's overall business:

  • Exposure to Alberta - as at Sep 30, 2015, 30% of the portfolio is located in Alberta, and 12% of gross rents are derived from Encana
  • Encana occupied almost 11% of gross leasable area, but had a remaining lease term of around 22 years.  
  • Any significant change in Encana's business could have a material impact on H&R.  If Encana were to go bankrupt, H&R would be left with 2.1M sq ft of vacant leaseable office space in Alberta.
  • As the remaining 22 yr term of Encana's in place lease/s include  legacy negotiated rent escalation clauses which likely reflect pre-2014-2016 oil crash "market" rents for Alberta space, in the worst case, H&R would need to drop rents to below pre oil crash "market" in order to re-lease the space
  • I have no idea what may or may not happen with Encana, but certainly, any investor in either of H&R's debt or trust units should at least consider the possibility of this outcome (however remote)

So far, I'm considering the 2016 convertible debentures and not the 2020 Debentures or Trust Units. The reason being, these debentures mature on Dec 31, 2016 and yield 4.5% to maturity, so I can keep my duration short and earn 300 BPS over comparable risk free GIC's, but, I have to consider the possibility that if an adverse "Encana" event or an adverse credit market event occurred this year, H&R could redeem these debentures in units instead of cash.  I don't think it's highly likely, but there is always a possibility.  And if they did, hopefully the units would be depressed enough in terms of valuation that I wouldn't actually care.

I ran the following series of analysis using H&R's reported #'s over the last 8 years in order to assess the business overall:

First, an analysis of comparative valuation and composition of capital structure as per below:

What jumps out at me immediately is that the valuation comparison between mkt cap vs. net fair value of investment properties + investment in JV's (valued using the equity method) is slightly higher than the same relative valuation back in 08 and 09.  To be fair though, I used average market cap to assess the overall discount or premium, and at times during the 08/09 crisis, when H&R got down to below $10, the discount was in excess of 50%, so certainly, just because I've calculated -23% now doesn't mean much.  If access to credit or liquidity dried up again and H&R was forced to cut or suspend distributions, there's no reason why this discount can't widen to -50% (or more).

The next observation is the change in capital structure relative to 2008.  Back in 08, funding was predominantly mortgages.  Now it's 71% mortgages, 29% debentures.  My guess is that if convertible or senior debentures with a low enough strike price and lower coupon than conventional mortgages can be issued in order to minimize overall cost of funding, H&R will continue to do so.  While H&R cannot control market rents, it can control the coupons it chooses to pay (subject to market demand for unsecured obligations), so the overall spread between rents and funding costs is more a function of the latter than the former.  On that note, here's my calculation of this spread over time using property operating income as a proxy for NOI / FV of properties.  I figure that this measure is similar to EBIT in the case of non-REIT's, and surely, investors want to see ability to maintain a sufficiently wide spread between % NOI vs. cost of funding, as well as adequate interest coverage:

What jumps out at me here are the following observations:

  • Interest coverage has improved since 2008 on a property operating income / finance costs basis.  However, 2.59x is susceptible to change in the event of an adverse event 
  • I've calculated efficiency three ways, one as operating margin based on NOI / FV of properties (similar to cap rate), two as NOI / gross rents, and three as gross rents / FV of properties.  I suspect that all three measures are of difference importance
  • I have then compared cap rate to weighted avg cost of funding in order to determine a basis point spread over the last 8 yrs.  I suspect that this spread drives valuation over time, and over 8-10 years, I should be able to see a trend in spread.  My suspicion is that a 174 BPS spread today is a function of much lower weighted avg funding cost vs. 8 years ago
  • Occupancy at 96% through the 9 months ended Sep 30, 2015 is lower than at any time during the last 8 years, however, this may be a function Target vacancies in the last year in the retail (Primaris) portfolio.  
  • I have also calculated an at market margin spread  = gross rents / FV of properties, which has ranged from as low as 3% in 2011 to 6.3% in 2010.  This spread is a lot more variable vs. NOI / FV of properties, so I'm going to attach less importance to this spread vs. NOI / FV of properties
  • The avg lease term to avg mtg term spread has increased from 2.2 yrs in 08 to 4 yrs currently. This may be more a function of H&R increasing the proportion of debentures with 5 yr maturities in the capital structure relative to 2008 as noted above.
  • Finally, I've calculated NOI / gross rents as an alternative measure of analyzing efficiency. This operating margin shows improvement since 2008, however, 2008 may not be a fair comparable starting point.  It's entirely possible that due to the credit crisis in 2008, lessors (in general) had to offer below market rents in order to induce tenants to sign leases.  It's entirely possible that NOI at the time was abnormally depressed relative to what NOI would have been during economic expansion.  If this is the case, I may need to revisit the above analysis and adjust NOI as reported down to normalize for cyclicality in the business cycle.  It's possible that we haven't yet seen the full economic fallout of $30 oil in Alberta on business activity in Western (and Eastern) Canada as the initial price shock is still fairly recent.

Concluding Thoughts

Over 8-10 years, I should be able to analyze the trend in % NOI : Cost of Funding spread.  I think that this spread drives valuation and demand in the market for the REIT itself.  REITs are highly interest rate sensitive, so if the velocity of cost of funding increases (or is expected to increase) faster than noi/gross rents (a measure of how efficiently the properties are run before finance costs), then valuation should decrease.

We saw this in 2008, and it's interesting reading H&R's annual report in 2008, where they specifically speak about access to funding drying up as a result of the credit crisis, which caused massive compression in all REIT valuations.  When cost of funding spiked in 2008 (& H&R was & still is rated BBB), my noi/gross rents less cost of funding spread tightened, and valuation fell.  Even if they were never going to sell their interest in Scotia Plaza, the market repriced imputed cap rates in this scenario by extrapolating the impact of H&R having to refinance at peak cost of funding in 2008.  And really, this is the time to buy REIT trust units, when there is a massive disconnect between the market pricing renewal cost of funding vs duration of remaining mortgage term & probability of peak crisis cost of funding remaining elevated over time.

So, I don't think buying H&R trust units is the correct move now, because cap rates are low (& valuations are high), and there is no real fear in the market over limited access to credit.

The convertible debentures make more sense because the imbedded call options are near worthless the longer the units stay below the strike price, so they trade like straight bonds, and the shorter duration convertible debentures maturing Dec 31st this year will likely get redeemed & replaced by another issue with a lower coupon and a lower strike price so H&R can ratchet down their overall cost of funding for another 5 yrs, with minimal default or extension risk.

Wednesday, 27 January 2016

Morguard REIT 10/31/17 Convertible Debentures

As I continue scouring the North American investment universe for possible ideas, unrelated to alpha or beta or gamma or whatever, I've begun looking into cracks and crevices that I feel are not ordinarily looked at by the ordinary Joe or Jane retail investor, either due to unfamiliarity or oversight.  One of these areas is convertible debentures.

You can find a full listing of TSX traded convertible debentures here.  My thoughts are that the universe of convertible debentures is like the wild west.  The majority of the issues are absolute crap. There's a reason why issuers have to offer sweeteners such as imbedded call options in addition to juicier coupons in order to float issues: because the majority of issuers here are junk issuers.

I sorted the listing in excel.  Of the 151 issues listed for trading, a whopping 9 issues are in the money. Thinking about this, 6% of trading issues are trading based on the imbedded call option feature being in the money.  The remainder are trading out of the money, meaning, these issues should straight like straight bonds as the imbedded calls have zero value.  The farther away the strike price, the more the issue will trade like a straight bond.

I stumbled across the following issue which I thought was interesting:

These debentures trade at just under par and are convertible into underlying MRT.UN units at a strike price of $24.60 up until maturity.  As the REIT unit price has tanked, the call feature is basically worthless and the debentures should trade like straight bonds of equivalent coupon and maturity, but they don't!

Here's the equity performance over the last 5 years weekly, as compared to the BMO equal weight REIT index (on a price performance and correlation basis):

You can see that the units pretty closely track the overall BMO REIT universe on both a price performance and on a correlation basis.  I'm not sure why though.

Here's the debenture vs. the REIT:

Here's what's interesting about this debenture:

  1. The entire amount of the convertible issue is a tiny fraction of Morguard REIT’s overall debt.  They could redeem the entire issue without making a meaningful difference to their balance sheet.  It’s only about $147M on the balance sheet (see below)
  2. Morguard REIT is 48% owned by Morguard (the parent company), which actively buys shares of Morguard REIT in the open market.  I would hazard a guess that depending on how cheap Morguard REIT gets, Morguard could very well take Morguard REIT private in the best case, and in the worst case, continue to buy units in the market.  You can see that Morguard REIT has performed extremely badly since last January! It’s down almost 40%, and I suspect this is a function of Alberta industrial and commercial exposure and exposure to Target leases
  3. The convertibles trade at $.99 on the $1, but yield 4.85%.  The maturity date is October 31st, 2017, so there’s about 1 ¾ years left to maturity at almost 5%.  The concern is that Morguard REIT has the option to settle the $1,000 maturity obligation by issuing units instead of redeeming the units at par of $1,000.  I don’t think this is such a bad trade off though.  The cheaper the units get, the more units you would eventually get for $1,000 par, and see 2) above, Morguard owns 48% of the units and is an active buyer.  If the units got cheap enough, my guess is that Morguard would take the REIT private.  The net value of the real estate (carried less total debt) is around $1.47B.  The units have a total capitalization of $775M, so I think there’s a margin of safety here in buying the debentures
  4. The conversion price is way above current price, $24 or so, vs $12 currently, with no real chance of the stock getting there before 10/31/17, so it should trade like a straight bond, but it’s not because of the optionality in 3) above, re: Morguard REIT having the option to pay the debenture issue off in units instead of cash.  But I wonder if this is such a bad thing?  You’d be receiving units where total cap is $775M vs. net value of real estate of $1.47B and a ready buyer in the parent company willing to continue buying units?  Compare this to Riocan, with a capitalization of $7.74B vs. net value of real estate of $7B?

Here's an excerpt from the most recent quarterly with details surrounding the issuer's option to redeem the debentures in units.

If maturity was tomorrow, I would receive the equivalent of $1,000 worth of units calculated as:

$1,000 / avg trading price for previous 20 days x 95% = $1,000 / (avg ($13.80,$12.57) x 95% = 80 units (I haven't used VWAP here, I've used closing price, but close enough for interest's sake).

Concluding Thoughts

I bought $3K face value of these debentures.  I figure that the following set of possibilities can happen:

  1. They go lower and they get redeemed at par ($1,000) in cash on Oct 31, 2017.  Between now and Oct 31, 2017 I collect 4.85% x $3,000 per year
  2. They stay where they are and they get redeemed at par ($1,000) in cash on Oct 31, 2017.  Between now and Oct 31, 2017 I collect 4.85% x $3,000 per year
  3. They go lower and they get redeemed in units of Morguard REIT on Oct 31, 2017.  Between now and Oct 31, 2017 I collect 4.85% x $3,000 per year.  If the price per unit gets low enough, my margin of safety improves.  

Thursday, 21 January 2016

Cdn Natural Resources 2020 2.89% MTNotes

I was looking at these bonds yesterday because they showed up at Waterhouse again.

Here they are at Waterhouse, priced to yield around 4.3%

And here they are at Candeal yesterday, priced to yield 4.44%

Here is my initial calculation of interest coverage using the last 5 years of reported results, and my payback on the bonds if I were to purchase them today:

As can be seen, these are rated BBBh, and yield about 100 BPS over comparable BBB corporates, and I'm wondering if this is enough given the deceleration in EBIT over the last year.

What I find truly amazing is how quickly things have changed economically for the company.  Prior to 2015, interest coverage wasn't a plausible concern as the company generated sufficient earnings from operations to cover interest charges.  What a difference a couple of years make.

Here are the company's recent disclosures regarding liquidity from the Sep 30 1/4ly:

And, on the subject of balance sheet strength, here is the most recent balance sheet:

And here are the company's most recent 9 month 1/4ly results:

Here are my observations in no particular order:

  • I'm not sure where the balance sheet “strength” is.  The business is a juggling act.  They either run working cap deficiencies or rely on sustained production (at a loss to cover fixed costs) and access to debt and equity markets to finance continued production and exploration, and in years like 2014/2015, they defer capx to ensure they can meet fixed charges. 
  • You can get a feel for how much they rely on access to credit by reading the disclosure from the 1/4ly report on different avenues of credit available
  • I’m curious as to why these bonds are only priced at 107 bps above other BBB's
  • Regarding the comparative P/L from the Sep 1/4ly, my observation is that this is an overall business with huge gearing!  Rev’s (production + royalties) are off 38% and 34% respectively, but production expenses are highly fixed in nature, & are only off 7%, to me this means that there must be significant lag time to adjust cost structure.  Transportation & blending seem to have adjusted faster at -27%

Concluding Thoughts

If WTIC doesn't rebound (and soon), how are they going to continue paying fixed charges if cost to produce exceed costs to sell for a prolonged period of time?  Why aren't these bonds junkier?  2020 is 4.5 yrs, a lot can happen in 4.5 yrs.

I suppose that if they really got into trouble, they could sell off non strategic assets…maybe this is why they still carry a BBBh rating, because there's $53B of assets they can parcel off to meet the fixed obligations. 

It's interesting to look at this from this perspective.  EBIT is in the toilet, but PPE is worth something.  Even if it's worth $.50 on the $1, it's still $25B.

Amazingly, they raised the dividend recently.  This will be the first thing they cut.

Tuesday, 19 January 2016

Netflix, Going Concern or Headed Towards Insolvency - You Decide

I won't beat around the bush.  I despise Netflix.  I have a far fetched theory that they will eventually go bankrupt.  And I'm putting this out there here and now, based on the following trail of breadcrumbs. 
  1. The stock hovers pretty close to lifetime highs despite horrible free cash flow, and continuous debt and equity financings used to fund the business model.  The stock is up almost 8% after hours on ridiculous results which I'll look at shortly. And equity (and all of Wall Street + Cramer) lap it up and see nothing wrong and pump the stock.
  2. How sustainable is the fee for streaming model over time, and are investor expectations predicated on future growth not already reflected in the price at 120x EV / EBITDA?  Netflix invests heavily in producing and licensing content, but does the return on capital exceed the cost of capital here?  I recall Professor Bruce Greenwald discussing how growth at a cost of capital in excess of return on capital is actually destructive.  
  3. Equity investors are reflexive.  They want to own Netflix not because it's a fantastic business. They want to own it because a) the stock has gone up, b) it's pumped by Wall Street and Cramer.  There is a certain collective cult mentality surrounding Netflix which is unjustified.
  4. I think the play here is, don't own Netflix, own the companies that take a fee for monthly data streaming charges

I had a quick look at the reported results and I offer the following snapshots from the company's release:

Here are the free cash flows for the last three years.  Granted, in 2015, they invested heavily in content which is why free cash flows were negative.  The question I have is, to what end.  When does the pendulum swing.  Aren't they going to have to invest heavily in content on pretty much a go forward basis over time?  What needs to grow are top line streaming margins.  Interesting that for cash flow purposes, the net change in streaming content assets vs. content liabilities are deducted.  They aren't income, but they certainly are a use of cash. 

Next, here are the P/L and the Segmented Results:

Note that on a GAAP basis, consolidated operating income has grown at 16% over the last 3 years.  A far cry from the 32% CAGR growth in consolidated contribution profit.  The difference is a function of "other operating expenses" which eat up 78% of contribution profit.

Interest coverage has dropped from to about 2.30x, but the company will explain this away as a function of higher content costs incurred in 2015 while streaming revenues (and accompanying margins) haven't caught up yet.  Well, we all know how they paid for the content.  Debt.

Here's a note on debt, incidentally from today's 8-K

I guess the disclosure that the company will, once again, have to tap the bond markets to be able to pay for more content is being overlooked by equity who are scrambling to buy the stock at +8% after hours.

Well equity, here's what you have a claim to (in the event of bankruptcy):

Content liabilities of $7.6B to liquid assets of $2.3B, or $.30 on the $1, and then there's this from last year's 10K

At the time, $6B of off balance sheet content obligations weren't capitalized because the company decided that the asset side of the equation hadn't yet met the criteria for capitalization.  Thank goodness they disclosed the amount though.

Assuming off balance sheet content obligations haven't changed, that's $7.6B + $6B  = $13.6B to $2.3B of liquid assets, or $.17 on the $1.

Concluding Thoughts

I'm sure bullish equity participants will make the argument that I'm wrong b/c I have to look at the capitalized content assets because they produce future cash flows.  My rebuttal to this is, are these cash flows infinite or finite once the novelty surrounding current content wears off?  i.e., what type of impairment model are we into in respect of capitalized content that no one wants to watch.

In any case, I have no position, I'm just a casual observer observing manic participants doing what they do best.

Great Canadian Gaming 6.625% Callable Unsecured Notes

Quick post on Great Canadian Gaming Corporation.

In the last couple of weeks, the stock has rallied while the overall market has not, so I look at this as a clue that something may be up.

Here's the chart:

On Jan 11, 2016, GC announced the closing of a deal to operate casinos / facilities in Ontario. The company had previously disclosed that it was in the bidding for the license.  Here's a link to the press release and an excerpt from it, describing the win:

So, I take this to mean the following:

  • The company is diversifying it's exposure base away from Western Canada to Ontario with this win.  Prior to the win, the Company had revenues of approximately $330M from existing facilities over the 9 months ended 09/30/15.  The OLG win gives them a minimum guaranteed fixed fee component of $15M per year (before Belleville is opened), and $24M thereafter, and a variable component = 70% of gross gaming revenue plus a fixed amount for approved capx + 100% of non-gaming revenue.  Even if the variable component is 0% (unlikely), the OLG piece is somewhere between $15M & $24M depending on when Belleville opens.
  • EBITDA would have been $16-$17M had the OLG win been in place for the year.  Here's the 09/30/15 P/L for reference:

I get EBIT of around $103M annualized (excluding new OLG).  EBITDA should be $103M + $28.9/9*12 = $38.5M, so EBITDA margin = ($103M +$38.5M) / $332.7/9*12 = 32%

Quick and dirty, taking the low end of their pro-forma range of $16M and applying overall company wide EBITDA margin, I get pro-forma revenues $16 / .32 = $50M.  $50 / $443M = 10% incrementally

Here are the bonds as listed at TD yesterday:

Apart from Corus 4.25%, these bonds are the only other BB+ rated bonds, and I think there's an opportunity here for a number of reasons:

  1. The bonds have come down in price along with all other high yield bonds
  2. I think the bonds reflect uncertainty re: Western Canada and specifically, consumer discretionary activity related to Western Canada
  3. The bonds appear to be well covered, not only by virtue of my muppet math above, but also based on analysis of the company's most recent balance sheet, which looks pretty clean, see below, there was cash on hand of around $291M vs. LTD of $443M, and the company generates positive cash flow
  4. The incremental cash flows from the OLG win should be credit positive, which is why I think the equity has rallied
  5. The bonds are callable at 101 anytime before July 25, 2017 according to the indenture, clause a) see below, and the company has already recalled one issue back in 2012 to take advantage of cheaper available cost of funding in the credit market, see below

Here's the balance sheet


Here's the indenture clause re: the call provision

Here's the press release on the last call back in 2012, where they called early and refinanced at 6.625% down from 7+%.

And here are the historical #'s demonstrating interest coverage and FCF (not including the OLG win):

Concluding Thoughts

I bought $5K face value of the bonds at 100.1 + accrued interest (next coupon is Jan 25th, so I've effectively paid $6 accrued interest).  I believe the bonds will get redeemed, it's just a question of when, as they will need to tap into access for financing to perform required capital improvement in respect of the OLG win.

My best case scenario is that the bonds don't get redeemed until after July 25, 2017 and they're redeemed at 103, but I don't know why the company would do this when they can save 200 bps and redeem them at 101 prior to July 2015.

My worst case is that I'm completely wrong.  Always a possibility.

My mid case scenario is that they get redeemed in less than 1 year at 101.

Monday, 18 January 2016

Canadian Natural Resources Highway Robbery

Quick lesson on how brokers make money...

Here are CNQ 8/14/2020's, 2.89% coupon, per Candeal:

And here are the same bonds at waterhouse this morning:

If waterhouse does not have these bonds in inventory, they buy $96.31's and sell retail $100.75's all day, and pocket the spread, risk free.  Caveat emptor indeed.

Sunday, 17 January 2016

Revisiting Non NVCC Canadian Insurance Preferreds

I realized after I posted my last analysis that I made an error in the analysis (it happens to me a lot).

If you read any of Mr. Hymas' writings (and/or subscribe to his newsletters), you'll see that he grosses up the dividends received in his analysis by a factor of 1.3x to get back to a pre-tax interest equivalent dividend (a second important  factor to consider is the after tax equivalent of holding preferreds in non-registered accounts for Canadians as the dividends qualify for the dividend tax credit).

When I initially did my analysis, I used only the stated dividend yield without considering the 1.3x gross up.  I've redone the analysis for IFC.PR.A using a gross up of 1.3x vs. no gross up (on the assumption that participants other than Canadians hold them, or on the assumption that some Canadian participants hold them in registered accounts and can't make use of the DTC as a result).

I've also done the analysis excluding the impact of deemed retraction in 2025 as Mr. Hymas has postulated just to see what the market is theoretically pricing in here at Friday's close on a worst case basis.  For my discount rate, I've interpolated in order to solve for this based on Friday's close.  The 2018 PV is calculated as straight perpetual dividends = 2018 div / R / (1+R) ^ 2 ).

Here are the results:

And here are the results interpolating the discount rate for the possibility of deemed retraction in 2025:

Which really doesn't make an ounce of sense, as I've interpolated a higher discount rate with a better result in 2025 (i.e., redemption)?  <January 18th update, this actually may make some sense now that I think about it, I've solved for YTM buying at current market, maturing in 2025, and the reason YTM is 12% is due to the market not pricing in redemption.  If it did, YTM would approximate YTM on comparable bank preferred's.>

For comparisons sake, here is the same exercise using BNS.PR.Q fixed resets (at almost the same reset spread) with a deemed maturity in 2022 (note that in all of these cases, I've modelled next reset at GC 5 yr = 0):

You can immediately see the difference in market price between BNS.PR.Q which is slated for redemption in 2022 and IFC.PR.A which is not.  The difference is about $7 in differential.  Part of this difference must be attributable to optionality, i.e., BNS.PR.Q is +$7 vs. IFC.PR.A because the market recognizes and is pricing in the redemption feature in BNS.PR.Q and no such feature is priced into IFC.PR.A (yet), and the remaining difference must be due to duration.

Here's IFC.PR.A modelled at BNS.PR.Q interpolated discount rates + deemed retraction:

Concluding Thoughts

I have no idea what may happen from here, and I'm certainly not enjoying watching the daily demolition of these issues.  I suppose my saving grace is that these issues are an overall small %ge of total assets and I can only observe the implosion with a sense of humour (if this is at all possible), while investors flock to obscure ETF's like BMO US Put Write ETF under the guise of "safety". Situation normal.

I can say one thing, should OFSI issue a ruling sooner rather than later (which was supposed to occur in early 2016), the market will most likely adjust violently to price the missing optionality in. In the meantime, it's batten down the hatches time.

Saturday, 16 January 2016

BMO US Put Write ETF, Anyone Else Out There Find This Absolutely Stupid?

A quick post on tomfoolery in the guise of an ETF.

I was looking through the 52 week highs/lows from Friday, and was astounded to find this.  This is a 1 yr comparison of the BMO US Put Write ETF vs. the S&P 500.  It's a fairly new ETF, having less than a 6 month trading history, but conceptually, this thing should not be hitting new highs as the S&P 500 hits new lows, and $VIX spikes to new highs.

For the life of me, I cannot understand the absurdity behind this move.  Here's the profile from BMO:

Reproducing the portfolio strategy below:

Portfolio Strategy

BMO US Put Write ETF has been designed to deliver an alternative income exposure by writing put options on an underlying portfolio of U.S. large cap equities. The ETF writes short-dated out-of-the-money put options by analyzing the available option premiums, while investing the portfolio in cash equivalents. The ETF may be subject to a loss if the stock prices decline significantly over the option period.

Here are the portfolio holdings and sector allocations (top holdings).  I note that 20% of the ETF's sector allocation is to short energy puts.

Here is an excerpt from the portfolio strategy posted by BMO right on the ETF profile page (note the disclosure regarding what should happen to return as short puts move into the money, it's right there in plain view!):

Anyone not familiar with the theory behind put writing should refer to the following:

Here are my theories on what may be going:

  • (Canadian) Retail investors are scrambling into this ETF because it's going up (which is dumb)
  • (Canadian) Retail investors are drawn to this ETF because they mistakenly think that due to it's 100% collateralized US T-bill position, it's a fixed income equivalent
  • (Canadian) Retail investors love this ETF because it writes premium in USD's, and the USD is rising vs. the CAD
  • (Canadian) Retail investors are too lazy to figure out what this ETF actually does

My questions?

  • At what point do the pros running the ETF have to post margin against every single position going against them at the same time?
  • What happens to the collateral held by the ETF when this happens?
  • When will this ETF implode?

Stay Tuned...

Thursday, 14 January 2016

Canadian Preferred Shares: Bottomless Pit or Misunderstood Opportunity?

I guess the best place to start is a visual comparison of two periods in time.  Here's the ishares index:

I've highlighted two areas of interest which, at first glance, appear comparable, at least to the "technical" trader.  The school of thought is something along the following lines:

"The index has broken support from 2008, therefore it's a sell"

While I have to acknowledge the existence of participant muppetry, it doesn't mean I have to agree with it.

Garth Turner published an interesting piece explaining the space in the attached link.  I'm reproducing excerpts from the piece below (circa July 2015):


Preferred shares are supposed to be a steady asset class, rarely declining dramatically and providing investors with a consistent return. Unfortunately, this has not been the case in 2015 with the S&P/TSX Preferred Share Index falling by a gut-wrenching 14%. So what has changed? Why has this traditionally defensive asset class behaved with so much volatility?

First, let’s begin with some history. Prior to the credit crisis of 2008–09 Canadian preferred shares were mostly of the perpetual variety. Perpetual preferreds have a fixed, usually very attractive, dividend, but they can also be redeemed by the issuer—the issuer can, at their option, “call” them back from investors at par in exchange for cash. The attractive dividend usually prevents major price declines and the call feature usually prevents major upside price moves. Hence, perpetuals historically had predictable price movements rarely straying far from their redemption, or par, values. However, perpetuals also have one key weakness: no fixed maturity date. This weakness became apparent during the credit crisis when investors fled from perpetuals because there was nothing compelling issuers to ultimately pay investors a set price for their shares. 


As confidence in markets eroded, particularly in the financial sector, which is a major issuer of preferred shares, investors, who had no maturity feature to protect against the downside, watched their perpetuals plunge in value. 

In the aftermath of the credit crisis, investors were stuck in a world of rock-bottom interest rates and depressed bond yields. They’d also had enough of perpetual preferreds. They wanted a product that at least offered a quasi-maturity feature and some protection against rising interest rates, as the accepted wisdom following the credit crisis was that interest rates had only one way to go: up. Thus rate-reset preferreds were born. Rate-resets could still be called by the issuer, but they offered investors the opportunity to “reset” their dividend, typically every five years, at a yield equal to the Government of Canada (GoC) 5-year bond plus a pre-determined premium spread. So, for example, if in five years’ time GoC 5-year bond yields moved to 3% and the premium spread on a rate-reset preferred was 200 basis points (2 percentage points), investors had the option to reset the dividend to the equivalent of a 5.0% yield. Investors loved these new products because they ostensibly offered protection against rising interest rates (if bond yields moved higher, investors stood to receive a higher dividend down the road) and, in theory, provided the maturity feature investors desired because the reset spread would incentivize issuers to simply redeem, or call, their preferred shares at par rather than support the new reset yield, which might be above current market rates.

Eventually, the majority of the Canadian preferred share market moved to a rate-reset structure and perpetuals fell out of favour. Currently, the market is roughly two-thirds rate-resets. 


Unfortunately, of course, interest rates did not move higher, they stayed low and the reset spreads, which were initially modest (100–150 basis points) made redemptions improbable—“resets” were likely to be at yields lower than prevailing market rates, so there was no advantage for issuers to call. In other words, the wave of redemptions (or “maturities”) that investors were hoping for seemed unlikely to occur. The Bank of Canada unexpectedly cutting interest rates in January 2015 and then again in July 2015 has only compounded the problem. Interest rates and bond yields have plunged and preferred share values have fallen almost in lock-step (see chart below). Compounding the problem even more is that preferred shares tend to be widely held by retail investors who, unfortunately, often sell out of fear without fully understanding market conditions. The final difficulty is that the preferred share market is illiquid, which can magnify downward price action, particularly when retail investors are running for the exits."

 So, my overall takeaways are as follows:

  • Index is plagued by the worst features attached to both 2008 and 2015/2016, namely issuer credit concerns and lower resets in face of tumbling GC 5 years (more on this shortly).
  • Space was (and likely still is) perpetuated by retail thirst for yield expecting issues to trade close to par without understanding reset features in context of GC 5 years
  • Initial retail expectation that high enough reset spreads would ensure issuer call issues if GC 5 years rose, ensuring that issues trade close to par (in retrospect, it's interesting that no signal was taken that non-investment grade issuers offering high reset spreads were issuing high reset spreads for a reason).  As GC 5 years have dropped, the exact opposite has happened.  Non investment grade issuers have tapped into a cheap source of funding and have chosen to extend their reset issues, so investors who had initially hoped for issues to get redeemed are stuck with extended non-investment grade issues paying .5% + x bps.  It's no wonder the junk in the index has dropped  so precipitously 
  • New issues have come to market recently with minimum reset floors, which have perpetuated selling on non-floor issues
  • It's interesting that investors are thirsty for imbedded puts with no upside - these new issues are basically collared, investors would rather buy the sure thing with no prospect for capital gain vs. going through the wreckage and sorting out what may be salveagable

Here's the GC 5 year.  Notice the slope of the drop, since 2001. 

Now, I can't write a blog about Canadian preferreds without mentioning James Hymas.  I follow his blog regularly, link here, and I think of him as a rocket scientist in terms of evaluating preferreds. He writes a regular monthly newsletter and runs the Malachite Aggressive Preferred Fund.

Mr. Hymas had the following to say regarding bank and insurance company issued preferreds back in 2011, link here, courtesy of Globe and Mail:

He suggests looking at bank and insurance company perpetual preferred shares. Generally, perpetuals have no fixed redemption date and offer no rate-reset potential. Really, they're a lot like open-ended bonds with no maturity date.
Mr. Hymas argues that most perpetuals issued by banks are a different animal because the 2022 regulatory deadline is almost like a drop-dead date for redemption. In fact, he regards them as being nearly as good as retractable preferred shares, which have a preset date for redemption.
Retractables are considered a desirable kind of preferred share because they offer an escape hatch that perpetuals lack.
There's some uncertainty right now about whether insurance companies will be bound by the same rules as banks on preferred shares. Mr. Hymas thinks they will be, and he therefore suggests insurance company perpetuals as another potential landing spot for people selling bank-issued rate resets.

Mr. Hymas goes into much more detail regarding why he believes the OSFI / NVCC rules will eventually end up getting applied to certain insurance companies, but I don't want to do Mr. Hymas a disservice and let the cat out of the bag - his thesis is mentioned regularly on his blog.  He makes a number of recommendations in his newsletters regarding potential insurance preferrered candidates for consideration, and I'm going to analyze one of his recommendations in my own way as follows.

Here's Intact Financial Series A Preferreds:

This issue has the following features:

  • Initial dividend of 4.2%, or $1.05 per share
  • Resetting to GC 5 year + 172 bps on Dec 1, 2017 (so just under 2 years to reset at a potential $.55 dividend, almost a 50% reduction)
According to Mr. Hymas, there is a probability that the "OSFI Advisory Treatments  of non-qualifying capital instruments" gets extended to this and other specific insurance issues.  In this case, these issues may have to be redeemed by the issuers at par.  For analytical purposes, Mr. Hymas has imposed a theoretical deemed maturity for this issue of 1/31/2025.  I note that the OSFI rules already extend to banks with non NVCC compliant issues, which explains the differential in price between bank non NVCC issues and insurance non NVCC issues with similar reset spreads.

For my purposes, I wanted to determine if there's a margin of safety in the event that Mr. Hymas is proven right in respect to insurance preferreds.  Here are my results as pertaining to IFC.PR.A:

Take one:

  • Reset dividend at $.555 in 2018 = 2.22% x $25, no change through next reset date
  • Model redemption in Dec 2024 (close enough to Jan 2025)
  • Use a high enough discount rate to account for risk, I used Long gov't + reset spread for 5.72%
  • Overall PV = $19.89 vs. current market of $14.40

Take two:

  • Reset dividend at $.555 in 2018 = 2.22% x $25, no change through next reset date
  • Model redemption in Dec 2024 (close enough to Jan 2025)
  • Use a high enough discount rate to account for risk, I used 5% + 3.5% current seniority spread for 8.5% (=interest equivalent yield  - long corporates as offered by Mr. Hymas )
  • Overall PV = $16.27 vs. current market of $14.40

Take three - what is the market currently pricing in terms of worst GC 5 year using highest discount rate?  Approximately -1.25% over the next 9 years.

Concluding thoughts

Maybe my analysis is simplistic, maybe I'm putting too much weight on the possibility of Mr. Hymas being right about NVCC rules getting extended, but I believe there is a margin of safety in buying selective issues with the prospect for capital gain.  I have to weigh the possibility of a negative GC 5 year getting to -1.25% indefinitely vs. buying IFC.PR.A today to yield 4% at $14.40.  I've already made my decision (and I'm taking my lumps), but I'm willing to bet against the consensus here.