On Monday I wrote a blog (highrockcapital.ca/pauls-blog/corporate-bond-investments-the-best-part-of-high-rocks-private-client-division-part-i) about why our ability to invest directly in corporate bonds (specifically high yield bonds) is so important to our Private Client division. I used our recent purchase of Yellow Media's new issue of 10% 2022 as a good example. In fact, we bought another high yeild bond new issue yesterday as well to be allocated to our Tactical Model (as was Yellow Media).
The simple fact that High Rock is able to transact this way in the Institutionally-traded corporate bond market is, as I say in the title of these two blogs, one of the best parts of our Private Client division. But if that is not enough, I am going to describe in detail how we trade and allocate bonds across all of our Private Client accounts once the trades are done. I will continue with the Yellow Media example.
Trade Allocation Policy
First, I need to describe a regulatory requirement that is placed on all Portfolio Management companies (like High Rock) by the Ontario Securities Commission (OSC) stating that we need to fill all client accounts first before employee accounts and all accounts get filled on a pro-rata basis according to what their original needs were on a percentage basis.
First Trade in Yellow Media
Our first trade in Yellow Media was the new issue buy order for $2mm bonds at the new issue price of $98.00. We only got filled on $1mm bonds at $98.00 (cutbacks due to such high demand from buyers).
Second Trade in Yellow Media
Our second trade in Yellow Media bonds was to buy another $1mm bonds immediately in the aftermarket or secondary trading market. I think we were the first trade out of the blocks and were immediately filled on $1mm bonds at $99.25.
The total of $2mm bonds filled all of our internally-managed accounts (including the BNS high yield fund we manage).
So now comes the time to allocate those two different purchases. First, we need to fill all non-employee accounts at the first trade of $98.00. Once they are filled, then we allocate the second $1mm piece across client accounts so they get their "full fill" allocation and then we start filling employee accounts (Scott, Bianca and my households) with the second $1mm at the price of $99.25.
So, as you can see, our client accounts get filled at the preferential price of $98.00 first before employees. Once client accounts got their full allocation, their average price ended up being ~$98.58. It may not seem like much of a difference from the weighted-average cost of $98.625 but...it matters to us. Sure we employees would have liked to have bought these bonds in our personal accounts at $98.00, given they are now bid at $101.25, but not to the disadvantage of our clients. So clients own these bonds in their accounts at ~$98.58 and employees own them at $99.25.
Three years ago this December, I decided to start a Private Client (PC) division within High Rock to manage my household/family money more efficiently and effectively. I told Scott what my plan was and he ended up joining me in February 2015 and we officially launched our Private Client division to third party investors on April 1st 2015 (highrockcapital.ca/private-client.html).
One of the biggest reasons for starting the PC division was to take advantage of the synergies that came with managing funds for a division within Scotiabank. At the time, we managed four funds totalling $250 million and most of it was focused on high yield corporate bonds. This was, and still is, our Institutional division. You see, High Rock started out as an Institutional Asset Management firm and the reason why this is so important is that it provides us with certain privileges and benefits that retail advisors do not get.
So to be clear, an Institutional firm could be defined as follows - manages funds or pools of capital on a large scale basis. They get "covered" or have relationships with Institutional traders, salespeople and analysts at all of the big banks/dealers. They get Institutional pricing (especially important in bonds which do not trade on a visible exchange like stocks do). They are invited to conferences, get one-on-one meetings with company management teams, etc.
Whereas as an investment advisor works for one bank/dealer and does not get the same level of access to pricing etc that an Institutional firm does. They are largely beholden to the offerings of their own firm, certainly on the bond side, which is not terribly efficient.
And as an example of the difference between Institutional and retail pricing and why I started the PC division I give you the following - I would call up an advisor at CIBC WG that I have had for ions (great guy and old friend). I would say, "I want to buy $125,000 of XYZ corporate bond across my household accounts". He would go to the retail trader at CIBC and get an offer at $102.00 ($100 is called PAR on bonds). Now I don't believe my advisor friend was marking the bonds up in price on me but rather, that was the price the retail trader gave him. Now because we were/are an Institutional firm, I could call the Institutional trader at CIBC and buy the same XYZ corporate bonds at $100.00, about 2% less, but only for the BNS funds. Imagine that? But for my household/family, I couldn't get them into my personal accounts at $100, only for the Scotiabank funds. 2 points on a bond like that is 2%...some of these bonds only yield 4-6% so paying up 2% is insane. So starting the PC division provided me with the opportunity to buy the bonds simultaneously for the Scotiabank funds and our PC division...same bond, same price. Efficient and Effective.
Now to last week and why I think this key difference between Institutional and retail pricing is one of our greatest strengths.
Last Tuesday, I got a couple of emails and phone calls from both BMO and National Bank (both banks were "lead" banks running the new issue process) on news (anticipated) that Yellow Media (Pages) was going to refinance an existing corporate bond. What this means is that the company (the Issuer) was going to "call" or "redeem" an existing bond and pay for it by issuing a new bond. I owned the old bond in the BNS fund and knew I would want to replace it with the new one. But I also decided that it would be a good fit and opportunity to add the new bond to our PC accounts.
Now a couple of very key points to understand about this particular bond (and most high yield bonds) is that:
So I spent all day Tuesday and Wednesday ripping thru the OM (reading thru an OM ain't easy nor is it exciting but it is a must as this forms our legal rights), making notes, on the Institutional conference call the issuer hosted and trying to figure out what weight I wanted to own in both the BNS fund and in our PC accounts. My credit work was already up to date as I have been invested in the existing bond for quite a few years and I run a robust excel model on the name.
I then put in an order with BMO (they were designated to cover High Rock on what is called an Institutional Exempt List of Institutional firms and BMO was the lead bank on the new issue) on Wednesday night as the bond was meant to price on Thursday. A little about this Yellow bond: New issue price was to be $98.00 (usually $100.00 but there are slight tax benefits to pricing below Par) with a coupon of 10%, a yield at new issue price of 10.52% and a security level of 1st Lien Secured debt. There are all kinds of intricacies in this bond I won't go into but I liked the bond structure (the OM) and I liked the pricing.
Thursday afternoon, BMO and NBF called all of their Institutional clients and gave them their "fills" (the amount of new issue bonds they would sell you at $98.00) and then it would start trading in the Institutional market. Fair to say no one get as many bonds at the new issue price ($98.00) that they wanted so there were what are called "cutbacks". I can tell you that, due to a good relationship with BMO and the trader there, we actually got a pretty good fill (I know other Institutional firms that got "0"). As good a relative fill we got, it still wasn't the amount I wanted to own. So once the new issue opened up to trade, I had a standing order with BMO to buy more at $99.25. Sure 1.25 points (~1.25%) higher but my view was this thing was going to go to $101 area and sit. And there were four ginormous accounts that owned the bulk and were not likely to sell so I didn't mind paying up a snick to get the right weighting. And I believe I was the first post-new issue trade as BMO somehow found me bonds at $99.25. They ended Friday at $100.75 bid. So High Rock PC's own this bond at an average price of ~$98.625. Not bad. Now remember, we did the exact same two trades in the BNS fund...each trade gets "split" according to our Trade Allocation Policy (more on this tomorrow in Part II).
To me, this is one of the biggest benefits to High Rock's PC division. None of us, not even me with 20 years of high yield bond experience and great relationships with traders at the banks, could possibly get bonds like this Yellow Media new issue into our own retail accounts if we did it individually.
Together, we can.
As a Credit Analyst (corporate bond analyst) and a Fixed Income (bond) Portfolio Manager, I am naturally skeptical about everything.
Think about it...you buy a bond at Par ($100.00) and hope to collect your coupon for the life of that bond and then get paid back at maturity. If the company's prospects improve and the bond moves higher in price, that is a bonus. What we question is how we could get !$^&%%$ if the company's prospects and cash flows decline and the price of the bond follows suit into the sewer. So as a credit analyst, we question everything and are naturally a dour group of folks more worried about the downside than the upside. Such is our lot in life.
With that dourness, comes a spoonful of contrarianism as well. It too comes with questioning everything a management group tells you, what conventional thought claims and what markets are saying.
This morning at 10am, the University of Michigan (Go Blue!) released it's Sentiment Indicators for mid Sept to mid Oct. Remember, these Sentiment Indicators are considered "soft" economic data as they are simply surveys, not "hard" economic data (even those are probably manipulated by various government agencies...there I go again questioning everything).
Within the various Michigan surveys reported this morning, they reported that respondent's confidence in a rising stock market (in the USA) for the next 12 months is the highest...ever! My contrarian senses kick up a gear when I see this type of sentiment from retail investors. Water sure feels warm...come on in:
We never know what the event will be that may knock a heated market lower but we can pay attention to conventional thought and be prepared.
No, not Trump, Weinstein, or even the NFL.
More importantly than all that "noise" is the US economy. Here we will look at US Initial Claims for Unemployment Benefits vs US Recessions.
Initial claims are reported weekly as the number of people who are filing jobless claims during the week for the first time. To be honest, I am not sure how accurate this statistic is week over week but we are going to look at it over the past few decades so I think it is safe to assume the numbers are valid. Jobless claims are shown in the graph below as the yellow line and are on the left hand scale in hundreds of thousands of people.
Recessions are defined as two consecutive quarters of negative economic growth (GDP) and are easily seen in the graph below as the shaded blue areas with a white outline.
A few things to note:
The dotted red arrow on the far right simply shows something to watch. I think after 8.5 years of economic expansion, it is time to look at recession indicators like jobless claims. To be clear, we are not trying to predict when a recession will happen (not that smart) but rather to begin to manage our risk appropriately in advance.
StatsCan just released our Merchandise Trade report for the month of August. Merchandise trade is the difference in exports that we sell to foreign countries vs imports we buy from foreign countries, and it is just merchandise, not services. This came in at a very negative C$-3.4 billion with the average of economist's forecasts for only a C$-2.6 billion. This means we are importing about C$3.6 billion more than we are exporting. See below:
Notice how over the past year or so that the merchandise trade report has gone from C$+1 billion to ~C$-3 billion? What really drove this surprising deficit was the fact that exports were down 1% in August but down 10.6% since May 2017, reflecting one of the worst three-month declines on record. Hmmm, the month of May also coincides with the recent weakest point in the C$. See the chart below for the USD/CAD (in US$ terms, higher is a stronger US$ and a weaker C$):
Interesting how the Canadian economy was clipping along in the 1H17 with ~4% GDP growth and the currency at ~1.3800 but as soon as the Bank of Canada hiked rates 2x and the C$ rallied about 10% (to 1.2100), the export machine completely shut-down. I hope our leaders in Ottawa are not patting themselves on the back too much about the 1H17 economic growth - arguably it was all due to a strong export machine driven by a weak C$. That has now changed dramatically.
All part of the reason why we think the Canadian economy will slow a fair bit going into the 2H17. This will lead the Bank to pause on further rate hikes and that is now driving the USD/CAD (second chart) higher over the past month. Armed with some of this knowledge/expectation, we were proactive and purchased US$ and sold C$ back in July.
TREB just released housing stats for the GTA and surrounding area for the month of September 2017. As readers may recall, I am only tracking the City of Toronto real estate market. As an old college friend of mine who lives in Burlington said to me last week, "oh, the world revolves around the City of Toronto. What about Burlington?" Sorry, but in the interest of time, and the fact that the City has been driving the surrounding areas, I am only tracking the metrics for the City of Toronto's Detached, Semi-Detached and Condo Apartments - the three main categories in types of housing.
Keeping it super brief, here are the average sales price stats for month over month (mom) and year over year (yoy) for the three types of housing:
Average sales price actually increased mom from $1.191mm to $1.355mm representing a 14% mom increase and a 5% yoy increase. Still lower than the April 2017 peak of $1.578mm but the first mom increase since then.
Average sales price increased mom from $895k to $936k representing a 4% mom increase and 5% yoy increase. April's peak was $1.104mm so still a bit lower than the peak.
Average sales price increased mom from $540k to $554k representing a 3% mom increase and a 24% yoy increase. April's peak was $578k.
In conclusion, the increase in detached average sales price was the real surprise. A 14% mom increase is rather stout. Our view remains that, over the longer term, detached housing in the City of Toronto will continue to widen the average sales price gap to semis and condos, largely due to densification in the City brought on by the Province of Ontario's two policy initiatives (Place to Grow and Greenbelt Acts 2005). You can go back and read Part III of a blog series I wrote in late June on this topic: highrockcapital.ca/pauls-blog/city-of-toronto-housing-part-3-the-positives-if-you-own-a-house
Apologies in advance but I couldn't come up with a better title for today's blog.
For whatever reason (likely because Scott and Bianca used to work at Investment Dealers before joining High Rock) we get two copies of this monthly paper called "Investment Executive". It is clearly written for the benefit of the the Investment Advisor community, which High Rock is, thankfully, not part of. So the October issue lands on my desk and the headline to the main article on the front page reads, "Investor Fees Drive Growth in Profits". Hence the title to this blog. Normally I throw this rag in the garbage but because I have such a bee in my bonnet with regards to how retail investors are treated, I just had to read the article.
Here are some highlights that lit me up (my resting heart rate is normally 39bpm...today it is 42bpm to give you an idea of my pet peeve on this topic):
"Yet industry profits are rising steadily, fuelled by a boom in retail investor fees" --> Pretty self-explanatory but let me tell you that over the past 3 years we have had a Private Client division at High Rock, I would argue that only about 1% of those clients who joined us know exactly what fees (both Management Fees they pay their broker and the embedded MER's they pay on funds they own) they pay. Most don't even know if they pay per trade or are charged on a fee-based basis. Conversely, 100% of our High Rock clients know exactly what fees they pay for everything from custody fees, trade costs and our High Rock management fee. It's right here for all to see around the 4:41 mark on the video: highrockcapital.ca/private-client.html
"A big reason for the investment industry's remarkably healthy bottom line is the resilience of the retail investment business" --> No kidding? Wonder how they add that much value to the bottom line? Take a guess...comes out of your pocket.
"The big driver of revenue increases over the past few years is fees" --> What do you pay? Does your broker drive a fancy car like a Porsche?
"These trends come at a time when investment fees should be under intensifying pressure due to slow growth, low-return environment that has prevailed in recent years" --> Fees matter, a lot. Watch our Introductory Webinar in the link above and pause at the 5:05 mark. Shocking. The difference in fees is your money (or your broker's Porsche).
"The Investment Industry Regulatory Organization of Canada (IIROC, which is a self-regulatory body owned by the banks/dealers...a conflict of interest in and of itself) review found that firms are pushing their brokers to put clients into fee-based accounts by providing both the maximum grid payout for these accounts along with performance bonuses connected to assets under management held in these kinds of accounts" --> Holy Dinah, that is a big one. There is a big push for brokers to put their clients into fee-based accounts which simply means you pay the dealer/broker a percentage of your assets under administration (say 1.5%). The brokers claim this is to remove any potential conflicts of interest (like selling you mutual funds just so they get paid a commission from said mutual fund company) but does it really? What if a static (passive) portfolio was created for a client, Ms. Smith. Fees would be paid by Ms. Smith at initiation and then no trades would be done at all...well the broker/dealer wouldn't be too happy with that because trading commissions have come down huge the past 10 years so the broker wouldn't make much money in Year 1 at portfolio initiation and wouldn't make any money in Years 2 and onward? So the employer (dealer) tells the broker to put Ms. Smith in a fee-based account where they charge her 1.5% every year. Nice annuity of revenue for the broker, isn't it? And now we find out the dealer provides incentives like bonus payments to the broker to move Ms. Smith into a fee-based account? Therein lies the difference between a Standard of Care (to treat clients fairly) and Fiduciary Duty (a legal obligation to hold the client's interests above your own at all times) (Guess which one High Rock is held to by the Ontario Securities Commission?). In fact, we feel so strongly about our Fiduciary Duty to our clients that we created and signed a Voluntary Code of Conduct: highrockcapital.ca/uploads/3/4/2/5/34254660/our_voluntary_code_of_conduct_as_stewards6.pdf
Here's the article in it's entirety: www.investmentexecutive.com/-/investor-fees-drive-growth-in-profits?redirect=%2Fsearch%3Fp_p_id%3Dsearch_WAR_search10%26p_p_lifecycle%3D0%26p_p_state%3Dnormal%26p_p_mode%3Dview%26p_p_col_id%3Dcolumn-1%26p_p_col_count%3D1%26_search_WAR_search10_search%3Dgeneric
At High Rock, Scott and I are the only shareholders. Sure, we want to provide a reasonable living for our families but we are not pressured by Sales Managers, Executives, Branch Managers, etc to increase profits anyway we can. We don't have public quarterly earnings reports and have to worry about the stock getting hammered 10% on a bad quarter. We don't have schemes like "boondoggle" trips for top-performing brokers, bonus payments etc for those brokers who can "squeeze" out more revenue from each client. That's not what High Rock is about and never will be.
We are about managing our own money and our client money in exactly the same models and securities with the exact same timing and pricing on trades (I just did 9 corporate bond trades today and every client, including Scott and I, gets the same bonds, at the same price and the same time). We use our decades of Institutional experience to invest our collective capital in a very disciplined, low-cost way and we keep a constant eye on managing risk, first and foremost. On top of all that investment management, we take client service to a new level; meeting with clients a minimum of twice per year, wealth forecasts to create a tailored financial plan and an open door policy if you ever want to talk the guys who are actually managing your money (vs farming it out to asset management firms, like High Rock, in fact).
If that sounds different or interesting to you...call us. Really.
Scott will often show both the Canadian and US yield curves on our weekly webinars (highrockcapital.ca/current-edition-of-the-weekly-webinar.html).
By way of background, the bond yield curve is comprised of 2yr bonds out to 30yr bonds. The shorter bonds respond and reflect monetary policy more than the longer bonds. That is to say, when the central bank is raising very short term rates (overnight rates), the 2yr bond yield is likely to rise much more than the 30yr bond yield. The 30yr bond yield really is only affected by one thing: inflation. Inflation is the #1 enemy of long bonds. Anyone who thinks that bond yields are low only because the Fed has been buying bonds during their Quantitative Easing over the past number of years, should read my blog on Tuesday (highrockcapital.ca/pauls-blog/fed-balance-sheet-reduction). There you will see that bond yields actually moved higher when the Fed started buying bonds and then proceeded to move lower when the Fed ended their bond buying programs. The exact opposite of what you would have thought, eh? Budget deficits, shutting down the government, elections, hurricanes, nuclear war...the only thing that really matters to long bonds is...inflation, or lack thereof.
That being the case, the yield curve (30yr yields minus 2yr yields) has been a good predictor of past recessions. The reason being is that the yield curve tends to flatten (30yr yields drop and/or 2yr yields rise) when the central bank starts hiking rates. And the central bank hiking rates usually brings on a recession, in and of itself. Also, if the Fed is hiking rates to combat inflation, then 30yr bonds feel like the Fed is "getting ahead of the inflation curve" so it doesn't rear it's ugly head.
So what does the 2-30 yield curve tell us today? Chart below with the yellow line being the 30yr minus the 2yr yield and the white and shaded areas are past US recessions:
Note a two things:
I might as well explain why this dynamic exists. It really goes back to inflation being the enemy of long bonds. Right now, the lack of inflation is producing questions for all of these PhD's at the Fed. With all the monetary (and fiscal stimulus) they have put into the system over the past (almost) 10 years, how on earth could inflation not be rearing it's ugly head? The answer is probably for a separate blog but it has something to do with employment gains that have been made and the spectacularly low Unemployment (UE) rate which now sits at 4.4% (remember in 2012 when former Fed Chair Bernanke said he would automatically raise rates when the UE rate hit 6.5% or something stupid like that? And that was when the US rate was 7.7%). Well here we sit at 4.4% and they have barely raised rates. Why? Simple...the quality of those job gains that has driven down the US rate to the low-4's is, well, crappy at best. Lots of low-paying jobs like retail sales, servers in the food/beverage industry, part-time vs full-time, etc. So no wage gain pressure and wage pressure is what really drives inflation...you make more, you spend more.
The economy is going thru a seismic structural change where old rules (like the Taylor Rule which states where overnight rates should be vs full employment) simply don't hold any more. In fact, a few regional Fed Presidents stated yesterday that they are confused as to why inflation is not resurrecting at this stage. The Fed has been dead wrong. (And remember, a PhD in Economics gets to be called "doctor" but if he/she is wrong, no one dies. No big deal...just the global economy hanging in the balance).
So what will happen? The Fed will probably hike rates further but at a very measured pace due to their confusion on inflation, amongst other reasons. As for the longer end of the yield curve (30yrs), the yield will likely continue to fall for two reasons: 1) there is no inflation to erode purchasing power and 2) 30yr bonds will start to believe, rightly, that the Fed rate hikes are premature and will start a recession, at some point.
But before we start talking too much about a recession, the curve needs to flatten a fair bit more. Unless the old rules no longer apply and the new rules surprise everyone. Remember, the bond market is almost always right and leads all other markets. We pay attention to it, that is for sure.
The US Federal Reserve Open Market Committee (the FOMC; the decision-making body of the US central bank) meets today and gives us results of their two-day meeting tomorrow at 2pm. The FOMC has been talking for most of the year that they would start the unwinding their $4.5 trillion balance sheet (up from $800 billion before the 2008 crisis). This unwinding would initially be in the form of not re-investing coupons they receive on the bonds they own.
StatsCan just reported our Canadian jobs report this morning at 8:30am. The country produced about the number of jobs Bay St Economists had expected at 22,200 new jobs. The Unemployment rate fell from 6.3% to 6.2%. On the surface, about as expected and all good.
Beneath the surface, the quality of those jobs gains were not so stellar. Of the 22,200 new jobs created, +110,400 of them were Part Time (PT) while Full Time (FT) saw a healthy retraction of -88,100. The reason why it is so important to differentiate between FT and PT jobs is that FT jobs offer more security and a better annuity for the worker which leaves that FT worker feeling more confident about their earnings stream and more willing to spend. PT employees do not feel that same sense of confidence - they are unsure about many things like, how many hours work they will get, whether they will be terminated tomorrow, etc. We call this "the quality of the job gains".
Interestingly today, we saw PT jobs gain by the second most in the past 30 years at +110,400 vs the highest at +136,300 in July 2010 (according to Bloomberg and StatsCan). Not a good sign - we would always want to see strong FT gains, not strong PT gains. PT job gains below:
And FT job losses at -88,100 for August were the third largest over the past thirty years. The only two other times the Canadian economy lost that many FT jobs over the past thirty years was in Feb 2009 when it lost -120,100 FT jobs and in July 2010 when it lost -145,100 FT jobs. FT jobs below:
And speaking of the quality of jobs produced, higher paid sectors like manufacturing and resources showed declines. Peeling back the layers and looking at the quality of jobs is important but we also do need to keep in mind that one month does not make a trend.
As for the market's response after the release, the C$ has weakened off a little bit. It has been on fire since the Bank of Canada raised interest rates on Wednesday morning, all through yesterday and even overnight, however, after this report, it appears to be flat to slightly weaker. The Loonie is probably due for a breather but it is really being driven by two things: 1) the US$ is getting pounded lower against every currency as Fed officials have been talking more dovish (not wanting to raise rates) over the past month and 2) the Canadian economy has been strong and the Bank of Canada clearly wants or wanted to remove some of the stimulus they put in place when oil hit $26/bbl. They have raised interest rates 2X in less than two months and higher interest rates drives buyers of the currency because they get paid more to hold it as rates rise.
Also, we and some of our business colleagues are having a hard time reconciling just why the US$ is so weak given we could be on the precipice of a (nuclear) war. Normally, the US$ would see capital flow to it for safety reasons during times of war but, right now, it appears the market does not really think war is imminent or a reality. The market seems more concerned with the Fed talking more dovish about not hiking rates further.
Expect the Unexpected. The path to least resistance, maybe not today or tomorrow, would be to a stronger US$. We are not hoping for war but certainly are preparing our portfolios for it, especially when the portfolio protection is relatively cheap.