Preferred Shares, Buyers Beware

Bryden Teich (BT) | Matt Manara (MM)

BT: So, one of the places I thought that we could start today’s conversation is this topic of liquidity that we’ve talked about regularly in the office. In the last several months, central banks around the world are providing so much liquidity into the market and it seems like stock markets are taking their marching orders from what central banks are doing. So, from what you’re seeing, what’s the feel in terms of what markets are doing and what kind of impact are you seeing from that liquidity from central banks?

MM: Well, it’s a good question. I think the average person still doesn’t know what it means when you say central banks are adding liquidity into the system, and will get back to that, but what are we seeing out there? You’re seeing this liquidity-driven, momentum-driven market on one side of the equation where you see some stocks or sectors that are going completely parabolic, for example Tesla, which I think Elon Musk has made 20 million dollars an hour for the last two months on a company that loses $5,000 a car. And then on the other side of the equation, you’re seeing deteriorating fundamentals, including the whole US economy in aggregate. You’re seeing declining earnings growth, and we can also get into that.

BT: Yeah, I think I think that’s a good place to start. So, for the last number of months, I think focus on the market has been on whether the US and China would reach this phase one trade deal and it’s amazing how with all the rest that’s going on with the coronavirus and the Fed driven liquidity. All of a sudden that phase one trade deals seem so much farther in the rear view mirror, but at the same time, to your point, if you look at manufacturing and you look at a more industrial side of the economy, it still doesn’t feel like it’s turned the corner in that respect. So, the underlying fundamentals are still a bit soft and then if you layer over that the coronavirus, and what that’s going to do to Chinese growth, and then also global growth, there’s still a lot of this murkiness out there with regards to what the fundamentals are going to say.

MM: What really struck me and caught me off guard was not only with the coronavirus you have the second largest world economy that’s effectively being taken offline, but you’ve had that one day -a few days ago- the Chinese market was down nine percent in one day and the S&P opened up positive with some momentum and I think that tells you everything that you need to know about this momentum liquidity driven market that’s not trading based off of fundamentals

BT: Yes, and I think, to that point exactly, Sunday night, North American time, China was down 9%.  We all came into the office Monday morning expecting markets to be down here in North America and what happened was both the TSX and S&P were up significantly and I think it also speaks to the point of the amount of liquidity being thrown at the market, whether it’s in China or whether it’s in the US, the dips become so shallow because as long as money’s being pumped into the system then there’s always going to be a bid to asset prices and I think that that theme has now really taken the core focus of a lot of investors but at some point obviously fundamentals do have to matter and earnings have to matter and if you don’t have fundamentals improve it seems like the market is not really reflecting what the underlying economy is doing.

MM: That’s exactly it.  And let’s take a step back for a second.  We keep on using this word “liquidity”. For our listeners, let’s talk about what that means and specifically let’s talk about the repo market.  What is it in a very general overview? What is the repo market? How is the liquidity or money being injected into the system and what does it mean for your average investor or, furthermore, your institutional investors out there?

BT: We’ve explained this to our clients before and just talking to ourselves about it. I think the easiest way to explain what the repo market or the repurchase market is, it’s basically the overnight plumbing for the financial system and so it’s a place where banks and large institutions lend to themselves for very short-term money. And specifically what happened in September is [the] overnight interest rate spiked up for a minute to 10% and I think that was the first earthquake that sent a tremor into the market and really what it signals is that there’s not enough liquidity in the system, especially the very short-term funding markets. To your point, what the Central Bank’s been doing since then is the Federal Reserve [has] been buying 60 billion a month of Treasury Bills and at the same time doing both one- and two-day repos and then also a shorter-term repo which says a week or 14 days. But from September to now, if you look at what the Fed balance sheet has done, and also what the stock market has done, the correlation is as close to 1 or 0.95 as you can possibly be; meaning that as the Central Bank’s expanding their balance sheet, stock markets have gone up. So, I think the Fed had a meeting last week and they held interest rates, and it sounds like for the time being -at least through the end of tax season, so into April- they’re going to be supplying this liquidity. I think the bigger question is, with the size of US spending being so significant -at almost five percent of GDP- does the liquidity have to continue for longer because of the size of the federal deficit?

MM: Yeah and it doesn’t matter if you’re Republican or Democrat or what your political views are. So if you’re a Democrat, and let’s say Bernie Sanders gets into power, and you forgive student loans, you have universal health care; or the Republican side whether the military spending or tax cuts, neither the Republican party or Democrat party is being responsible financially in the context that they need a record amount of debt to fund their platforms and is neither party’s fault because you’re talking about 30-40 years of government overspending, entitlements, defense spending, and under taxation that has led to this problem and there’s consequences to this.

BT: I think one of the most telling charts that we’ve looked at in last couple of weeks has been, if you look at the federal spending in the US as a percentage of GDP and you look go back 50 years. The level of Federal spending right now is 5% of GDP; so simple math is the US economy is about 21 trillion and the deficit spending is about just over 1 trillion (1/20 = 5%), but if you go back and look at previous recessions -so in the 1970s, the 80s and early 90s- the level of spending today fiscally in the US is at the same level as the troughs of the last recessions, in the depths of what you would call Keynesian stimulus, but we’re in a world where the narrative or the perception is that we’re in a very strong economy. So, I think that’s the underlying thing that people almost a third rail: that the Fed isn’t really talking about is that the US government spending has been out of control and then if you layer over this idea that foreign central banks have also stopped buying US treasuries en masse and they’ve been a huge buyer for a long time. So maybe talk a little bit about that dynamic.

MM: So as you know, the government is issuing doing massive T-bill issuances and the US dollars reserve currency is 80% of global payments are in US dollars, but the amount of money that they need to raise, there’s not even enough liquidity in the whole financial system for various countries to even buy these issues, nor do they want to at the rate that they’re borrowing money. It’s not worth it at a sub-two percent type interest rate and you have the US that has weaponized the dollar essentially whether it’s through tariffs or policy with Iran. And you have foreign governments saying, “well, you know what? First of all, I don’t have enough money to buy all this. Secondly the US’s weaponizing the dollar, why don’t I buy gold? Why don’t I buy Euros? Why don’t I buy anything but the US dollar?” and you’re seeing that trend continue which is incredibly scary to me.

BT: I think the underlying reason why they’re not buying treasuries in the same level is both the fact that the US is in some ways weaponized the dollar but also you had 20 years of rising trade surpluses and capital surpluses in all of these developing countries and so when you’re running a capital surplus the easiest thing to do is you take that money and you buy US treasuries and so all of the global central banks have done that for a number of years and now that trend has reversed in the last several years -say five years specifically- and that brings us back to this idea of what the Fed is doing and they’re having to supply all this liquidity in the T-bill market because the record amount of US issuance is just so significant.

MM: And if you were to clear this at a normal interest rate -and you’re not pumping the liquidity, you’re pumping into the system- it would be high, whether it’s 5% to 7%. And if interest rates spike, you throw the whole world into recession or depression on one side the ledger, and on the other side the ledger you have a Federal Reserve that has to keep injecting capital into the overnight lending market to keep things going. And whenever you hear these words, “quantitative easing” or “monetizing the debt” or “repo lending,” all it means is it’s a nice way of saying, “I can’t pay you back and we’re going to print more money and we’re going to continue to try to inflate our way out of this.” The average guy does not understand why his purchasing power, or his cost of living seems much higher, and not to talk about history or politics, but [if] you go back through any period of time where you’ve had waves of populism, there’s a direct correlation with inflation.

BT: Right the people’s cost of living has been higher and then there’s the everyday person feeling the pressure of the cost of living going up. Yeah, totally agree with you on that. If we switch directions a little bit and we’re in this world with lots of liquidity being supplied with record low interest rates and obviously, the knock-on effect of that has been this reach for yield both in credit markets and high yield market, and stock markets from that perspective as well. So, if we look at both the credit market and the high yield market, what are you seeing in terms of that reach for yield and people’s demand for anything that yields an income stream but it’s changing the dynamic in the corporate bond market pretty significantly.

MM: First of all, half of the world is in negative interest rates, and you have billions of dollars, pools of capital that need a rate of return, and you’ve seen this chase for yield. What we’re seeing specifically in the corporate bond market or high yield market is all these issuance even with not the greatest credit quality being bid up and I don’t want to mention any names but there was a new issue that just came out recently in Canada. The credit is lousy, it’s not backed by any assets, and the deal is oversubscribed and we’re faced with a situation where you’re saying “well, I can buy my clients junk and get 5% but it’s not secured by assets, the credit rating’s not good,” or “I can have a little bit more of a cash weighting until I wait out.” The one area of the market where we where we are seeing a few opportunities that institutions can’t take advantage of due to their size is the convertible bond market.

BT: Oh yeah that’s actually good point! I think the unique thing about the Canadian bond market is that because the size of our companies in Canada, a lot of them don’t want to have to pay the rating agencies -Moody’s, S&P, Fitch, DBRS- they don’t want to have to pay them to get rated, so they end up defaulting and saying, “I can issue convertible bonds and there’s a liquid convertible bond market in Canada,” and so the size of the issuances are smaller but at our size we’re able to find very attractive yields in the convertible market where we’re getting you know, 5-7% on a convertible bond and at the same time you have the embedded option in stock that comes along with the bond; so if the stock gets to a certain price, that bond converts them into equity. There’s a nice asymmetry to what we’re doing and we’re able to get the yield, be comfortable with the credit, and then have the same optionality on the equity. The one thing I’ll also ask you is that we’ve seen -over the last number of years- a huge rise and issuance of preferred shares. A lot of people think that preferred shares are fixed income substitutes and so what’s your view on the preferred market and what are some of the things you’re seeing there?

MM: This absolutely drives me crazy. First of all, the preferred share market is really a retail phenomenon. So, RBC, TD, or any of the bigger banks have issued billions of dollars in these preferred share issues, and it’s really important to make the distinction between preferred shares and fixed income. Fixed income as you know, you’re lending money, you’re a creditor on the assets; they have to pay you back. Preferred shares do have some fixed income characteristics: (1) you have a fixed dividend payment versus a fixed coupon, (2) you’re higher up the capital structure on the equity side (the preferred share versus the common share) but it’s not fixed income. Just to clarify even further, if a company becomes insolvent or goes through a period of distress, the prefer shareholders equity is usually not worth anything. If you’re a bondholder and you have a claim against the assets, you’re lucky to get paid 75-80 cents on the dollar. So the moral the story is preferred shares are equity, they’re not fixed income -although they have a fixed income characteristics- and the other issue is since these issues are smaller in size there’s not a ton of liquidity, and the banks have issued these “sexy features” so rate reset preferred shares. What does that mean? Well a lot of advisors did not know how to articulate the risks adequately to their clients and you’re at a point in time in 2017 where interest rates were starting to go up, so investment bankers thought “okay you issue these things. If you have a rate reset preferred share, all it means is [that] every five years or after a certain time period, if interest rates go higher, we’ll revise your dividends higher.” But really what happened is interest rates went the other way, so a lot of retail investors that have preferred shares that they thought were fixed income, rates continue to fall; you had these dividends that were reset lower; a lack of liquidity; and they’re down fifteen to thirty percent; and once again you have no claim on the company’s assets: you’re not a creditor, you’re not a bond holder. You can obviously make the argument that preferred shares can have its place in the market and not to mention, advisors making generous commissions of 2% upwards on these types of things but sorry for the rant.

BT: No that was good! I think the other thing to your point is once the shares collapse and the dividend is reset to a lower level, the unfortunate reality is at that point I’m sure a lot of the common stocks are actually then yielding higher than what the preferred is. And so, you lose the income and let alone the capital loss as well.

MM: Yeah and not to get too complicated, but if a new issue comes out with the reset preferred that [has] better terms or sexier features, that also affects the resale market and how it’s valued. So the risks and dynamics are not understood versus a client lending money to a Bell Canada or an Enbridge and saying, “Here, we’re going to lend you money for 3-5 years, Enbridge is going to pay me back and if they don’t, I have a claim on their assets.”

BT: Yeah. I think the one term you mentioned was illiquidity of preferreds, but if we look at what’s been going on -let’s say the private equity and then also the venture capital space too- to your earlier points of saying Japan and Europe are both zero interest rates, so money around the world is searching for a positive yield or a positive return anywhere. And so you’ve seen a lot of money go into private assets or private credit or private equity or venture capital as well and so maybe speak to that dynamic a little bit and some of the sort of the risks that you see going on in that space.

MM: Okay we can talk about it in a few different ways. Since we’re already talking about fixed income, one of the things that I’m seeing in fixed income portfolios is that need for yield because interest rates are so low, the bond market doesn’t pay you that much. Like you said half of the world is in negative interest rates, so you’re going up the risk curve and saying “Well, I can buy a private mortgage that yields higher. I can buy foreign denominated bonds in China that pays higher. I can buy a preferred share that gives me a higher coupon. I can buy anything that is not fixed income or high yield debt that’s not creditworthy to get that higher yield,” and investors don’t realize you’re going right up the risk curve. More specifically about private equity in general, you’re seeing billions and billions of dollars out there looking for a home and this whole sales pitch saying you can buy private real estate and it has a lower correlation to public markets. It’s not correlated as less volatile and you can get earn a better rate of return. Well in some respects that’s true and in other respects is not true. So for example, you’re seeing tons of money going to private real estate and it is real estate is correlated to equity markets or REITs are correlated to equity markets but if you calculate the NAV once a year -who knows how they’re calculating it, whether it’s an arbitrary or more standardized formula- but that once a year NAV doesn’t mean that (1) it’s accurate and (2) that doesn’t mean you don’t have a correlation to equity markets. If you owned an apartment building and you were to price it daily, it would just be as volatile as any other REIT or real estate component or change in the discount rate. And the other thing you’re seeing is because of attracting the amount of capital into these spaces, you’re actually seeing private equity valuations on the real estate side that are more expensive than buying a public market REIT so that’s just one issue.

BT: I think the other thing too, to piggyback off of that is, we talked about this I think maybe two or three quarters ago in the case study about looking at -a perfect example of the private equity market going awry- WeWork and the valuation collapsing before the company tried to go public. You had the CEO have to leave and I think that is the is the poster child for what low hurdle rates for investment look like and so maybe speak to that aspect of you seeing a year of record IPOs in the US but a lot of that private capital has gone into businesses that actually aren’t doing as well as what the stock market is showing you.

MM: Yeah so WeWork is a great example. You’re just seeing this continued push to value assets higher. It’s like saying this, if Enbridge was a private company, it’s probably worth $100 a share but that doesn’t mean that the market can bear $100 a share; it’s worth $56 per share. So, you can say it’s valued at whatever you want, you can attract all kinds of capital but when you go to IPO the market might tell you something completely different.

BT: Right which also goes back to the idea that markets are actually far more efficient than sometimes people realize, and markets also don’t take any prisoners, and it’s just a function of being priced every day when you own securities. If it’s a corporate CEO trying to say “My company’s worth X” and it’s whatever the people on the exchange trading your stock says it’s worth; it’s not what you think it’s worth or it’s not what your private multiple of cash flow or your EBITDA or whatever that number is. So, the valuation on private assets is also very not transparent and so I think that’s where a lot of these valuations have just gotten out of whack.

MM: And one thing that we haven’t added to that is also the amount of leverage and private equity. The growth in private equity is also on the debt side where you’re using a lot of leverage and you’re valuing it based on whatever formula. When the economy goes the other way and you need some form of liquidity, there can be a real unraveling and real mismatch for institutions trying to match up with their liabilities and liquidity requirements.

BT: Right. I think that the concept of leverage is interesting because when you have a private equity fund or a private asset pool, you can apply leverage to it and make returns look really fantastic, but eventually the rubber has to hit the road in terms of what your investment is actually worth, that cash flow or that earnings in 5-10 years. I think the underlying theme of being in a low interest rate world and this reach for yield or stretch for returns, has led to a number of years of malinvestment because money’s been free.

MM: One thing people are doing is you end up buying riskier equities -common shares with higher dividends- and you effectively end up buying a company there’s something wrong with. Obviously, there’s exceptions to that and there are anomalies at times in the marketplace. You see the pools of capital going into private equity leverage. You see it going into foreign bonds or private mortgages. You’re saying, “just give me a rate of return that’s better than the interest rate and I will do anything in my power to bid that up.” The investor does not realize how far up the risk curve they’ve gone, so it doesn’t matter if it’s a preferred share, rate reset, doesn’t matter if it’s a high yield bond, doesn’t matter if it’s a dividend yield a 10% where the market is telling you something’s wrong with this company. Maybe there isn’t something wrong, and you’ve done your analysis but they’re few and far between.

BT: So if we go back to the underlying theme that we started off with, looking at the liquidity being supplied by the Federal Reserve, and liquidity being pushed in the system from global central banks: what’s your view on how long this can continue and how long you think fundamentals and stock prices can be divergent? Do you think that the outlook for the Federal Reserve -for the balance of this year into an election year at that- do you think they’re going to continue being forced to supply that liquidity?

MM: I think you don’t have a choice. The Federal Reserve is going to be effectively forced into printing money, injecting capital into the overnight system because you have record amounts of debt where foreign governments are starting to walk away from. They do not have enough liquidity on their own or the size or scale to be able to buy the amount of debt that needs to be issued, so the Federal Reserve is going to continue to buy it. And if they take liquidity out of the system -well we know what happens- when you’re in a rising interest rate environment and you’re starting to take some liquidity out of the system at the end of 2018 December, you saw the S&P drop 20%, although it was briefly and then the Fed reversed course and started cutting. Then you had this repo issue in September and the printing issue that’s going on. So I think central banks are aware that they have to keep printing money because you’re not going to be able (politically) to start taking things away from people and say well we’re not we’re not going to provide the social services we provide, or these entitlements are being taken away and even if you did, it probably doesn’t matter much now with the debt level. The second part of your question is how long can this go on? Well in any bear or bull market, it always comes back to fundamentals. You can be in a bull market where liquidity and momentum is driving the market higher and fundamentals are secondary even if they’re deteriorating but that can’t go on for forever but it certainly can push you past the point of comfort where you can say after this point in the market, “Shoot! Why don’t I own these things that trade at 30-50x earnings” and maybe it goes to 60 times earnings. It can certainly push you past that point of comfort, but you have to sit here and say well, if you go back in time, there always is a day where fundamentals do matter. With that being said, I think with this continued injection of liquidity into the system, you can really make the argument that asset prices -I don’t care if it’s farmland, real estate, income streams, gold, silver- asset prices continue to go higher over the next decade and you run at a bit higher inflation and I think it’s going to lead to more political instability, more populism, you’re already seeing it across the globe, and I think it’s a real issue. So if you have a long-term time horizon or you don’t need monthly or yearly liquidity, if you’re retired to fund your life, really fixed income has become a bank account substitute almost where you don’t want to be in cash or bonds unless you absolutely need to or you need that money. But if you don’t, it’s hard to say, “well if I’m going to be putting this type of liquidity into the system, how is real estate not going higher? How is owning infrastructure in Canada or across the globe going higher? Or hard assets?”

BT: I think the difficult thing is that if they continue supplying liquidity, the risk is always that they actually don’t supply the liquidity that the market needs and you could have a very quick reversal and so I think that that’s why in the last number of weeks we’ve raised a little bit more cash than we’ve had previously last year because even if that scenario plays out where central banks keep putting liquidity in the market it’s going to be a volatile March higher and so you want to be opportunistic with having cash on the sidelines so you can deploy that when the market does pull back.

MM: Yes, so just to be clear, that’s exactly right. So we can have this view and say they continue to keep printing money and injecting liquidity into the system because they have no choice, looks fairly clear; but it always comes back to what if you’re wrong and not operating in extremes when structuring a portfolio and to Bryden’s point, that’s why we do have a little bit more cash than usual in the portfolio because that bucket of high yield bonds in good conscience, you can’t go out and buy crappy credits not secured by any assets to get 5% rate of return. So you do run a higher cash or what we’ve done, you have increased your exposure to precious metals, you do have that infrastructure or real estate component; you still do care about valuation and doing your valuation work and having income coming into the portfolio each and every single month. It also comes down to understanding your clients life and their personal circumstance where if they need monthly liquidity or daily liquidity to pay their bills because they’re retired or there isn’t income there, well guess what? You do have to have cash or be in the bond market so at Avenue we try not to operate on any extremes and always take the negative view by saying: what could go wrong here?

BT: So, on that note, why don’t we wrap it up there and thanks for the conversation. And that was great and looking forward to the next one.

MM: Excellent, I really enjoyed the unscripted conversation and hope everyone was able to follow along.