Monday, 26 October 2015

Home Capital Group December 10, 2018 Bonds

Sorry equities, another rant on fixed income.

It's funny, I ran a screen on TD's fixed income database mid-week last week and I found the following result, and I wanted to do a quick post on my thought process last week but I didn't have time:



















My first thought on finding these bonds was something along the lines of:

"Ok, these yield 3.35% to maturity (on the offer), but I have to pay par + accrued interest.  What's my spread over Rf?"

So I searched the 3 year GIC's on offer, and here's what I found (I should probably compare to 3 year government yields for true Rf):
















My second thought was something along the lines of:

"Ok, these yield about 150 bps over 3 year GICs (I'll call these Rf), but I have to pay par.  Am I getting compensated enough for risk paying par?"

FYI, these bonds are all gone from my broker's database, so I'm assuming that investors must have bought all 732,000 on offer.

The globe ran an (overly simplistic) article on these bonds last week , link here:

(In case the link doesn't work, here is the article)

"Wednesday, October 7, 2015
ROB CARRICK
Inside the Market
Wild times in the markets are creating opportunities in bonds for yield-starved investors.
You probably know all about how yields on dividend stocks have been rising with the recent market pullback. Less understood is the fact that there's now a decent selection of bonds issued by companies with middling credit ratings that yield in excess of 3 per cent.
Some examples: Home Trust Co.'s 3.4-per-cent bonds maturing Dec. 10, 2018, had a yield of 3.3 per cent at the end of September. Cominar REIT 3.6 per cent bonds coming due June 21, 2019, had a yield of 3.5 per cent. Ford Credit Canada 2.9-per-cent bonds maturing Sept. 16, 2020, had a yield of 3 per cent. To put these numbers in context, five-year Government of Canada bonds were yielding about 0.8 per cent, five-year bank GICs were yielding about 1.5 per cent in late September and alternative banks were offering 2.5 per cent at best.
There's more risk in corporate bonds than GICs backed by Canada Deposit Insurance Corp.
We're talking here about the risk of a default on interest or capital repayment at maturity, and of price volatility ahead of maturity. You can see this risk level reflected in the fact that the aforementioned bonds, and others like them, are rated BBB (high) and BBB (low). That puts them on the lower rung of what qualifies as an investment grade bond, which means suitable for use by pension funds.
Ways to minimize risk with bonds such as these include keeping your term as short as possible and familiarizing yourself with the challenges faced by the companies that issued them.
Diversification is also important - consider adding several different names to a portfolio that also contains GICs or government and blue chip corporate bonds."

I think the key takeaway here is, why were Home Trust Co.'s bonds rated BBB by Fitch, and BBBh per TD's database (not sure who they use for ratings), when bonds of equal duration (but with a higher credit score) yielded about the equivalent to 3 year GIC's?

A bit of background.  The company has been a subject of hotly contested debate over the last year over loan practices.  The globe profiled short seller Mark Cohodes during July 2015 on his Home Capital short call, link here.

If anyone has the chance to read up on Cohodes, he's brilliant (he's also pretty funny on twitter), but strong caveat, he doesn't sugar coat anything.  I have the utmost respect for participants like Cohodes who basically peel back the layers on situations that mainstream money managers don't. Many a mainstream manager has stayed long Home Capital throughout the ongoing debacle. Who's going to end up being right when all is said and done is anyone's guess.

Cohodes' thesis is that Home Capital, Canada's largest alt/subprime lender, is basically a house of cards. His thesis seems to have been helped along by lower loan originations earlier this year coupled with Home Capital severing ties over fraudulent external broker mortgage originations shortly thereafter. Personally, I'm not smart enough to pass judgement.  I don't know enough about the business, and there seem to be plenty of exceptionally smart professional money managers who think very highly of management.

What I can do though, in my capacity as small fish who does not need to buy anything, is to attempt to reframe and stress test the company's balance sheet in the event that Cohodes is right.  It's not that I think he's right.  But the question of "what if" he's right is a very poignant question.


First, here are two excerpts from the Q2 2015 F/S:

Loans:

















and, liquidity:





















I recall reading that in analyzing a bank, a bank's liabilities are it's assets and it's assets are it's liabilities.  Makes intuitive sense in the context of HCG.  The company takes deposits in via Home Trust and makes loans.  As at June 30, 2015, they had deposits on hand of $14.97B (+ debt not shown, $300M of which are our subject bonds above), and they loaned $23B.

What's interesting about the loan composition is that more than 50% of loans are non-securitized single family residential loans.  Here's a graphic on composition from the report:



















And here's further disclosure from the MD&A regarding insured vs. uninsured mortgages:



















The difference between insured and uninsured?  CMHC.  From the annual report:


"The traditional single-family residential portfolio is the Company's "Classic" mortgage portfolio which consists of mortgages with loan-to-value ratios of 80% or less, serving selected segments of the Canadian financial services marketplace that are not the focus of the major financial institutions.  These mortgages are funded by the Company's deposit products."


I did the following quick and dirty analysis when I initially looked at these bonds, and I'm probably oversimplifying here, but my take at the time was, should there ever be a run on Home Trust bank, where is my margin of safety if I were to pay par and chase yield today?

PS, I know, this is most likely a huge "tail" event in most investors' minds (a lot of whom are much smarter than me), but it doesn't mean that it cannot happen, it just means that investors expect that it's "unlikely" to happen.

First, here's the balance sheet on the presumption that the sky is not falling, i.e., 100% of uninsured alt mortgages are collectible.


AssetsAs reportedAdjustmentRestated
Cash + securities for sale1,365100%1,365
Loans for sale21100%21
Loans:
Securitized2,814100%2,814
Non-securitized15,147100%15,147
Allowance-35100%-35
Total loans17,92617,926
Other:
Restricted assets733100%733
Derivatives other3510%0Derivatives, other
G/W1200%0
Total LT4710
Total Assets19,78319,311
Liabilities
Deposits on demand1,436100%1,436
Fixed date deposits13,531100%13,531
Senior debt152100%152
MBS366100%366
Canada Mtg Bond3,145100%3,145
Other liab's3510%0Derivatives, other
Total liab's18,98018,629
Liquidation value tomorrow, assuming all loans are 100% collectible1.04


Next, here's the balance sheet on the presumption that 75% of uninsured alt mortgages are collectible.

AssetsAs reportedAdjustmentRestated
Cash + securities for sale1,365100%1,365
Loans for sale21100%21
Loans:
Securitized2,814100%2,814
Non-securitized15,14775%11,360
Allowance-35100%-35
Total loans17,92614,139
Other:
Restricted assets733100%733
Derivatives other3510%0Derivatives, other
G/W1200%0
Total LT4710
Total Assets19,78315,525
Liabilities
Deposits on demand1,436100%1,436
Fixed date deposits13,531100%13,531
Senior debt152100%152
MBS366100%366
Canada Mtg Bond3,145100%3,145
Other liab's3510%0Derivatives, other
Total liab's18,98018,629
Liquidation value tomorrow, assuming 75% of uninsured loans are collectible0.83


Finally, here's the balance sheet on the presumption that 50% of uninsured alt mortgages are collectible:

AssetsAs reportedAdjustmentRestated
Cash + securities for sale1,365100%1,365
Loans for sale21100%21
Loans:
Securitized2,814100%2,814
Non-securitized15,14750%7,573
Allowance-35100%-35
Total loans17,92610,352
Other:
Restricted assets733100%733
Derivatives other3510%0Derivatives, other
G/W1200%0
Total LT4710
Total Assets19,78311,738
Liabilities
Deposits on demand1,436100%1,436
Fixed date deposits13,531100%13,531
Senior debt152100%152
MBS366100%366
Canada Mtg Bond3,145100%3,145
Other liab's3510%0Derivatives, other
Total liab's18,98018,629
Liquidation value tomorrow, assuming 50% of uninsured loans are collectible0.63


Let's assume for a moment that I look at whether I should pay par for the bonds as a probability distribution with three outcomes based on the uninsured mortgages, 1) the bonds are covered, 2) the bonds are .83 x covered, and 3) the bonds are .63 x covered.

If I assign tail risk of 5%, I get .95 x 1.04 + .83 x .025 +.63 x .025 = 1.02, pay par.

But what if tail risk is greater than 5%?  Certainly, Cohodes thinks it must be.

If I assign tail risk of 10%, I get .9 x 1.04 +.83 x.05 + .63 x .05 = $1.  I still pay par.

At what level of tail risk do I not want to pay par?  Around 16%.  This gives me 1.04 x .839 + .83 x .0806 + .63 x .0806 = .99

What does the options market think (and is this at all relevant)?

Here's HCG (I looked at the April 32 straddle):





















The straddle is pricing in a 26% move (either direction).  Pretty hefty premium and reflective of uncertainty.


For comparison's sake, here's XFN (S&P financials index) March $30 ATM straddle:























The straddle is pricing in an 8% move.  Obviously HCG individually is riskier than all the constituents comprising the financials index, but 3 x as risky?

This is mostly nonsensical (and inconclusive), but I do think that the most remote sounding probabilities need to be considered here as tail risk always seem to be one of those obscure concepts that only gets discussed after the unthinkable happens.

Closing comments:

I didn't buy the bonds.











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