Today was the second arguably the most important (although few would argue the point) treasury auction this week. The U.S. Treasury sold $21 billion 10-year notes as the new supply and strong corporate earnings help to push treasury yields higher. Listening to the financial media one would have thought that demand was soft for the reopening of the 3.50% due 5/15/20 notes. However, demand was strong as the bid to cover ratio was 3.09 versus an average of 3.03 for the 10 previous auctions. Indirect bidders (which include foreign central banks) purchased 41.7% of the new supply versus an average of 40.7% for the 10 previous auctions.
So if the bid to cover ratio indicates strong investor interest and foreign central banks have not lost their appetite for U.S. treasuries, why were commentators and market participants, such as Richard Bryant of MF Global (who said: "Investors didn't see a lot of value at today's yield levels") declaring the party over for long-dated treasuries? Maybe it was because the auction was priced to yield 3.119% versus an expected 3.109%? Maybe it was because it was only a short time ago that the 10-year yield dipped below 3.00%. Maybe people see just what they want to see.
The fact is that an extended period below 3.00% the 10-year would be priced for an extended malaise and possibly a double-dip recession. The market is coming to the realization that a double-dip recession is not the most likely scenario. Of course a 3.11% 10-year does not indicate an economic boom is on the horizon either. It appears as though that what is in store for the U.S. economy is a long road higher with persistent headwinds from more restrictive regulation, anti-growth tax policies, sub-par job growth and consumers who continue to deleverage.
There has been much discussion of the Collins Amendment to the Dodd Bill (AKA Fin Reg) and what it means for trust preferreds and their investors. First: It means that it is unlikely that financial institutions will use such structures in the future as trusts (or hybrids as they are also known) will no longer we counted towards a bank's Tier-1 capital levels (there will be some grandfather provisions for smaller banks). However, Tier-1 classification was not the only reason why banks issued these securities. A clue is the word "hybrid."
Trust securities are debt / equity hybrids. Depending on the specific structure an issuer could count a portion of the capital as debt and a portion as equity. The equity portion would count toward a bank's Tier-1 capital requirement. However since hybrids pay interest instead of dividend (even though the payments on $25-par securities appears to be dividends the payments are in fact interest) banks could take advantage treating payments as an expense as is customary with interest payments. When banks really wanted to raise Tier-1 capital without diluting common shareholders they would issue non-cumulative preferred equity as they did in 2008 when mounting mortgage losses deteriorated the values of their existing Tier-1 capital.
There is another more basic economic benefit banks that banks receive from hybrids, which is cheap financing. During the mid portion of the past decade treasury yields were low and credit spreads were tight allowing banks to issue hybrids with very low coupons for long-term debt. Coupons below 7.00% or even 6.00% were common. For economic reasons banks may choose to not call lower-coupon hybrids because they are sources of cheap financing. Some newsletters and even a money manager or two suggested buying low-coupon hybrids at discounts as they are essentially short-term bullets as banks will call them in. Good luck with that. The Street knows full well that the Dodd Bill is practically a done deal. If they thought these issues would be called in short order they would not be trading at deep discounts. Sorry folks, such a strategy is a low percentage play.
Other experts have been advocating buying high coupon hybrids as banks will not want to call them away from investors at par so as not to anger they very people needed to purchase Tier-1 structures which they will need to issue. Good luck with that strategy as well. There are many $1,000-par hybrids with coupons over 8.00% (some are over 9.00% or over 10.00%). It is unlikely that a bank would leave a high-coupon hybrid outstanding when it is not receiving a Tier-1 benefit. Absent the Tier-1 capital status, banks will probably simply treat hybrids like very subordinate debt and retire the more expensive issues first. Remember, banks do not have to do anything for two years and then they have three years to gradually restructure their capital.
The main sources of Tier-1 capital (as per Basel II) are equity (common and true preferreds) and deposits, both time deposits (CDs) and demand deposits (checking and savings accounts). This is why smaller banks which do not need large enough quantities of Tier-1 capital to issued securities offer above average CD rates (relatively speaking). It is is a main source of Tier-1 capital.
I will be away from the computer for much of the rest of the week. Talk to you soon.
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