Watsa Modeling Buffett Sparks Rally in Fairfax Debentures: Canada Credit
Investors are showing more confidence in Fairfax Financial Holdings Ltd.’s debt than they have in at least six years after Chief Executive Officer Prem Watsa’s bets against U.S. financial companies made it the most profitable insurer in Canada.
The cost to insure the company’s debt fell to the lowest in at least three years, making its credit default swaps the second-best performer in Canada this year behind those of Celestica Inc. The yield on Fairfax’s 7.375 percent bond maturing in 2018 fell to 6.18 percent this month, the lowest in at least six years.
Watsa, who models the insurance company after Warren Buffett’s Berkshire Hathaway Inc., benefitted from declines in U.S. banks during the financial crisis. The rising earnings overshadowed legal controversies and accounting probes that had weighed on the Toronto-based company’s debt, pushing the yield on the 7.375 percent bond to 13.1 percent in 2006.
“Nothing makes people forget about what happened in the past more than being right,” said Ric Palombi, who manages about C$325 million ($318 million), including Fairfax bonds, for McLean & Partners Wealth Management Ltd. in Calgary. “Diversification, buying business lines that are not as cyclical and continued demonstration of improving credit metrics, all of these things are indications he’s delivering.”
Elsewhere in credit markets, the extra yield investors demand to hold the debt of Canada’s corporations rather than its federal government, widened yesterday to 135 basis points, or 1.35 percentage points, from 134 basis points the day before, the narrowest gap since May, according to Bank of America Merrill Lynch data. Yields rose to 3.81 percent, from 3.85 percent the day before.
U.S. Corporate Bonds
Relative yields on U.S. corporate bonds ended Nov. 16 at 176 basis points, the Bank of America Merrill Lynch data showed. Global corporate spreads were 167 basis points. Canadian corporate bonds have lost investors 0.9 percent this month, compared with declines through Nov. 16 of 1.1 percent for U.S. company debt and 0.9 percent for global corporates.
In provincial bond markets, relative yields expanded to 52 basis points, from 51 basis points the day before, the tightest spreads since April. They reached as wide this year as 71 basis points in May. Yields rose to 3.20 percent, from 3.18 percent the day before.
Provincial bonds have lost 1.7 percent this month, headed for the worst performance since September 2008.
Government bonds dropped today, pushing the yield on the two-year security up five basis points, or 0.05 percentage point, to 1.62 percent. The price of the 1.5 percent security maturing in December 2012 slid 9 cents to C$99.75. The yield increased as much as seven basis points to 1.65 percent, the highest level since July 27.
Canada’s government bonds have lost 1.5 percent in November, headed for the worst performance since December, the Bank of America Merrill Lynch data show. Treasuries are down 1.1 percent this month through Nov. 16, and global sovereigns have lost 0.9 percent.
Ontario Finance Minister Dwight Duncan said today the province will run a deficit of C$18.7 billion in the current fiscal year, down from a June forecast of C$19.7 billion. The province will have budget gaps of C$17.3 billion in 2011-12 and C$15.9 billion in 2012-13. Ontario’s fiscal year starts April 1.
Canadian Debt Sales
Detour Gold sold $250 million in 5.5 percent bonds maturing in November 2017 in a so-called bought deal led by BMO Capital Markets. Canada sold C$1.4 billion in 30-year bonds yesterday at an average yield of 3.638 percent.
Fairfax’s 7.5 percent bond maturing in 2019, which is held in at least 36 mutual funds, according to Bloomberg data, has returned 12 percent this year, compared with a 7.3 percent return for a Bank of America Merrill Lynch index of Canadian financial companies’ bonds.
Fairfax’s credit-default swaps have dropped 59 percent this year, behind only those of electronics manufacturer Celestica among Canadian companies in Bloomberg data.
Swaps on Fairfax debt have decreased 210.8 basis points this year to 147.9 basis points. One basis point equals $1,000 annually on a contract protecting $10 million of debt. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt.
The swaps declined after Fitch Ratings raised Fairfax’s credit rating to BBB from BBB- on June 21, citing its “improved capitalization, strong profitability, reasonable financial leverage and sizable cash position.”
The four acquisitions Fairfax announced this year, especially its $1.3 billion purchase of Zenith National Insurance Corp. of Woodland Hills, California, convinced investors the company is diversifying its operations and spreading its risk, Palombi said. In the past, disasters such as the Sept. 11, 2001, attacks and Hurricane Katrina in 2005 led to losses in Fairfax’s property and casualty insurance businesses.
“The more diverse you can be, the more comfortable investors will be in giving you the spread that you deserve,” Palombi said.
Fairfax remained profitable through most of the financial crisis, even as bigger rival Manulife Financial Corp. posted losses in five of the past eight quarters. Fairfax was among the six most-profitable insurers in North America based on return on equity in 2007 and 2008 and was in the top 25 percent last year.
Credit Default Swaps
Earnings soared to a record in 2008 as the company profited from investments in credit-default swaps on U.S. banks and insurers. The swaps became more valuable as the subprime mortgage market collapsed and banks began to fail.
Fairfax’s own credit-default swaps were the second-most- expensive among 20 Canadian companies tracked by Bloomberg data at the end of last year, behind only those of forestry company Sino-Forest Corp.
Investors were hesitant largely because of questions over the company’s accounting, Palombi said.
In 2006, the company restated financial results, received subpoenas from the U.S. Securities and Exchange Commission and faced allegations of tax fraud from a money manager Fairfax had accused in court of spreading false information.
The money manager, Institutional Credit Partners LLC, was itself charged with fraud by the SEC in June of this year. The lawsuit between Fairfax and defendants including ICP remains pending. The company said the U.S. Internal Revenue Service audited the tax years in question and required no changes.
The SEC ended its investigation of Fairfax last year without taking action, Paul Rivett, a company spokesman, said in an e-mail message.
“Because of his past, people were not willing to jump on the bandwagon when he was issuing over 7 percent coupons a year ago,” Palombi said of Watsa, 60, who like Buffett built his company by investing profits from insurance operations in out- of-favor securities.
Over the past four years, the company’s debt-to-equity ratio, a measure of its debt relative to its size, has dropped by more than half even as the ratio for the S&P/TSX Insurance Index has increased 19 percent. Fairfax’s liabilities have risen to $23.6 billion over the period, from $23.2 billion, while its shareholder equity has more than doubled to $8.91 billion.
Fairfax’s debt may advance further as ratings companies consider more upgrades, Palombi said.
“Looking at the business and Prem’s investment strategy, I think people are going to get more comfortable that upgrades are definitely possible,” he said.
A Bank of America Merrill Lynch index of 7-to-10-year U.S. corporate bonds of companies with ratings of A+ to A- yields 4.08 percent, while an index of similar BBB+ to BBB- debt yields 4.69 percent, below Fairfax’s borrowing costs.
“We believe our company and our credit, with over $1 billion at the holding company, low net debt and approximately $8 billion in equity, deserves higher ratings,” Rivett said. “The fact that we are a strong investment grade credit is now beginning to be reflected by the marketplace in our bond prices.”
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