Shorts Make Volkswagen #1

What a week as the S & P posted its largest gain in almost 35 years and its worst month since 1938.  As short selling and naked short selling in particular is creating more volatility, I thought I would touch on something interesting where the naked short selling of shares in Volkswagen created the worlds most valuable company overnight.

For those who may not know what short selling is, it involves the practice of selling stock today with the hope that the share price will decline in the future. By buying the stock back at a lower price, you would cover your short position and make a profit. Should the stock price go up, you would have a loss.

Legally speaking, in order to short sell stock, there must be shares available to short. If you call your broker to short sell a postion, they should have the stock in inventory allowing you to do so. If they allow you to short and dont have stock available, this is called a naked short or naked short selling.

Porsche that was thought to own about 35% of the outstanding shares disclosed that it actually owned 74%. VW’s home state of Lower Saxony owns 20% which leaves only 6% available for shorting purposes. There was lack of disclosure on Porsche’s part that it owned so much of VW as the disclosure was not required by the German Stock Exchange.

VW’s stock closed on Tuesday at 1,005 Euro or $370 Billion US overtaking the Exxon that had a value of $343 Billion. Hedge Funds lost over $35 Billion US in two days on this trade alone. However, Porsche indicated that they would help alleviate some of the hedge fund problems by allowing more of their shares to be borrowed in the marketplace for shorting purposes. VW’s shares closed at 475 Euro by the end of the week.

All I want is 10% Guaranteed!!!

With the markets as volatile as ever, it can be difficult to stomach the ups and downs as you try and have  a portfolio generate enough income or growth to last a lifetime. I know of many clients who talk about the days when they could get 19% on Canada Savings Bonds, 20% or more on Term Deposits, and those lucky few who annuitized and locked in 16% for life.

Of course inflation was running rampant in double digits and with higher tax rates, you were lucky to break even. Over the last year, while the Fed and the Bank of Canada have lowered rates to stimulate the economy and try and avoid recession, rates on corporate debt and preferred shares have gone up significantly. The spreads between bank debt and government debt are the widest they have been in over 20 years.

You could argue that Canadian banks are going to collapse so the risk of investing in a bank guaranteed bond or preferred share is too high. Looking at things objectively, the likelihood of one of our banks going bankrupt and the common share price going to zero are remote.

If you are on the same page as me and believe that a bank failure in Canada is not likely, there is an interesting opportuntiy that awaits. Preferred shares issued by corporations in Canada are eligible for something called the dividend tax credit. Because Canadian corporations have already paid tax on their earnings, the dividends that flow through to individual investors are subject to a reduced level of tax.

As I look at my stock screen today, I see that CIBC and Laurentian Bank have perpetual Preferred shares currently yielding approximately 7.25% per annum with the dividends paid quarterly. So, how do I come up with 10% when they are paying 7.25%. Interest earned on GIC’s is fully taxable. The preferrential tax treatment on dividends and preferred shares equates to just under 10% for a Canadian in the highest marginal tax bracket on an interest equivalent basis.

Some would argue that there are further write downs to come and that interest rates in Canada are going to rise since inflation is going up. I would agree that government bond rates will probably rise over the next 12 months. Nobody knows how much, but, I would argue that while government rates go up, the spread between government and corporate bonds could fall which means that you wont be able to get 8%, 9% or 10% on these preferred shares next year and that this deal will look like the annuity that we should have locked in at 16% for the rest of our lives.

What are your thoughts on interest rates and corporate debt? Your opinions are more than welcome.