Investor Insights

September 2019 Investor Report

Published: October 31, 2019Updated: November 1, 2019

With the second Federal Funds rate decrease in three months, financial markets are entering the fourth quarter looking for more support and guidance from the Federal Reserve. Sentiment is growing among market participants that a new round of quantitative easing will begin. Historically, providing free capital to bank reserves has tended to bolster financial asset prices.

Many financial news outlets have begun reporting interest rate increases in repurchase agreements. Repurchase agreement (or repo) markets are markets in which institutions borrow cash for extremely short durations, sometimes for as little as a day. These short-term loans require high creditworthy collateral to be exchanged (such as US Treasury notes). These interest rate increases are a noteworthy development as they suggest a lack of general liquidity in financial markets. The Federal Reserve has reacted to these liquidity restraints by creating temporary open market transactions, providing liquidity directly to the repurchase agreement markets. It is important to note that bank reserve balances are not currency, however they do provide a means for banks to settle transactions. As our government spending deficits continue to accelerate, the need for the Treasury Department to issue larger amounts of US Treasury bonds grows, removing cash from money markets. Concurrently, foreign Central Banks have found higher yielding alternatives compared to buying low yielding US Treasury bonds.  Finally, Basel III rules have required some of our largest banks (banks that have been major beneficiaries of quantitative easing) to hold more reserves then traditionally needed. With this bank reserve drawdown, the Fed is seeking to preserve fluidity in repo markets, so reserves remain accessible. If bank reserves were to become scarce, lower-capitalized companies would struggle to remain solvent. 

This Federal Reserve action in the repo markets differs significantly from quantitative easing. When the Federal Reserve assists in repo market transactions, it is simply offsetting a reduction in reserve balances. During quantitative easing, by contrast, the Federal Reserve directly purchases US Treasuries, with the proceeds going directly to the bank reserves where the individual bank reserves will be credited. Those bank reserves do not cost anything (0%) and banks are paid a certain interest-rate to hold them.

              On a separate note, GCWM would like the announce our new digital outreach program. We recently invested in new resources that will allow us to directly reach clients via email in the case of a material development in a position. We respect our clients’ time and do not want to clutter email inboxes, but we feel it is important to maintain open lines of communication. In the middle of September, we reached out to owners of the Rose Rock Midstream bonds to inform them of a merger that had a positive impact on their holding. We are still building out the system hope our clients’ will be receptive to receiving important communications from us over email in the future. As always, we will continue to provide updates on existing positions in our monthly letters. This new email-based method, however, will allow us to provide updates in a timelier fashion.

Please review the following updates from some of the existing positions that we manage:

B. Riley Financial Inc. Senior Unsecured Bonds maturing in October 2021— (Symbol: RILYL): On September 23, B. Riley announced the closing of a new bond offering. With the announcement, the company detailed that the bond proceeds will be used to redeem our bonds early. The date of the expected redemption will be the end of the October. The company has performed well recently. Their acquisition of FBR a few years ago really gave B. Riley a stronger path to credit markets. We are disappointed to be losing these bonds as they represented one of the firm’s largest individual positions.  SemGroup / Rose Rock Midstream— (CUSIP: 77714PAB5): As we wrote in the August letter, there were two reports detailing the interest of acquirers in buying SemGroup. Those reports have proven to be accurate and, on September 16, the merger was announced. Energy Transfer will purchase SemGroup for a total consideration of $5 Billion. We own the Rose Rock Midstream bonds and Rose Rock was a fully owned subsidiary of SemGroup. Accordingly, it will be part of the acquisition by Energy Transfer. Our Rose Rock bonds have a change of control clause where we can offer our bonds to Energy Transfer for $1,010 per bond. The average price of our bond acquisition, a couple years ago, was approximately $950 per bond. The merger is expected to be completed towards the end of 2019. Therefore, we will decide on the disposition of our holding when the corporate action tender period commences.