PrefBlog

Many thanks to John Heinzl for quoting me in his piece A case study in how not to invest in bank stocks:

BK and BK.PR.A are two different classes of shares issued by Canadian Banc Corp., an investment vehicle known as a “split share” corporation. Canadian Banc Corp. holds a portfolio of the six biggest Canadian bank stocks, and while BK and BK.PR.A both provide exposure to those underlying stocks, they do so in different ways and with dramatically different results.
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You may be wondering how BK can pay a 10-per-cent dividend when the preferred shares are already yielding 5 per cent. According to the prospectus, “to supplement the dividends received on the portfolio and to reduce risk, the company will from time to time write covered call options in respect of some or all of the common shares in the portfolio.”

But many split share corporations also resort to selling stocks in the underlying portfolio to generate cash required to pay dividends on their class A shares, said James Hymas, president of Hymas Investment Management. “It is my belief that, if people understood class A split shares, they wouldn’t buy them.”
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What’s more, your adviser should have known that, although BK and BK.PR.A have different characteristics on their own, they are complementary pieces of the same underlying portfolio. When you put them together you’re essentially buying a portfolio of bank stocks – just in two different wrappers that add unnecessary layers of complexity and fees. Canadian Banc Corp.’s management expense ratio of 1.35 per cent is more than double ZEB’s MER of 0.62 per cent.

“Your reader was given really stupid advice by the adviser, because when you own the class A shares and preferred shares in equal proportions, all you own is a fund with a lot of bells and whistles that owns bank stocks,” Mr. Hymas said. “You can do that a whole lot easier by buying an ETF that owns bank stocks. And it’s much cheaper.”

Neither Mr. Heizl nor I can be faulted for any lack of consistency, since nine years ago he quoted me as saying:

For those reasons, Mr. Hymas says the capital shares are only appropriate for “suckers.”

That sparked a certain amount of debate. I look forward to receiving a lot of angry mail from everyone who’s ever made a nickel on their Capital Unit investments!

Many thanks to Rob Carrick for the shout-out in his recent piece Five reasons why it’s so hard to invest in preferred shares:

RESEARCH
Considering the high level of interest in preferred shares, there’s a surprising lack of analyst reports and other commentary. Two websites to try are PrefInfo.com and PrefBlog. The investor relations pages on corporate websites are often of little help in trying to make sense of how various preferred shares work.

… and there’s gold down in the comments section …

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I’m grateful to Rob Carrick for kindly quoting me in his piece Amid a long bear market for preferred shares come glimpses of why you might want them in your portfolio:

“Common share dividends can be cut quite easily,” said James Hymas, president of Hymas Investment Management Inc. and an authority on preferred shares. “Preferred share dividends can only be cut when the common share dividend goes to zero.”
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The preferred share index was down more than 30 per cent from its pre-pandemic peak to its March 23 trough, but then bargain hunters stepped in. “There was a growing sense that the yields available were completely ridiculous,” Mr. Hymas said. “At the bottom, you had the bluest of the blue chip companies yielding 7 per cent on their dividends.”

A quick refresher on falling share prices and dividends: When stocks fall in price, their dividend yield rises. Mr. Hymas said that six months ago, rate reset preferred yields were in the 5.5 to 5.75 per cent range.
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Preferred share dividends are more secure than common share dividends, but defaults have happened in rare cases. Mr. Hymas said these defaults are rare because the total amount of preferred share dividends paid out by companies tends to be a comparatively small corporate expense. Also, a company is considered to be financially failing when it suspends preferred share dividends. “It is extremely difficult for a company to get financing once it has pulled that trigger.”

There are two main types of preferred shares – rate resets and perpetuals, which pay a fixed dividend. Perpetuals typically behave more like bonds, rising in price when rates fall and losing ground when rates rise. However, Mr. Hymas said perpetuals have been lumped in with rate resets lately and have not done well, either.
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Why consider rate reset preferreds at all, then? Mr. Hymas says their yields are attractive now and would remain so even if they undergo a dividend reset at today’s depressed rates. And, as we wait for the pandemic’s impact on the economy to hurt corporate profits, there’s the added level of security over common share dividends.

The do-not-ignore caveat: Forget about preferred shares altogether if you want a secure investment that doesn’t change much in price. “Preferred shares are volatile beasts and you shouldn’t buy them for preservation of capital,” Mr. Hymas said. “They are all about preservation of income.”

It is a pity that the article uses Current Yield to illustrate the reward side of the case in favour of preferreds, instead of calculating the yield properly as with the yield calculator for Resets. This inaccuracy is particularly glaring with respect to BAM.PR.B, a Floater paying 70% of Canada Prime based on par, so (2.45% * 70%) * 25 = 1.715% * 25 = 0.42875 p.a. The article touts a Current Yield of 9.1% at a price of 7.64, implying a dividend rate of $0.69524 p.a., or 2.78% of par, implying Canada Prime of 3.97% …. this is consistent with the March dividend of $0.172813 … prime hit 3.95% in October 2018 and was reduced to 3.45% in early March 2020 and then to 2.95% in mid March 2020 and then to 2.45% in late March 2020. Some people are going to be awfully disappointed.

John Heinzl was kind enough to quote me in his recent piece Amid dividend cuts, income investors can still find safety:

James Hymas, president of Hymas Investment Management, said the risk of banks cutting dividends is “so small that it cannot be quantified.”

“The saving grace in all of this is that after the credit crunch the regulators really went to town, insisting on higher capital levels,” Mr. Hymas said in an interview. “So the banks have an enormous shock absorber … in terms of their capital and their size and their protection from competition.”

Rob Carrick was kind enough to quote me in his piece A close-up look at preferred share ETFs, a mega-hit with investors turned surprise money-loser:

The people selling preferred shares and the ETFs that hold them include investors who used rate reset preferreds as a way to profit from rising interest rates, said James Hymas, a preferred-share specialist who manages the Malachite Aggressive Preferred Fund for high-net-worth investors.

“The other class of sellers are people who are selling just because these shares are going down,” Mr. Hymas said. “They’ve take pretty significant losses in the last eight months or so and they’re saying, ‘I’m out.’”

Mr. Hymas’s guideline for investing in preferred shares is that you should only use money you’re pretty sure you’re not going to need for 10 years or more. That way, you can ride through the periods of volatility that seem to be inevitable in a world where interest rates keep defying expectations. Pref shares are particularly attractive in non-registered accounts, where the dividend tax credit applies.
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Bond yields could definitely fall further, so there’s a risk that the yield from rate reset preferreds might be lower still. But Mr. Hymas points out that there’s nothing exceptional about holding income-producing investments that renew at lower yields.

This happens all the time when investors use five-year ladders of guaranteed investment certificates. That’s where you invest equal amounts in GICs with terms of one through five years and then invest maturing GICs back into a new five-year term. Anyone who has done this in recent years knows that it’s common to renew at lower rates.

It’s also important to understand that the problems faced by preferred share ETFs have nothing to do with the quality of the securities they hold. While Mr. Hymas points out that some less financially solid companies have entered the preferred share market in the past 10 years or so, most issuers are big banks and other blue chips that can be relied on to pay their dividends.

Preferred share ETFs are a hostage to interest rates, then. The rate reset shares they mostly or exclusively hold are pummelled when rates fall and they’ll have their day when rates rise. “As a matter of fact, I think they’re going to shine even if things stay the way they are now,” Mr. Hymas said. “I believe they’re totally oversold at this point.”

John Heinzl was kind enough to quote me in his latest piece, Winners and Losers in the Bond-Yield Collapse:

If you haven’t checked guaranteed investment certificate rates recently, you’re in for a shock. After climbing for most of 2018, GIC yields have gone into reverse. A five-year GIC at Tangerine, for instance, now pays just 2.5 per cent annually, down from 3.1 per cent as recently as November. Government bonds are even less attractive. The five-year Canada bond now yields less than inflation – the Consumer Price Index rose 1.5 per cent in February – which means bond investors are earning a negative real return, said James Hymas of Hymas Investment Management. “And that’s before taxes,” he said.

John Heinzl was kind enough to mention me in his Investor Clinic column today titled Why preferred shares plunged, and the ACBs of the Loblaw deal:

James Hymas, who manages a preferred share fund and writes the PrefLetter, said the recent drop may have been exacerbated by tax-loss selling, in which investors dump losing stocks in order to offset capital gains on their winners.

“There’s also a certain amount of ‘fighting the last war’ syndrome,” Mr. Hymas said in an e-mail. “People remember what happened the last couple of times the Bank of Canada cut its [benchmark] rate (January 2015, especially) and are terrified it will happen again.”

Despite those fears, after the recent drop many preferred shares now offer even more attractive yields. That’s especially true considering that preferred shares, unlike corporate bonds, qualify for the dividend tax credit. What’s more, assuming the five-year Canada yield stays roughly where it is, most preferreds will actually raise their dividends – not lower them – on the next reset date, Mr. Hymas said.

“My advice to current holders of preferreds remains the same as it was during the credit crunch: Shut up and clip your coupons,” he said.

Barry Critchley was kind enough to mention me in his piece Assessing the value of the minimum reset yield:

The minimum rate reset feature has some value for the investor and could become real value in five years if the five-year Canada bond rate is below the current five-year rate. The question is whether investors are being rewarded now.

James Hymas, portfolio manager of the Malachite Aggressive Preferred Fund and publisher of the PrefBlog thinks they’re not. “I think it’s overly reflective in the price, but given the current yield on five-year Canada bonds (around 1.70 per cent) the current value is minimal.”

Hymas said the minimum reset has value if in five years, the five-year Canada rate is below 1.70 per cent, a level that’s “significantly below the target inflation rate,” of two per cent set by the Bank of Canada, and not far from the record low five-year rate.

In Hymas’s view, a coupon that starts with a five is required. In the meantime, he says that better value lies in the secondary market.

John Heinzl was kind enough to mention me in his recent article What is a ‘Canada call’ and why was my bond redeemed early?:

In April of 2009, I purchased a 10-year Manulife bond that yields 7.768 per cent and matures on April 8, 2019. However, in early October, I looked at my discount brokerage account and was surprised to see that Manulife had “redeemed” the bond. I have never heard of a bond being redeemed at the behest of the issuer. Is this legal?

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“That’s known in the business as a Canada call and it’s very common,” said James Hymas, president of Hymas Investment Management. “One of the very important things to do when investing in corporate debt is to look at the call provisions, because they will almost always be there somewhere.”

Generally, companies will only redeem bonds when it is in their best interests (or when required because of the terms of the issue). When Government of Canada bond yields were at historic lows, it wasn’t advantageous for Manulife to redeem the notes because it would have had to pay a steep price. But when government yields started to spike several months ago – and as the maturity date approached – redemption became attractive, Mr Hymas said.
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Manulife announced on Aug. 15 that it intended to redeem the notes and, on Oct. 3 it said the redemption price would be $1,073.81 (per $1,000 face amount) plus accrued interest of $38.52. The redemption price was based on the second option in the prospectus, as it was higher than par. This equates to a yield to maturity (YTM) of 2.73 per cent, Mr. Hymas said. (If you’re wondering why the YTM is lower than the 7.768-per-cent coupon rate, it’s because the notes were trading above par.)
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“They essentially bought back their old debt at a yield of 2.73 per cent and were able to replace that with an extension of term of more than five years and with debt that was actually subordinated and that’s a good deal for them. They’re only paying about 32 basis points [in additional yield] and that’s a bargain,” he said. (Subordinated debt, with its higher risk from a bondholder’s perspective, would normally carry a higher interest rate than senior debt.)

Rob Carrick was kind enough to quote me in his piece Are these preferreds a 5-per-cent solution?:

James Hymas, president of Hymas Investment Management and a preferred-share specialist, said there are roughly a dozen blue-chip perpetual issues that combine a straightforward structure with a share price below their $25 issue price. These shares, issued by Brookfield Asset Management, Canadian Utilities, E-L Financial, Power Corp. of Canada and Power Financial, had an average yield of 5.1 per cent as of earlier this week.

Mr. Hymas said perpetuals could be an attractive option for investors who are looking at long-term corporate bonds, which mature in 10 years or more. These bonds have a yield of roughly 3.6 per cent on average today compared with perpetuals in the range of 5 per cent.

You’d need about 6.6 per cent from a bond to give you the same after-tax yield as a perpetual preferred share. Multiply a dividend yield by 1.3 to get the rough equivalent from a bond after paying taxes, Mr. Hymas said.

The drawback with perpetuals is that they are highly sensitive to rising interest rates. Mr. Hymas sees five-year Government of Canada bonds eventually rising from current levels just above 1 per cent to the 3-per-cent to 3.5-per-cent range. If that happens, expect perpetuals to plunge in price. “It could be quite traumatic,” he said.

Much less of a concern is the security of the dividends paid by perpetuals. The dozen perpetuals highlighted by Mr. Hymas are all rated Pfd-2 by the rating agency DBRS, which means satisfactory credit quality. Pfd-1 is superior quality, while Pfd-5 is highly speculative.

Companies that issue perpetuals have an option to redeem the shares based on terms set out in the prospectus (you can find prospectuses on Sedar.com). While you shouldn’t buy these shares based on the potential for a future redemption at the $25 issue price, there are some perpetuals that might actually be in line for this at some point in the next several years.

Mr. Hymas believes that regulations covering the banking sector and its capital structure could, in the next few years, be applied to life insurance companies. Some preferred shares would then become disadvantageous for insurers and, in turn, be candidates for redemption in the years ahead. A redemption would turn a perpetual preferred share into a maturing investment similar to a bond.

Mr. Hymas said he likes three issues of insurance-company perpetuals with redemption potential: Sun Life Financial Series 5 (SLF.PR.E), Manulife Financial Series 3 (MFC.PR.C) and Great-West Lifeco Series I (GWO.PR.I). All have yields at or just below 5 per cent based on recent share prices and dividends. If the shares were redeemed in the next eight to 12 years at $25, that yield would work out to be a bit higher (the shares all currently trade below $25).

For argument regarding my belief “that regulations covering the banking sector and its capital structure could, in the next few years, be applied to life insurance companies”, see the posts DeemedRetractible Review: September, 2016 and OSFI Dovish on Insurance Tier 1 Eligibility Rule.