Archive for the ‘Reader Initiated Comments’ Category

eMail To A Client

Saturday, August 1st, 2015

There has been a very steep decline in the Canadian preferred share index in 2015 – so steep, in fact, that some investors are selling simply because their investment has lost value, which has to be one of the worst trade techniques ever (it imposes a form of negative convexity on your portfolio, among other bad things).

Still, it is unnerving. Look at the graph of the value of an investment in CPD, as published by Blackrock:

Click for big

This isn’t the smooth ride that some were expecting! The broad TXPR index was down 4.10% on the month and is down 11.47% over the past year. The FixedReset TXPL index has fared even worse, down 5.31% on the month and a horrific 17.26% on the year. I don’t have figures for the BMO-CM 50 at this time, but if I plug in the TXPR results for July, I can draw the following graph, which shows the rolling twelve month and twenty four month total returns from December 31, 1992:

Click for Big

So both the one- and two-year returns for the index now show losses exceeded only by the depths of the Credit Crunch in the 20+ years of data I have available. And, I will note, the four year total return for TXPR is now negative – in fact, you have to go back to January, 2011, to find a starting point that will give you a better than zero return through the period.

So I received an eMail from a client that said, in part:

But my real problem is that in trying to decide whether to stay in your fund or pull out, I do not know what I am betting on. The prospect of rising CDN interest rates (seems unlikely that would help), the overall Cdn economy? Something else?

What is your take on what it would take for preferred values to start moving in the right direction?

What follows is my answer, with minor edits to ensure anonymity and to reflect the medium of the message.

I can appreciate your concern.

Your first investment was valued on 2012-11-19; the second on 2013-1-21.

From the end of November, 2012, to June, 2015, the fund’s total return (reinvesting dividends, before fees) was -0.35%, compared to the BMO-CM “50” index return of -3.64%. TXPR (the broad S&P/TSX Preferred Share index) returned -4.04%, while TXPL (S&P/TSX, FixedResets only) returned -9.65%.

For the period beginning 2013-1-31 I find: Fund, -1.95%; BMO, -4.86%; TXPR, -5.56%; TXPL, -11.42%.

So the problem is not with the fund so much as it is with the market.

The indices are currently comprised of about 1/3 Straight Perpetuals, 2/3 FixedResets. For an idea of what has happened to Straights, see the attached Chart #22 from the July PrefLetter, which shows the interest-equivalent spread between Straight Perpetuals and long-term Corporate bonds (the “Seniority Spread”).

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Market Yields changed as follows, from November 28, 2012 to June 30 , 2015
Five Year Canadas: 1.31% … 0.81%
Long Canadas: 2.38% … 2.37%
Long Corporates: 4.2% … 4.0%
Straight Perpetuals: 4.88% … 5.20%
Interest-Equivalent Straight Perpetuals: 6.35% … 6.76%

These changes have had the effect of widening the Seniority Spread from 215bp to 276bp. I can think of two rationales for this widening:
i) the retail investors who dominate the preferred share space are demanding a higher spread to compensate for perceived risks of losses once “interest rates start to rise”; that is, they are reacting more than the institutional investors in the bond market to risks of loss. This could be due to higher risk-aversion (defining “risk” as chance of loss), less binding duration constraints on the portfolio, simple lack of sophistication, or any combination of these three considerations. Note that I have not made a formal study of the subject and there may be other factors, but those are the ones that occur to me through my experience talking to investors.
ii) Straight Perpetual yields are being pushed up (or at least supported) by FixedReset yields (see chart FR-44, below, from the extract from the July PrefLetter ). This would be due to a perception amongst investors that Straight Perpetuals are more “risky” (whatever that means!) than FixedResets and hence deserving of a positive spread; note that this effect is not observed when comparing sovereign inflation-indexed bonds to nominals (the Inflation Risk Premium).

Click for Big
These spreads use Yield-To-Worst, not Current Yield
This is Chart FR-44

With respect to FixedResets, it is clear from the horrible performance of TXPL referenced above relative to that of the broader TXPR (which one can approximate as being comprised of about 2/3 TXPL throughout the period of interest, although it has, of course, varied, with FixedReset issuance slightly overcompensating for capital losses) that FixedResets have been whacked.

I have hypothesized a rationale for this underperformance in the attached extract from PrefLetter under the heading “An Experimental Data Series”, to wit: in the face of declines in the Five-Year Canada yield (which is the basis for the resets of of this type of preferred share), investors are attempting to maintain a constant yield irregardless of what is happening with other yields. This is hard to justify on rational grounds, but there has always been an element of irrationality in preferred share pricing! Thus, declines in the GOC-5 yield have been 100% compensated for by declines in price, without referencing yields of comparable long-term instruments; this contradicts one of the features of FixedResets that was used (perhaps inadvertently through indiscriminate use of the term “interest rates”) to help sell the issues when they were developed – that price would remain constant given parallel shifts in the yield curve (with credit spreads assumed, again implicitly, to be constant).

Click for Big

This 100% dependence of FixedReset price on GOC-5 has a very large effect, as derived in the last equation on page 3 of the extract:
i) The base Modified Duration of FixedResets is equal to (1 / EFCY). The term EFCY (“Expected Future Current Yield”) is about 3.75%, implying a Modified Duration of about 27 – not only far higher than long bonds, but dependent upon more volatile five-year yields to boot!
ii) The term (25/P) in the equation implies negative convexity

So to summarize, I feel that the poor performance of the market since your initial investment is due to:
i) very high dependence of FixedReset prices on GOC-5 levels, which has contradicted prior assumptions of an equal and opposite co-dependence on long-term yield levels.
ii) maintenance of a spread to PerpetualDiscounts, which has prevented Straight Perpetuals from participating in price increases due to declines in long-term corporate yields.

Click for Big
The “Bozo Spread” is the Current Yield of PerpetualDiscounts less the Current Yield of FixedResets
It is not yet clear whether the market pays more attention to these Current Yields, or to the Yields-to-Worst, when relating FixedResets to PerpetualDiscounts

I will also note that to a certain extent, we’ve seen this movie before: during the Credit Crunch Floating Rate issues performed appallingly poorly, since their dividends were linked to contemporary (as opposed to expected!) Canada Prime while their yields were linked to PerpetualDiscounts (see my contemporary article and the next chart)

Click for Big
Negative Total Return Over Fifteen Years!

So, while I can appreciate your dismay regarding the performance of your investment, I will point out that:
i) the key consideration is not past performance but how the characteristics of the asset class may be expected to fit into your portfolio requirements going forward.

ii) Expected income per unit in the fund has actually increased over the period, from $0.4643 in December 2012 to $0.5217 in June 2015 (see MAPF Performance: June 2015 ). This calculation is dependent upon various assumptions which you may or may not accept, but it represents my best guess!

iii) The increase in spreads over the period implies a significant reduction in expected income should you switch to another Fixed Income type of investment at this time.

iv) Expected future performance of FixedResets is highly geared to GOC-5, insofar as we can accept that the last equation on page 3 of the July PrefLetter extract reflects market reality. While I agree that we might be waiting a while for GOC-5 to increase substantially, I will suggest that current levels must be at or near a bottom. Mind you, I’ve been suggesting that continually for several years now and been wrong every time, so you may wish to disregard that particular exercise in market timing!

v) Expected future performance of Straights should be better than that of corporate long bonds over the medium term; and corporate long bonds should in turn outperform long Canadas; in both cases due to moderation of current high (by historical standards) spreads

I hope all this helps. I realize that I have used a fair bit of jargon in this eMail (and, what’s worse, jargon that I’ve developed myself!) so if there is anything in the above that makes no sense, feel free to ask for clarification. And, of course, if you would like to discuss this further prior to making an investment decision, that’s fine too – whether by eMail or telephone.


Market Inefficiency: AIM.PR.A vs. AIM.PR.C

Saturday, March 28th, 2015

I was challenged on Financial Wisdom Forum to opine on preferred share market inefficiency:

I do wonder if this market is as inefficient as you suggest. It seems to me when inefficiencies exist (that is to say easy money to be made) in capital markets such inefficiencies don’t last long as smart money rushes in to scoop up the cash and thus eliminating the inefficiency . Perhaps Mr Hymas would care to offer an expert opinion on the preferred share market with respect to its inefficiencies or lack there of.

Fortunately enough, there’s an example of inefficient pricing noted just above:

Take AIM.PR.A (which is one of my holdings and is definitely not investment grade). It was yielding 7.3% (current) when I started buying in February. I knew it was resetting end of March at around 4.5% of the redemption price (for a current yield of 5.1% at my ACB), but thought: ‘It must be safe to buy because the market must have priced in whatever.s going to happen’. Well, in early March they announced the details of the reset and then it sunk like a stone! So a week or so after the announcement, I thought: ‘Now the market must really have priced in everything, so now I can buy some more at a bargain’. Which I did. But it kept sinking and sinking and still is sinking!

Let’s look at the yield of AIM.PR.A using the new and improved yield calculator for FixedResets. Assumptions are always necessary when making yield calculations so assume

  • The bid in thirty years will be the same as the close on Friday, 19.31
  • Constant 5-year Canada yield of Friday’s close of 0.79%

and combine that with what we know about the issue

  • Resets 2020-3-31
  • Reset yield is GOC-5 +375bp
  • Paydates are quarterly from June 30

We calculate the yield as 5.85%.

Now look at AIM.PR.C, which closed on Friday at 24.91, currently pays $1.5625 p.a. and resets at five year intervals commencing 2019-3-31 at GOC-5 + 420bp. Make the same assumption of a constant price. The yield is 5.33%.

This relative valuation makes no sense. AIM.PR.C should yield more than AIM.PR.A, since it has greater call risk.

Some people may tell you that the differential makes sense, because when AIM.PR.C resets in four years it is GUARANTEED!!! to reset at a higher level since GOC-5 will DEFINITELY!!! be higher at that time … to which we may retort that in that case, AIM.PR.A will also reset higher since it will reset again one year later.

In order for AIM.PR.C to achieve the 5.85% yield offered by AIM.PR.A, we must assume a constant GOC-5 yield of 1.49%. If we assume that GOC-5 will reach 1.49% and stay there forever, then AIM.PR.A will then yield 6.45% (n.b. a greater increase since the lower price of AIM.PR.A means it is more levered to the GOC-5 rate). So for the realized yields to be equal, we must assume that GOC-5 will increase to 1.49% by the time AIM.PR.C resets in four years, but return to 0.79% when AIM.PR.A resets a year later (there will be infinite equivalent paths for equality of yield, but they will all look more or less like that) and that this zig-zag will continue forever. This seems like a rather complex path to be betting on.

And the above ignores call risk, i.e., assumes that the Volatility of the Market Reset Spread for AIM is zero and that neither issue will be called with 100% certainty. This is another rather aggressive assumption.

If we turn the question around a little, we can determine that, in order for the yield on AIM.PR.A to be equal to the yield on AIM.PR.C (again, with zero allowance made for call risk), then we may say that the constant price of AIM.PR.A should be $21.20, given a constant GOC-5 yield of 0.79 (for both issues!). Thus, we may conclude to a first approximation that AIM.PR.A is about 9% undervalued relative to AIM.PR.C at current prices.

It is not at all unusual to conclude that cheaper issues are unduly cheap relative to their more expensive siblings. I believe that this is due to some feeling among preferred share investors as a group that:

  • Anything priced at around par will always be priced near par, because, dammit, they’re PREFERRED SHARES
  • Anything priced significantly below par is a speculative piece of shit

Regrettably, this hypothesis would be very difficult to prove. And, as the regrettable timing of MAPF’s move into low-spread FixedResets demonstrates, just because something is probably mostly true most of the time doesn’t mean it’s always true all of the time. But … if the odds are with you on all your decisions and you take care that an unlucky streak won’t wipe you out … you’ll do fine.

What’s The Benchmark Five-Year?

Tuesday, February 24th, 2015

Assiduous Reader gsp of the Financial Wisdom Forum writes in and says:

as I posted on the Preferreds thread on FWF (LINK) I am having a hard time understanding which source to best trust when trying to figure out the GOC 5 year benchmark that resets are based on.

The site you link on prefblog(LINK) says the closing 5 year on Feb 20th was 0.72 while says 0.79. The definitive source(BOC) today posted it as 0.80. I’m confused by the variance in all these quotes, especially for a closing rate.

I like to be as precise as possible when using your YTC resets spreadsheet, what’s the best source for intraday BOC 5 year quotes that I can access for free? I have no real use for real time quotes but prefer not to be out to lunch when the rate moves considerably intraday.

Using today’s quotes, we see that CBID’s site (which is the one I use) shows a “Closing Markets as of: 4:00 PM EST 23-Feb-15” yield of 0.66% for the “Canada 5 year”, while the GOC-5 yield list yield of 0.741% for February 23 for “Canada 5-Year Bond Yield Historical Data”.

That’s a big difference for a five year! So what’s a five-year bond, anyway? Is it the same one today as it was yesterday? Just what exactly is a “five year bond”?

According to the BoC Benchmark definition:

Selected benchmark bond yields are based on mid-market closing yields of selected Government of Canada bond issues that mature approximately in the indicated terms. The bond issues used are not necessarily the ones with the remaining time to maturity that is the closest to the indicated term and may differ from other sources. The selected 2-, 5-, 10-, or 30-year issues are generally changed when a building benchmark bond is adopted by financial markets as a benchmark, typically after the last auction for that bond. The selected 3-year issue is usually updated at approximately the same time as changes are made to the 2-year, and sometimes with the 5-year. The selected 7-year issue is typically updated at approximately the same time as the 5- or 10-year benchmarks are changed. The current benchmark bond issues and their effective dates, shown in brackets, are as follows.
•2 year – 2017.02.01, 1.50% (2014.11.21);
•3 year – 2017.08.01, 1.25% (2014.10.09);
•5 year – 2020.03.01, 1.50% (2015.02.20);
•7 year – 2022.06.01, 2.75% (2015.01.26);
•10 year – 2025.06.01, 2.25% (2015.01.26);
•Long – 2045.12.01, 3.50% (2014.02.21);
•RRB – 2041.12.01, 2.00% (2010.10.21);

So that’s pretty cool! The “Five Year Benchmark”, as defined by the Bank of Canada, changed last Friday, February 20;

From their page BOC Bond Auction information, we see that their Excel spreadsheet (updated to 2015-1-31) lists two prior auctions (of $3.4-billion a pop) of the 1.5% March 1, 2020, bond, on 2014-11-26 and 2014-10-08. The three prior five year auctions were for the 1.75% September 1, 2019, issue, on 2014-8-6, 2014-5-7 and 2014-4-9, each of which also had $3.4-billion size. And we also see that there was another “five year” auction February 18 for delivery February 23. So, it would seem, that they changed their official benchmark as of the day prior to delivery of the third and final auction of the issue.

We can go back to the CBID page: at the bottom, there are quotes for individual issues and we see:

Canada 1.750 2019-Sep-01 104.85 0.66
Canada 1.500 2020-Mar-01 103.72 0.74

So – while it’s not absolutely definitive, it would appear that is quoting the yield on the 1.5% of March 2020, while CBID is quoting the 1.75% of September 2019 as the “Five Year”.

Who’s right? Who’s wrong? It’s a meaningless question: virtually everything in the bond market is quoted in terms of convention, which is often highly exasperating when discussing yields.

How does the US Treasury do it? They provide a Constant Maturity Yield:

Treasury Yield Curve Rates. These rates are commonly referred to as “Constant Maturity Treasury” rates, or CMTs. Yields are interpolated by the Treasury from the daily yield curve. This curve, which relates the yield on a security to its time to maturity is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market. These market yields are calculated from composites of quotations obtained by the Federal Reserve Bank of New York. The yield values are read from the yield curve at fixed maturities, currently 1, 3 and 6 months and 1, 2, 3, 5, 7, 10, 20, and 30 years. This method provides a yield for a 10 year maturity, for example, even if no outstanding security has exactly 10 years remaining to maturity.

Treasury Yield Curve Methodology. The Treasury yield curve is estimated daily using a cubic spline model. Inputs to the model are primarily bid-side yields for on-the-run Treasury securities. See our Treasury Yield Curve Methodology page for details.

… and on the Treasury Yield Curve Methodology Page it states:

The Treasury’s yield curve is derived using a quasi-cubic hermite spline function. Our inputs are the Close of Business (COB) bid yields for the on-the-run securities. Because the on-the-run securities typically trade close to par, those securities are designated as the knot points in the quasi-cubic hermite spline algorithm and the resulting yield curve is considered a par curve. However, Treasury reserves the option to input additional bid yields if there is no on-the-run security available for a given maturity range that we deem necessary for deriving a good fit for the quasi-cubic hermite spline curve. For example, we are using composites of off-the-run bonds in the 20-year range reflecting market yields available in that time tranche. Previously, a rolled-down 10-year note with a remaining maturity nearest to 7 years was also used as an additional input. That input was discontinued on May 26, 2005.

More specifically, the current inputs are the most recently auctioned 4-, 13-, 26-, and 52-week bills, plus the most recently auctioned 2-, 3-, 5-, 7-, and 10-year notes and the most recently auctioned 30-year bond, plus the composite rate in the 20-year maturity range. The quotes for these securities are obtained at or near the 3:30 PM close each trading day. The inputs for the four bills are their bond equivalent yields.

Between August 6, 2004 and June 2, 2008, to reduce volatility in the 1-year Treasury Constant Maturity (CMT) rate, and due to the fact that there were no on-the-run issues between 6-months and 2-years, Treasury used an additional input to insure that the 1-year CMT rate was consistent with on-the-run yields on either side of it’s maturity range. Thus, Treasury interpolated between the secondary bond equivalent yield on the most recently auctioned 26-week bill and the secondary market yield on the most recently auctioned 2-year note and inputted the resulting yield as an additional knot point for the derivation of the daily Treasury Yield Curve. The result of that step was that the 1-year CMT was generally the same as the interpolated rate during that time period. As of June 3, 2008, the interpolated yield was dropped as a yield curve input and the on-the-run 52-week bill was added as an input knot point in the quasi-cubic hermite spline algorithm and resulting yield curve.

Between December 3, 2007 and November 7, 2008, due to Treasury’s discontinuance of 3-year notes, we added a composite rate in the 3-year range based on an average of off-the-run securities in that time tranche. This composite was replaced on November 10, 2008 with the on-the-run 3-year note upon its reintroduction.

Treasury does not provide the computer formulation of our quasi-cubic hermite spline yield curve derivation program. However, we have found that most researchers have been able to reasonably match our results using alternative cubic spline formulas.

Treasury reviews its yield curve derivation methodology on a regular basis and reserves the right to modify, adjust or improve the methodology at its option. If Treasury determines that the methodology needs to be changed or updated, Treasury will revise the above description to reflect such changes.

Yield curve rates are usually available at Treasury’s interest rate web sites by 6:00 PM Eastern Time each trading day, but may be delayed due to system problems or other issues. Every attempt is made to make this data available as soon as possible.

This is a much more sensible way to estimate what a reasonable person might call a “Five Year Yield”, with the reservation that I have always been deeply suspicious of the cubic spline curve fitting methodology. It is too abstract for me and there are mathematical problems at the knot points. But I can’t deny that it fits the data well.

While all of this may be considered illuminating, it still doesn’t really answer Assiduous Reader gsp-from-FWF’s problem: what number should he plug into his calculation in order to estimate a projected future dividend rate for FixedResets? Because the following definitions from the prospectus for RY.PR.J are pretty typical:

“Annual Fixed Dividend Rate” means, for any Subsequent Fixed Rate Period, the rate (expressed as a percentage rounded to the nearest one hundred–thousandth of one percent (with 0.000005% being rounded up)) equal to the Government of Canada Yield on the applicable Fixed Rate Calculation Date plus 2.74%.

“Bloomberg Screen GCAN5YR Page” means the display designated on page “GCAN5YR” on the Bloomberg Financial L.P. service (or such other page as may replace the GCAN5YR page on that service for purposes of displaying Government of Canada bond yields).

“Fixed Rate Calculation Date” means, for any Subsequent Fixed Rate Period, the 30th day prior to the first day of such Subsequent Fixed Rate Period.

“Government of Canada Yield” on any date means the yield to maturity on such date (assuming semi-annual compounding) of a Canadian dollar denominated non-callable Government of Canada bond with a term to maturity of five years as quoted as of 10:00 a.m. (Toronto time) on such date and which appears on the Bloomberg Screen GCAN5YR Page on such date; provided that, if such rate does not appear on the Bloomberg Screen GCAN5YR Page on such date, the Government of Canada Yield will mean the arithmetic average of the yields quoted to the Bank by two registered Canadian investment dealers selected by the Bank as being the annual yield to maturity on such date, compounded semi-annually, which a noncallable Government of Canada bond would carry if issued, in Canadian dollars in Canada, at 100% of its principal amount on such date with a term to maturity of five years.

And we don’t know how the GCAN5YR page is calculated (because it’s Bloomberg), although we can guess that it’s more akin to the US Treasury interpolation-on-a-fitted=curve method than it is to the Canadian pick-a-bond method because of the way the alternative calculation is stated. But that’s not a guarantee! Don’t bother calling your salesman to find out: if there’s one thing I have learnt over the course of my career, it’s that front-line staff don’t have a clue how their software works and wouldn’t understand it if they were told. They’re bankers, the sweet little dears, it’s their job to say “0.74 per cent” in a sincere voice, not to have a clue.

And, what’s more, we can’t even look up (for free) just what the GCAN5YR page might be saying at any particular point in time because fuck you, that’s why.

I don’t have Bloomberg – it’s incredibly expensive, it’s completely useless for serious work and it rots the brain – so I can’t provide any clues as to how the number might be calculated. Perhaps if some kind reader who does have access could provide a screenshot or two taken at around 4pm we can examine the matter more closely.

Effect of Varying GOC-5 Rate On Implied Volatility Rich/Cheap Analysis

Tuesday, February 3rd, 2015

Assiduous Reader Prefhound can always be relied upon for detailed analysis and he has not disappointed in his comment on the February 2 Market Report:

For the Jan 23 FTS series, the lowest reset spread was said to be “cheap”, but its return would only be higher than a higher reset spread if long run GOC-5 rose to an equilibrium around 3%. Current price and reset spreads made sense if the long run equilibrium GOC-5 yield were in the 1-1.5% range (vs 0.85% at the time). Only if the long run equilibrium GOC-5 Yield were 0-0.50% would the original rich/cheap analysis produce substantially different long run returns. This suggested to me that rich/cheap was fairly sensitive to long run GOC-5, so arbitrage returns would depend on changes in (and perception of) that benchmark. As you often note, perception can differ enormously from reality, so fixed reset arbitrage appears to have a substantial element of added GOC-5 risk.

It will be recalled that in my original essay on Implied Volatility for FixedResets I made the point that both the “Pure” price (that is, the price of a non-callable annuity) with any given spread would approach par as GOC-5 increased, while the option value would approach zero; thus, we may conclude that an increase in GOC-5 will cause all issues to move closer to their par value (and contrariwise!) regardless of whether they are at a premium or a discount.

As Prefhound has focussed on the January 23 analysis of the FTS FixedResets, I will show their data for that day to make it easier for Assiduous Readers to replicate and extend the analysis. My findings are at variance with Prefhound‘s conclusions, but I’m sure a bit more methodological detail will sort out a difference in assumptions:

FTS FixedResets: Characteristics
Ticker Current
FTS.PR.G 0.9708 +213 2018-9-1 24.70
FTS.PR.H 1.0625 +145 2015-6-1 18.28
FTS.PR.K 1.00 +205 2019-3-1 25.15
FTS.PR.M 1.025 +248 2019-12-1 25.58

So first we will perform a series of computations using the January 23 bids, but varying GOC-5; we come up with the following table:

  Rich / (Cheap)
5% 1% 247 -3.31 0.84 1.56 0.55
4% 1% 241 -2.98 0.79 1.55 0.3
3% 3% 234 -2.55 0.68 1.51 -0.02
2% 4% 227 -1.92 0.57 1.46 -0.31
1% 5% 217 -1.04 0.24 1.22 -0.7
0% 11% 196 -0.17 -0.17 0.8 -0.7

… which may be graphed as:

Click for Big

Further, we can use the Yield Calculator for Resets, which was given a thorough explanation in early December to determine the 25-year yield expected for each of the GOC-5 levels – note that no prior call is assumed in any of these calculations and that the end-price is set equal to current price. We derive the following table (nb: incorrect figures from the original post have been struck out and replaced with corrected figures 2015-2-4).

5% 8.80% 6.41% 6.19% 5.62% 6.26%
4% 7.47% 5.69% 5.50% 4.97% 5.64%
3% 6.14% 4.94% 4.79% 4.29% 4.99%
2% 4.80% 4.16% 4.05% 3.58% 4.31%
1% 3.45% 3.35% 3.28% 2.83% 3.60%
0% 2.09% 2.51% 2.47% 2.06% 2.86%

… and plotted as:

Click for Big
Corrected 2015-2-4

What makes this chart particularly fascinating is that the minimal difference between the four calculated yields is found at a value for GOC-5 that is very close to the actual GOC-5 rate of 0.78% at the close of that day:

Click for Big
Corrected 2015-2-4

This bears investigating … one might almost wonder if there isn’t some market making going on that has the effect of grouping these yields together …

Update, 2015-02-04: Prefhound wants to see the prices for the Implied Volatility fitting adjusted to reflect the period until the next Exchange Date. OK, here goes!

  Spread 145 213 205 248
2015-6-1 2018-9-1 2019-3-1 2019-12-1
2 15 17 20
1.0625 0.9708 1.00 1.025
Future Dividends
GOC5 5% 1.6125 1.7825 1.7625 1.87
4% 1.3625 1.5325 1.5125 1.62
3% 1.1125 1.2825 1.2625 1.37
2% 0.8625 1.0325 1.0125 1.12
1% 0.6125 0.7825 0.7625 0.87
0% 0.3625 0.5325 0.5125 0.62
Price Adjustment
GOC5 5% -0.35 -1.64 -2.07 -2.03
4% 0.15 2.11 2.18 2.98
3% 0.03 1.17 1.12 1.73
2% -0.10 0.23 0.05 0.48%
1% -0.23 -0.71 -1.01 -0.78
0% -0.35 -1.64 -2.07 -2.03
Effective Price
GOC5 5% 18.56 27.74 28.39 29.81
4% 18.43 26.81 27.33 28.56
3% 18.31 25.87 26.27 27.31
2% 18.18 24.93 25.20 26.06
1% 18.06 23.99 24.14 24.81
0% 17.93 23.06 23.08 23.56

And now we will perform a series of computations using the January 23 bids as adjusted in the above table, using the appropriate GOC-5:

  Rich / (Cheap)
5% 1% 193 -4.71 1.65 2.58 3.25
4% 1% 194 -4.51 0.50 1.52 2.27
3% 1% 216 -3.25 1.02 1.80 0.75
2% 3% 225 -2.11 0.65 1.38 -0.12
1% 7% 226 -0.73 0.29 0.95 -0.74
0% 26% 184 -0.23 0.23 0.67 -0.79

This allows the following chart to be drawn:

Click for Big

The price adjustments, of course, are very large, but it doesn’t make any difference to the fitting, which uses only prices. The Expected Future Current Yields are calculated only for display purposes. At any rate, while there are significant differences, the qualitative conclusions are the same – this chart looks pretty much the same as the one with unadjusted prices, although there’s a curious jog in the ‘Adjusted Price’ one.

What Is The Yield Of HSE.PR.A?

Friday, December 5th, 2014

Assiduous Reader B writes in and says:

I am a subscriber to your monthly newsletter but haven’t notice anything recent on this issue

My question is why would investors embrace the new issue at a yield of 4.50% while selling down the existing A issue which is now paying a yield that is a full percentage point higher.

I recognize the higher reset rate but the yield spread still seems excessive.

Thanks for your assistance

So, since he’s a customer I answered; and I said:

I will address your question in a post on tonight, but in the meantime can you tell me why you believe that HSE.PR.A is yielding a full percentage point higher?

… and he responded:

Thanks James for getting back to me – according to my screen on TD, HSE PR A is yielding 5.68 – the new issue is yielding 4.50% – I know there is something to be said for the extra reset pickup but the difference in current yield seems excessive

… and he included a picture:

Click for Big

OK, so his first mistake is getting advice – even advice on such a simple thing as yield – from a bank. You should never seek advice or analysis from a bank, because they’re all domeless wonderboys, with about enough brains to say “We’re big!” and not much else.

In this particular case, TD has told him that the yield on HSE.PR.A, when quoted at 19.56-59, is 5.6789%, which a little experimentation tells us, is the Current Yield Ask, that is to say, the Current Dividend, 1.1125, divided by the Ask Price of 19.59, equals 5.6789178%, where I have tacked another three decimal places on to their reported figure just to sneer at the bank and their precious four decimal places of meaningless precision.

Never Use Current Yield When Analyzing Preferreds

It isn’t even accurate when evaluating Straight Perpetuals (since the relationship between the calculation date and the next payment date is a significant source of error), and is absolutely hopeless when evaluating something that may be called (which is not important in this case) or which is expected to experience a change in dividend (which is very important in this case).

Assiduous Reader B has made the mistake of assuming that the Issue Reset Spread is of minor importance, a mere adjustment to Current Yield, but in this case the projected dividend is so different from the current dividend that he’s wrong.

HSE.PR.A is a FixedReset, 4.45%+173, that commenced trading 2011-3-18 after being announced 2011-3-10. It resets in March, 2016, and if the GOC-5 yield continues to be at its yield of 1.45%, the reset rate will be 3.18%, a 29% drop from current levels.

One chart I am particularly fond of illustrates the relative importance of the Current Dividend vs. the Issue Reset Spread for FixedResets that may be assumed to be perpetual (which is a pretty good bet in this case):

Click For Big

Given that HSE.PR.A resets in a little over one year, we see that the headline figure, 4.45%, contributes less than 10% of the valuation of the instrument – all the rest is entirely up to the Issue Reset Spread.

So, given that we know the importance of the Issue Reset Spread, how can we work out the all in yield of the issue in order to allow us to compare HSE.PR.A to the new issue, which is a FixedReset, 4.50%+313?

The answer is to use the Yield Calculator for Resets, which is an Excel Spreadsheet I have made available to the public, linked on the Right-Hand Navigation Panel under the heading “Calculators”. [Update: Note that this calculator has been improved since this post was written; the input of the data has been simplified. … JH 2015-8-7] It should be noticed that this is not a magic black box, nor is it particularly sophisticated. It’s simply a tool to allow a schedule of cash flows to be input into a spreadsheet easily. So to use the tool, we input our data into the yellow boxes. We’ll get the results of the calculation in the green boxes and the calculation is performed in the turquoise boxes;; we don’t touch them. Only touch the yellow boxes:

  • Current Price: we’ll put in 19.59, because that’s what the bank used.
  • Call Price: You can put in the call price here, but we’re not expecting the issue to be called – we expect it to remain outstanding in 25 years. So what will the price be in 25 years? There are various approaches to this, one of which is discussed in PrefLetter, but it’s reasonable to assume that in 25 years it will be priced the same as it is now, so we’ll put in 19.59. If you don’t like 19.59, put in some other number. It’s not magic. The Yield Calculation Police won’t take you away if you put in some other number. But your calculation is only as good as your assumptions, so if you calculate a very high yield by inputting some silly price – like $50.00 – as the end-price, well, your calculation is only as good as your assumptions.
  • Settlement Date: Strictly speaking, we should put in the date that a trade executed today will settle (2014-12-9), but I usually use the Trade Date, on the grounds that the bank won’t even let you enter the order unless you’ve got money available RIGHT NOW to pay for it. So I’ll input 2014-12-4.
  • Call Date: If it was priced at $26.00 and I was expecting it to be called, I would put in the call date. But I expect it to be around in twenty-five years (the maximum allowable in this spreadsheet) so I’ll put in 2039-12-4. Again, it’s up to you. If detailed examination of the numerological code embedded in The Gospel According To St. Mark has convinced you that it will be priced at 21.13 on 2028-7-8, go ahead and put in that call price and that date. Don’t worry about the Yield Calculation Police, I’ve paid them off.
  • Quarterly Dividend: So what dividend does it pay right now, expressed as a quarterly amount? I hate using a calculator to calculate six decimal places, so I will input a tiny Excel formula “=25 * 0.0445 / 4”, that is, “equal to the par value times the annual coupon rate divided by four”.
  • Cycle: This gets a little tricky, because we need to know the pay-date of each dividend. A little research tells us it’s paid on the last day of each quarter, March / June / September / December, which is cycle 3. So plug in “3”
  • Pay Date: So what day of these months? It’s the last day, so plug in “31”. In the cash flow schedule, the calculated date “June 31” will be transformed to “July 1”, as you can see in the turquoise area to the right of the data input area. This is a bit of an error, but a very tiny one.
  • Include First Dividend: This is quite important. As the spreadsheet tells you, the next dividend payment is December 31, based on the information you’ve input above. If you buy it today, will you earn that dividend? You’ll have to look up the ex-dividend date for the issue; in this case the ex-dividend date was 2014-11-25, which is now in the past, so you WON’T get the next dividend, so input “0”
  • First Dividend Value: For most issues, the first dividend payment is for a different amount from the others, since it’s adjusted to reflect the time from the security’s issue to the pay date, rather than pay-date to pay-date. HSE.PR.A has been around for a long time, so this does not apply and we’re not even earning the next dividend anyway, so it doubly doesn’t matter. Leave this field blank.
  • Reset Date: The issue resets 2016-3-31. Plug in this date
  • Quarterly Dividend After Reset: This is the moment we’ve all been waiting for! We have to estimate what the dividend will be after the reset, while bearing in mind that the yield we calculate will only be as good as our estimates. It’s generally best to assume that major market yields will not change; that on the reset calculation date the 5-year GOC yield will be the same as it is today, 1.45%. But if you feel this is unreasonable, put in another number you’re more comfortable with. If you think that 1.45% is ridiculous and that GOC-5 will be 2.00% on recalculation day, use 2.00%. You have to use some kind of assumption, there’s no way around that. We will note that TD’s calculation, in using Current Yield, assumed the dividend would not change; i.e., that the dividend would reset to be equal to the 4.45% it is currently, i.e., that GOC-5 on reset calculation date will be 2.72%. Well, if that’s the number you want to use, go ahead. It’s a free country and you can assume anything you like. Just remember that the quality of your yield estimate will reflect the quality of your assumptions; and also remember that consistency is a virtue, so if two issues are resetting at the same time, you should use the same estimate for GOC-5. But I will assume a future GOC-5 rate of 1.45%, so I’ll input the Excel formula “=25 * (0.0145 + 0.0173) / 4” = par value * (sum of assumed GOC-5 rate and Issue Reset Spread [expressed annually]) divided by 4 [quarters per year]. We should also note that the spreadsheet makes no provision for changes in GOC-5, so if you feel that GOC-5 will be 2.00% on the 2016 reset calculation date, but 3.00% on the 2021 reset calculation date, you’ll have to develop your own elaboration of this spreadsheet.

And that’s the end of our input and our answer pops up in the green boxes! Current Yield, 5.68%, just as advertised by TD, but an Annualized Quarterly Yield To Call of 4.17%. That’s quite a difference! And, I will note, it is substantially less than the New Issue FixedReset, 4.50%+313. Implied Volatility Theory tells us to expect less for a deeply discounted issue compared to one at or near par value, but just how much less it should be is a whole ‘nuther issue.

And, I suggest, you should always think of this number as “4.17%, assuming an end-price of 19.59 and a constant GOC-5 of 1.45%”, just to remind yourself of the two critical assumptions you made.

So there you have it. I suggest that those interested in using this spreadsheet as an adjunct to their trading first check all the calculations – Trust But Verify! – and second, play around with it a bit. Change the assumptions of end-price and GOC-5 estimate on reset, see how sensitive the answers are to the inputs. The better you understand your data, the better an investor you’ll be.

Market-Based Bank Capital Regulation

Wednesday, March 5th, 2014

Assiduous Reader DR sent me the following query:

Today’s Financial Posts has an article “A better Basel mousetrap to protect taxpayers”, by Finn Poschmann regarding NVCC.

What is your opinion?

A short search brought up the article in question, A Better Basel Mousetrap to Protect Taxpayers, which in turn led me to the proposal by Jeremy Bulow and Paul Klemperer titled Market-Based Bank Capital Regulation:

Today’s regulatory rules, especially the easily-manipulated measures of regulatory capital, have led to costly bank failures. We design a robust regulatory system such that (i) bank losses are credibly borne by the private sector (ii) systemically important institutions cannot collapse suddenly; (iii) bank investment is counter-cyclical; and (iv) regulatory actions depend upon market signals (because the simplicity and clarity of such rules prevents gaming by firms, and forbearance by regulators, as well as because of the efficiency role of prices). One key innovation is “ERNs” (equity recourse notes — superficially similar to, but importantly distinct from, “cocos”) which gradually “bail in” equity when needed. Importantly, although our system uses market information, it does not rely on markets being “right.”

Our solution is based on two rules. First, any systemically important financial institution (SIFI) that cannot be quickly wound down must limit the recourse of non-guaranteed creditors to assets posted as collateral plus equity plus unsecured debt that can itself be converted into equity–so these creditors have some recourse but cannot force the institution into re-organization. Second, any debt guaranteed by the government, such as deposit accounts, must be backed by government-guaranteed securities. This second rule can only realistically be thought of as a very long-run ambition – our interim objective would involve a tight ring-fence of government-guaranteed deposits collateralized by assets that are haircut at rates similar to those applied by lenders (including central banks3 and the commercial banks themselves!) to secured borrowers.

Specifically: first, we would have banks replace all (non-deposit) existing unsecured debt with “equity recourse notes” (ERNs). ERNs are superficially similar to contingent convertible debt (“cocos”) but have important differences. ERNs would be long-term bonds, subject to certain term-structure requirements, with the feature that any interest or principal payments payable on a date when the stock price is lower than a pre-specified price would be paid in stock at that pre-specified price. The pre-specified price would be required to be no less than (say) 25 percent of the share price on the date the bond was issued. For example, if the stock were selling at $100 on the day a bond was issued and then fell below $25 by the time a payment of $1000 was due, the firm would be required to pay the creditor (1000/25) = 40 shares of stock in lieu of the payment. If the stock rebounded in price, future payments could again be in cash.

Crucially, for ERNs, unlike cocos:

  • any payments in shares are at a pre-set share price, not at the current share price or at a discount to it—so ERNs are stabilizing because that price will always be at a premium to the market
  • conversion is triggered by market prices, not regulatory values—removing incentives to manipulate regulatory measures, and making it harder for regulators to relax requirements
  • conversion is payment-at-a-time, not the entire bond at once (because ERNs become equity in the states that matter to taxpayers, they are, for regulatory purposes, like equity from their date of issuance so there is no reason for faster conversion)–further reducing pressures for “regulatory forbearance” and also largely solving a “multiple equilibria” problem raised in the academic literature
  • we would replace all existing unsecured debt with ERNs, not merely a fraction of it—ensuring, as we show below, that ERNs become cheaper to issue when the stock price falls, creating counter-cyclical investment incentives when they are most needed.

OK, so I have difficulties with all this. Their first point is that non-guaranteed creditors “cannot force the institution into re-organization.” Obviously there are many differences of opinion in this, but I take the view that being able to force a company into re-organization – which may include bankruptcy – is one of the hallmarks of a bond. For example, I consider preferred shares to be fixed income – as they have a cap on their total return and they have first-loss protection – but I do not consider them bonds – as they cannot force bankruptcy. The elimination of bankruptcy, although very popular among politicians (who refer to bankruptcy as a form of terrorism) is a very big step; bankruptcy is a very big stick that serves to concentrate the minds of management and directors.

Secondly, they want insured deposits to be offset by government securities. There’s an immediate problem about this in Canada, because insured deposits total $646-billion while government of Canada marketable debt totals $639-billion. You could get around this by saying the CMHC-guaranteed mortgages are OK, but even after years of Spend-Every-Penny pouring fuel on the housing fire, CMHC insurance totals only $559.8-billion (out of a total of $915-billion. At present, Canadian Chartered Banks hold only about $160-billion of government debt. So it would appear that, at the very least, this part of the plan would essentially force the government to continue to insure a ridiculous proportion of Canadian residential mortgages.

And, specifically, they want all (non-deposit) existing unsecured debt with “equity recourse notes”. OK, so how much is that? Looking at recent figures from RBC:

Click for Big

So roughly a quarter of Royal Bank’s liabilities would become ERNs …. and who’s going to buy it? It’s forcibly convertible into equity long before the point of non-viability – that’s the whole point – so for risk management purposes it is equity. If held by another bank, it will attract a whopping capital charge (or if it doesn’t, it should) and it can’t be held by institutional bond portfolios (or if it is, it shouldn’t be). I have real problems with this.

The paper makes several entertaining points about bank regulation:

The regulatory system distorts incentives in several ways. One of the motivations for Citigroup to sell out of Smith, Barney at what was generally believed to be a low price, was that it allowed Citi to book an increase in regulatory capital. Conversely, selling risky “toxic assets” with a regulatory value greater than market is discouraged because doing so raises capital requirements even while reducing risk.[footnote].

[Footnote reads] : Liquidity reduction is another consequence of the current regulatory system, as firms will avoid price-discovery by avoiding buying as well as selling over-marked assets. For example, Goldman Sachs stood ready to sell assets at marks that AIG protested were too low, but AIG did not take up these offers. See Goldman Sachs (2009). For an example of traders not buying even though they claimed the price was too low, see the FCIC transcript of a July 30, 2007 telephone call between AIG executives. “We can’t mark any of our positions, and obviously that’s what saves us having this enormous mark to market. If we start buying the physical bonds back … then any accountant is going to turn around and say, well, John, you know you traded at 90, you must be able to mark your bonds then.” Duarte (2012) discusses the recent trend of European banks to meet their requirements to raise regulatory capital by repurchasing their own junk bonds, arguably increasing the exposure of government insurers.

However, don’t get me wrong on this: the basic idea – of conversion to a pre-set value of stock once the market breaches that pre-set value – is one that I’ve been advocating for a long time. They are similar in spirit to McDonald CoCos, which were first discussed on PrefBlog under the heading Contingent Capital with a Dual Price Trigger (regrettably, the authors did not discuss McDonald’s proposal in their paper). ERNs are ‘high-trigger’ instruments, and therefore will help serve to avert a crisis, rather than merely mitigate one, as is the case with OSFI’s NVCC rules; I have long advocated high triggers.

My basic problem is simply that the authors:

  • Require too many ERNs as a proportion of capital, and
  • Seek to Ban the Bond

However, it may easily be argued that these objections are mere matters of detail.

Calculation of RatchetRate Dividend Yield

Wednesday, February 12th, 2014

Assiduous Reader DT writes in and says:

I have been following your blog for quite some time but I have a question that I can not find a clear answer to….
Can you explain how an issuer calculates the ‘Ratchet Rate’ of their preferred shares on a given reset date?

The prospectus for BCE.PR.S / BCE.PR.T provides an archetypal example:

The annual floating dividend rate for the first month will be equal to 80% of Prime. The dividend rate will float in relation to changes in Prime and will be adjusted upwards or downwards on a monthly basis by an adjustment factor whenever the Calculated Trading Price of the Series S Preferred Shares is $24.875 or less or $25.125 or more respectively.

The maximum monthly adjustment for changes in the Calculated Trading Price will be ±4.00% of Prime. The annual floating dividend rate applicable for a month will in no event be less than 50% of Prime or greater than Prime.

The Adjustment Factor for a month will be based on the Calculated Trading Price of the Series S Preferred Shares for the preceding month determined in accordance with the following table:

If the Calculated Trading Price for the Preceding Month is The Adjustment Factor as a
Percentage of Prime shall be
$25.50 or more -4.00%
$25.375 and less than $25.50 -3.00%
$25.25 and less than $25.375 -2.00%
$25.125 and less than $25.25 -1.00%
Greater than $24.875 and less than $25.125 nil
Greater than $24.75 to $24.875 1.00%
Greater than $24.625 to $24.75 2.00%
Greater than $24.50 to $24.625 3.00%
$24.50 or less 4.00%

The maximum Adjustment Factor for any month will be ±4.00% of Prime.

This mechanism is very briefly summarized in my article Preferred Pairs.

All RatchetRate issues will be paired with a FixedFloater, but both elements will not necessarily be trading at the same time.

The Pairs Equivalency Calculator takes advantage of the known time before conversion opportunity and the fact that all these are now paying 100% of prime (and are more likely than not to continue at this rate until this time) to calculate an implied average prime rate that makes the two series equivalent. This relative value analysis can be useful; if you are enamoured of this type of share, it may turn out that your best bet is to buy the FixedFloater with the intent of converting.

The pairs currently are:

FixedFloater RatchetRate
BCE.PR.R Not trading
BCE.PR.I Not trading

It is the adjustment to the RatchetRate that makes these unsuitable for banks – in order to qualify at Tier 1 Capital, preferred shares must not have any provisions that provide compensation for loss of credit quality.

For those seeking to compare RatchetRates with FloatingResets, note that Prime is usually 3-Month Bills + 200bp. For this reason, we can reasonably expect that the RatchetRates currently extant will (a) trade below $25 forever and (b) remain outstanding forever and (c) that we could be wrong about (a) and (b), so don’t mortgage the house.

New RBC / NA / CWB reset prefs

Monday, February 3rd, 2014

I have been asked, in an eMail with the captioned title:

Not sure this is going to the right place. Can’t find anyone else to send these comments to.

I owned a number of bank “rate reset” prefs. In the past year, many have been redeemed, and a few have been reset for another 5 years.

There are 3 new issues that recently came out (RY / NA / CWB) with changes to factor in the new Basel capital requirements. My understanding is that basically, if real bad things happen to the bank, the shares can be converted to commons without the holders consent.

In my mind, this is a major negative change to an investor’s position compared to the previous reset prefs. But the pricing of these new issues (either the rate or reset premium) does not seem to give any value to the additional risk. In addition, there does not seem to be any discussion or commentary of the additional exposure anywhere. Is it possible that the people selling these new issues might have a bit of a conflict position (the brokerage houses are all owned by the banks).

Do you have any thoughts on this? If you agree, how does one convince the market that the pricing needs to be adjusted?

I would appreciate any comments you might have – maybe I’m missing something in my thinking. Thank you.

The new issues referred to are:

The desire for change is fueled by political resentment that European banks were bailed out while Tier 1 Capital note-holders were not wiped out and in some cases were unscathed (see my article Prepping for Crises; particularly the footnoted draft version. Or you could just google “burden sharing”).

As I have stressed in the past the big problem is that the Superintendent of Financial Institutions has a huge amount of discretion:

Principle # 3: The contractual terms of all Additional Tier 1 and Tier 2 capital instruments must, at a minimum Footnote 41, include the following trigger events:
  • a.
    the Superintendent of Financial Institutions (the “Superintendent”) publicly announces that the institution has been advised, in writing, that the Superintendent is of the opinion that the institution has ceased, or is about to cease, to be viable and that, after the conversion of all contingent instruments and taking into account any other factors or circumstances that are considered relevant or appropriate, it is reasonably likely that the viability of the institution will be restored or maintained; or
  • b. a federal or provincial government in Canada publicly announces that the institution has accepted or agreed to accept a capital injection, or equivalent support, from the federal government or any provincial government or political subdivision or agent or agency thereof without which the institution would have been determined by the Superintendent to be non-viable Footnote 42.

The term “equivalent support” in the above second trigger constitutes support for a non-viable institution that enhances the institution’s risk-based capital ratios or is funding that is provided on terms other than normal terms and conditions. For greater certainty, and without limitation, equivalent support does not include:

  • i. Emergency Liquidity Assistance provided by the Bank of Canada at or above the Bank Rate;
  • ii. open bank liquidity assistance provided by CDIC at or above its cost of funds; and
  • iii. support, including conditional, limited guarantees, provided by CDIC to facilitate a transaction, including an acquisition or amalgamation.

In addition, shares of an acquiring institution paid as non-cash consideration to CDIC in connection with a purchase of a bridge institution would not constitute equivalent support triggering the NVCC instruments of the acquirer as the acquirer would be a viable financial institution.

The first trigger is the tricky one, although there are also problems with number 2.

This uncertainty has led DBRS to rate these issues a notch lower than other bank issues (in line with S&P’s earlier decision), but there doesn’t appear to be any market recognition of this analysis.

This is precisely what the regulator wants – they have long been in favour of a low trigger for contingent conversion, in opposition to much of the rest of the world. As discussed on October 27, 2011 (the internal link is broken as part of OSFI’s policy to discourage public discussion of their pronouncements), OSFI dismissed high-triggers; while there were lots of rationalizations in their NVCC roadshow, the real reason was articulated by Ms. Dickson in a speech:

The conversion trigger would be activated relatively late in the deterioration of a bank’s health, when the supervisor has determined that the bank is no longer viable as currently structured. This should result in the contingent instrument being priced as debt. Being priced as debt is critical, as it makes it far more affordable for banks, and therefore has the benefit of minimizing the impact on the costs of consumer and business loans.

So to hell with high-trigger CoCos and their potential to avert a crisis! In normal times, it will be cheaper for the banks to issue low-trigger CoCos and thereby be able to pay their directors more, particularly the ones who are ex-regulators.

So that’s the background. With respect to the reader’s question:

If you agree, how does one convince the market that the pricing needs to be adjusted?

Well, you can’t, really. I get a lot more requests to recommend bank issues, good solid Canajun banks, none of this insurance or utility garbage, on the grounds of “safety”, than I get requests to comment on risk factors particularly applicable to bank issues.

All you can do is make your own assessment of risk and your own assessment of reward, feed all your analysis into the sausage-making machine, hope you’ve made fewer analytical errors than other market participants and that the world doesn’t change to such a degree that analysis was useless anyway. Which isn’t, perhaps, the most detailed advice I have ever given, but it’s the best I can do.

Final Dividend Calculation Questions

Friday, August 30th, 2013

I have received not just one, but two separate inquiries about the calculation of a final dividend lately, so I’ll publish this note to assist those who are too shy to eMail me…

For those unwilling to plough through the following (cough, cough), final dividend calculation may be summarized as:

  • Dividends are paid for a specific period
  • This period usually, but not always, is up to and including the payment date.
  • Ex-date and record date have nothing to do with it – at least, not in any instances of which I am aware
  • For an explanation of the dates, read my essay Dividends and ex-Dates
  • To determine the periods over which dividend payments are earned, read the prospectus with respect to the first dividend … the prospectus will generally include some statement along the lines of: “The first dividend will be paid on XXXX, and will be for $YYY per share, assuming that the issue closes on ZZZZ”. The fraction of a year between XXXX and ZZZZ will generally, but not always be equal to the fraction of the annual dividend paid on ZZZZ.

So, the first inquiry was sent by Assiduous Reader KB:

I wonder if you could clear up a question I have about Fixed Reset shares.

I was reading this months PrefLetter and was a bit confused by a yield calculation, so I went to the prospectus of some Fixed-Reset shares I own.

Both bank fixed-resets (RY.PR.P and TD.PR.K) are worded a particular way that concerns me, yet two non-bank fixed-resets MFC.PR.D and BAM.PR.P) are worded differently.

The bank fixed-resets state that dividends are paid every quarter, but excludes the initial rate on the last dividend for the final reset/call date? (see the pertinent prospectus excerpt reprint below.)

The non-bank fixed-resets include the initial rate on the last dividend for the final reset/call date? (see the pertinent prospectus excerpt reprint below.)

Question: Are the banks indicating that the dividend on the reset/call date (if reset) will be at the new dividend rate, and (if called) will be at the old dividend rate, yet the non-banks pay the old dividend rate on the reset/call dates regardless if called or reset?

Our Non-Cumulative 5-Year Rate Reset First Preferred Shares, Series AP (the “Series AP Preferred Shares”) will be entitled to fixed non-cumulative preferential cash dividends, payable quarterly on the 24th day of February, May, August and November in each year, as and when declared by our board of directors, for the initial period from and including the closing date of this offering to, but excluding, February 24, 2014 (the “Initial Fixed Rate Period”) at a per annum rate of 6.25%, or $1.5625 per share per annum. The initial dividend, if declared, will be payable on May 24, 2009 and will be $0.55651 per share, based on an anticipated issue date of January 14, 2009 …………………….. Subject to the provisions of the Bank Act (Canada) (the “Bank Act”) and the consent of the Superintendent of Financial Institutions Canada (the “Superintendent”), on February 24, 2014 and on February 24 every fifth year thereafter, we may redeem the Series AP Preferred Shares in whole or in part by the payment of $25.00 in cash per share together with declared and unpaid dividends to the date fixed for redemption.

This offering (the “Offering”) of Non-cumulative Rate Reset Class A Shares, Series 4 (the “Series 4 Preferred Shares”) of Manulife Financial Corporation (“MFC”) under this prospectus supplement (the “Prospectus Supplement”) consists of 14,000,000 Series 4 Preferred Shares. The holders of Series 4 Preferred Shares will be entitled to receive fixed non-cumulative preferential cash dividends, as and when declared by the board of directors of MFC (the “Board of Directors”), for the initial period commencing on the Closing Date (as defined herein) and ending on and including June 19, 2014 (the “Initial Fixed Rate Period”), payable quarterly on the 19th day of March, June, September and December in each year (each three-month period ending on the 19th day of each such month, a “Quarter”), at an annual rate equal to $1.65 per share. The initial dividend, if declared, will be payable June 19, 2009 and will be $0.4837 per share, based on the anticipated closing date of March 4, 2009 (the “Closing Date”) …………………….. The Series 4 Preferred Shares will not be redeemable by MFC prior to June 19, 2014. On June 19, 2014 and on June 19 every five years thereafter, but subject to the provisions of the Insurance Companies Act (Canada) (the “ICA”), including the requirement of obtaining the prior consent of the Superintendent of Financial Institutions (the “Superintendent”), and subject to certain other restrictions set out in “Details of the Offering — Certain Provisions of the Series 4 Preferred Shares as a Series — Restrictions on Dividends and Retirement of Series 4 Preferred Shares”, MFC may, at its option, on at least 30 days and not more than 60 days prior written notice, redeem for cash all or from time to time any part of the outstanding Series 4 Preferred Shares for $25.00 per Series 4 Preferred Share, together in each case, with an amount equal to the sum (the “Accrued Amount”) of (i) all declared and unpaid dividends in respect of completed Quarters preceding the date fixed for redemption; and (ii) an amount equal to the cash dividend in respect of the Quarter in which the redemption occurs, whether declared or not, pro rated to such date.


I answered with the following:

There is no need to worry.

If you examine the prospectus for TD.PR.S ([1].pdf) you will see that it is worded similarly to the other banks: “The holders of the Series S Shares will be entitled to receive fixed quarterly non-cumulative preferential cash dividends, as and when declared by the board of directors of the Bank (the “Board of Directors”), for the initial period from and including the closing date of this offering to but excluding July 31, 2013 (the “Initial Fixed Rate Period”), payable on the last day of January, April, July and October in each year (each three-month period ending on the last day of each such month, a “Quarter”), at a per annum rate of 5.00% per share, or $0.3125 per share per Quarter”

The dividends for the final period were at the old rate:

I believe that this is simply due to questions about how to count the days and refer to this count, given that interest is actually earned overnight (between the close on day X and the opening on day X+1) rather than during the day.

Every lawyer will have his own idea about whether the interest earning period is day X or day X+1 and draft the prospectus accordingly. And once the first prospectus is drawn up for a given firm, it is used as a template for the next one.

The next question came from Assiduous Reader GK:

Specifically, on BNA.PR.D, I know the call is July 9, 2014, and the last dividend record date is May 22 (or thereabouts).

I am interested in this series for a short term investment.

My question is, is there any accrued interest in the period between May 22 and the call date, July 9?

And my response:

This one is a little tricky and requires us to have a look at the prospectus for the issue, available on SEDAR.

First: “All Series 4 Preferred Shares outstanding on July 9, 2014 (the ‘‘Series 4 Redemption Date’’) will be redeemed for a cash amount equal to the lesser of (i) $25.00 plus any accrued and unpaid dividends, and (ii) the Net Asset Value per Unit.”

So on July 9 we will indeed be paid accrued dividends, if any. Are there any? With respect to the first dividend, the prospectus states: “Based upon the anticipated closing date of July 9, 2009, the initial dividend (which covers the period from closing to August 31, 2009) is expected to be $0.26318 per Series 4 Preferred Share and is expected to be paid on or before September 7, 2009 to holders of record on August 21, 2009.”

So checking: July 9 to August 31 is 22 + 31 = 53 days, and the expected dividend is: quarterly divided * 4 * fraction of year = paid dividend, or

$0.453125 * 4 * (53/365) = 0.263185

Which agrees with their calculation (except they rounded down, the bastards!)

So dividends are paid for quarterly periods ending at month-end February, May, August and November.

Therefore, on redemption July 9, dividends will be owing for the period May 31 – July 9 = 39 days = (39/365) of a year, so:

$0.453125 * 4 * 39/365 = 0.193664.

So it would appear that accrued and unpaid dividends of 0.193664 per share will be paid on redemption July 9, 2014. I urge you to double check this calculation and see if you can get confirmation from the company itself – see contact information at

SplitShare Capital Unit Debate

Thursday, March 3rd, 2011

Assiduous Readers will remember that I was quoted in a recent article by John Heinzl expressing a strong opinion on the Capital Units issues by SplitShare corporations:

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

This statement has attracted a certain amount of commentary and I have received some material criticizing my views. All further quotes in this post have been taken, in order, from an eMailed commentary – it has been interspersed with my commentary, but is quoted verbatim and in its entirety.

Response to “Ups and Downs of Doing The Splits” – John Heinzl, Globe and Mail, March 2, 2011

I have had a lot of involvement in split shares over the last two years, and I have to differ markedly from the assessment of Mr. Hymas, who prefers the preferreds to the capital units. I believe the exact opposite to be the case.

The split-share preferreds have limited upside, yet unlimited downside. They are essentially equity investments with a ‘preferred share’ wrapper. Most have downside protection to some degree, but rest assured, they can fall pretty well as much as the equity market can.

Asymmetry of returns is a feature of all fixed income, not simply SplitShare preferreds. Naturally, they can default, and one must take account of the chance of default: but firstly most will have Asset Coverage of at least 2:1 at issue time – meaning that the underlying portfolio can drop by half before the preferred shareholders take any loss at all – and secondly the Capital Unitholders will be wiped out before the preferred shareholders lose a penny.

No, there are no guarantees – there never are. But the preferreds have at issue time a significant amount of first-loss protection provided by the Capital Units.

The capital units are a whole other story. In my view they offer the BEST deal out there.

Imagine if you had a $100,000 portfolio of Canadian equities. You are totally exposed to the performance of the underlying assets, so a market fall of 50% takes an equivalent bite out of your assets. Now suppose instead you invest in a capital share with the following characteristics: leverage factor is 3.75 times. Discount to NAV is 20%. Maturity is 3 years. (These numbers are most assuredly achievable).

These numbers can be illustrated by the following:
Preferred Par Value: $10.00
Whole Unit NAV: $13.64
Price of Capital Units: $2.91

However, the capital units are issued at a premium to NAV (since they absorb all the issue expenses) of 5-10%. Thus, by choosing this example, you are to a degree saying that the Capital Units are only worth buying once they have lost about 25% of their value relative to NAV and have lost most of their NAV as well. I claim that this shows that the guys who paid full price for them are suckers.

While discounts of market price to intrinsic value are not unknown, they are by no means automatic. I gave a seminar on SplitShares in March, 2009 – the very height of the crisis! – and used the following chart to illustrate the fact that, even (or particularly!) when distressed, these things will generally trade at a premium to intrinsic value:

Click for Big

The seminar was videotaped and is available for viewing (and downloading in Apple QuickTime format for personal use) for a small fee.

You could invest $26,667 in the capital units, and put the remainder in cash or investment grade bonds yielding , say, 3.5%. By doing so you get the same upside as the underlying assets.

Actually, it will be a bit better, because at maturity the discount will be made up, so you get an extra kicker of 6% per year. But in the event of a 50% fall in the market, although you would probably lose all of the value of the capital units, your cash would remain at $73,333, plus interest. You have dramatically outperformed on the downside, losing about 27% vs. 50%.

Yes, certainly, but you are not looking at the situation at issue time. You are looking for a distressed situation, in which somebody (the sucker) has already taken an enormous loss, not just on the NAV but also on the market price relative to NAV. Your illustration relies on the same presumption as the attractiveness of the preferred shares: the willingness of the sucker to take the first loss.

Not all split share capital units are attractive: some trade at premiums, and offer little leverage. Remember, these things are effectively long-dated options or warrants, although – even better – they can receive dividends. Any option or warrant calculator will tell you that if the capital units are priced correctly they should trade at a premium, not a discount, especially when leverage increases.

I discussed the valuation of Capital Units as options in my Seminar on SplitShares and provided the following charts. The first shows the theoretical value – given reasonable assumptions regarding volatility – of the capital units as the Whole Unit NAV changes. I will also note that this computation of theoretical value ignores all of the cash effects in the portfolio – dividends in, dividends out, fees and expenses out and portfolio changes to offset these effects – that will, in general, reduce the attractiveness of the Capital Units.

Click for Big

The second shows the premium of expected market price over intrinsic value as the NAV changes:

Click for Big

Instead, over the last few years I have seen cases where capital units offered leverage of up to 20 times, and yet still traded at a discount to NAV. That remarkable set of circumstances enabled investors to replace all-equity portfolios with a capital shares and cash combination portfolio which limited their equity exposure, and hence risk, to a fraction of what would otherwise be the case. Yet without losing any upside.

The remarkable paradox about capital units is that the higher the leverage, and hence the risk, in these things, the more one can reduce portfolio risk.

Scott Swallow, Financial Advisor
Manulife Securities Incorporated

Scott, I suggest that the critical element of your argument is the phrase “remarkable set of circumstances” and that, in the absence of such remarkable circumstances, our views are probably not very different.

Perhaps, as printed, my “sucker” epithet was too general – I certainly did not mean to suggest that all capital units were always bad all the time at all prices. If somebody offers to sell me capital units with an intrinsic value of $10 for a penny each, I’ll back up the truck! As I like to say, at the right price, even a bag of shit can be attractive: I buy fifteen of them every spring for my garden! So, perhaps I can be faulted for not qualifying my statement enough – but the reporter and I were talking about the issuance of these securities and he only had 1,000 words or so to work with – a full investigation of Split Shares takes considerably more space than that.

But your argument, as stated earlier, rests on the assumption that somebody else has taken a double loss – first on NAV, then on market price relative to NAV. I claim, that given the risk-reward profile of capital units at issue time in general, the IPO buyers (and most of those in the secondary market) are suckers.