PrefBlog

I recently received the following communication from an Assiduous Reader:

Hello James

I have recently discovered your website and your excellent coverage of preferreds.  As an investor I am always, it seems, at loss for research and information sources on the subject so your website is a welcome surprise.

Like many I am the (not so) proud owner of a handful of perpetuals including the infamous BAM.PR.N.  As you have mentioned in your blog it is difficult for many investors to understand and make sense of the brutal price drop of this and other similar issues.

I understand the nature of perpetuals and their strong sensitivity to interest rate movements (or even the hint) so I am not surprised by the drop.  The way I look at it the yield is a leveraged function of the share price.  If current dividends are now 20% higher than new issues in the summer then it makes sense that share prices are 20% lower too.

Alternatively if interest rates drop in the future it should result in a return to higher valuations.

It’s never easy to live with drastic downward fluctuations in price and especially so with preferreds as we tend to buy them for their stability and preferential tax treatment.  I can live more easily with significant price drops from issuers like major Canadian banks and insurance companies because I am confident that the drop is a reaction to interest rates or, in the current environment, the asset backed commercial paper issue rather than some fundamental problem.  The situation with BAM.PR.N is perplexing though.  The price drop has gone beyond annoying into the realm of worrisome.

I guess I am asking your opinion on this issue in particular as it seems to have been singled out for brutal punishment.  From what I have read in your blog this price drop is way overdone.  Does that mean that we should stand firm and tough it out?  If this dramatic price drop is strictly a result of the asset backed commercial paper debacle then it makes sense to weather the storm until the problem runs it’s course.  If, on the other hand there are fundamental problems with BAM then does it make sense to cut and run?

I don’t mind waiting out the storm if it’s going to end up sunny.

Thanks for listening.

Frankly, I hate getting this kind of communication. The reader is not a client, I know nothing about his financial situation, I know nothing about his portfolio, I’m not making any money attempting to answer his question and there’s no good answer to his question anyway!

However, pretending to answer the question about the prospects for BAM.PR.N gives me a vehicle to reiterate my favourite themes … so here goes!

I wish I knew! If I knew for sure that BAM.PR.N was going to pay every single one of its projected dividends until Doomsday, I’d give up on this boring diversification routine I keep harping on and just lever up on the damn things 30:1 (assuming I could!).

If I knew for sure that BAM.PR.N was going to go bankrupt in two years, then I’d be shorting it 30:1. Why not?

Unfortunately, I don’t know anything for sure and, what’s more, I won’t claim that I do.

Life would be so much easier if I was stockbroker! If I was a stockbroker, all I’d have to do is ask a few questions to determine what the inquirer wants to hear and tell it to him!

Was this issue recommended by the inquirer’s current stockbroker and the inquirer is now alarmed and upset that it’s down so much? “Well, Mr. Blank, I consider this issue to be extremely risky. The yield is high, but it’s high for very good reasons! Why don’t you move your account over to me and I’ll keep a good eye on your investments?”

Or does the client like the investment, and is just looking for reassurance? “Well, Mr. Blank, I think you’ve made a very astute purchase … it’s just too bad that your timing was off. I was able to determine through my contacts that a period of turbulence was on its way and delayed my recommendation.”

Unfortunately, I’m an asset manager and my historical results are an open book. I’ve discussed the BAM issues before and I’ll probably be discussing them many times in the future. For those who are interested, I’ve uploaded a graph of prices and graph of YTW differences for BAM.PR.N and RY.PR.G for the period since the former’s issue on May 9. Note that by “price” in the graph, I mean “flatBidPrice“. I’ve also updated the same information (price and YTW difference) for BAM.PR.M and RY.PR.G for the period since the latter’s issue on April 26. Note that BAM.PR.N and BAM.PR.M are a Preferred Pair of the weak variety.

Credit quality? Brookfield was last reviewed by DBRS on June 11, 2007, and confirmed at Pfd-2(low). S&P rates the preferreds at P-2. Moody’s does not rate the preferreds, but upgraded the bonds a notch on February 27 to Baa2. Fitch has the bonds at BBB+. Brookfield has a lot of debt on its books, but the vast majority of it is secured by specific properties – or issued by a subsidiary – and is non-recourse to BAM. BAM could certainly lose their equity in each specific property if there were problems, but the non-recourse provision does give some comfort that problems in one area will not become so large that they drag down the whole company. I see nothing in the financials that lead me to suspect that the credit ratings agencies are being wildly optomistic.

Keep your eye on the news. Not the chatter; the news. Yahoo has a perfectly good clipping service available for free. Whatever BAM’s problems are at the moment, it doesn’t appear that headline risk is a factor.

As always, diversification is the answer. The world would be quite complicated enough if it was static, but it doesn’t even make us that concession; it changes in a dynamic and chaotic manner. It’s perfectly normal to be concerned about an investment that loses value for mysterious reasons; but if you go beyond concern to the point of worry, you own too much. Cut your holdings to the point where you’re merely interested.

Don’t make just a few big bets. The risks of such a strategy are legion. Make lots of small bets.

And for what I consider to be an excellent source of recommendations for buy-and-hold retail investors … subscribe to PrefLetter! Qualified investors who want me to do ALL the work may invest in Malachite Aggressive Preferred Fund.

This entry was posted on Monday, October 29th, 2007 at 3:07 pm and is filed under Issue Comments, Reader Initiated Comments. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.