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 |

BAM.PR.G | BAM.PR.E |

BBD.PR.D | BBD.PR.B |

BCE.PR.T | BCE.PR.S |

BCE.PR.Z | BCE.PR.Y |

BCE.PR.A | BCE.PR.B |

BCE.PR.C | BCE.PR.D |

BCE.PR.F | BCE.PR.E |

BCE.PR.G | BCE.PR.H |

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.

I am looking at the prospectus for BCE.PR.F, which will reset next February, in order to determine what will be the new dividend. (My understanding is that the new dividend is determined by a multiplicative factor – “the Selected Percentage Rate”- applied to the GoC5 rate x par, rather than by the “usual” additive reset spread w.r.t. GoC5.) The prospectus states that this multiplicative factor will be determined by the Board of Directors (and announced shortly beforehand), and seemingly the only guarantee is that it will not be less than 80%.

Does this mean that the BCE Board of Directors can “arbitrarily” choose any multiplicative factor that they so desire (>80%)? If so, why wouldn’t they just automatically choose the lowest possible dividend of 80% x GoC5 x par? After all, the existing holders can’t redeem the shares and would either have to exchange them to the floating-rate BCE.PR.E issue or simply “suck it up”…

Your clarifications would be greatly appreciated! Thanks!

Does this mean that the BCE Board of Directors can “arbitrarily” choose any multiplicative factor that they so desire (>80%)?Yes.

If so, why wouldn’t they just automatically choose the lowest possible dividend of 80% x GoC5 x par?Everybody would just convert to the RatchetRate issue – the existence of a viable alternative is very important in the valuation of these issues; HIMIPref™ analysis assumes that the chosen rate will be so lousy that the conversion is effectively forced.

However, this would only piss people off for no good reason. I hypothesize that in practice the rate is actually set according to the level of the five-year interest-rate swap, so BCE is indifferent to investors’ choices.

I have anecdotal evidence that supports this hypothesis; if these issues were in US funds I could examine it more closely, using historical interest rate swap data from the Federal Reserve, which is a competent Central Bank that seeks to make businesses more efficient by collecting and providing useful data. Regrettably, the issues in question are denominated in Canadian funds.

Thanks James for the informative response.

In your most recent PrefLetter, you have an interesting analysis of the implied average prime rate for various FixedFloater – RatchetRate strong pairs (including BCE.PR.E and BCE.PR.F) Am I to presume that, in order to carry out these calculations, you have assumed the new FixedFloater rate to be set accoding to the five-year interest-rate swap, as you mention in your response?

By the way, isn’t BCE.PR.F a “fixed reset” rather than a “fixed floater”? What exactly is the difference?

Oops! Sorry – I realize now that the “average prime” is from the present until the next exchange date — not the prime rate on the day of the exchange (or, rather, the day of the calculation of the putative five-year interest-rate swap) that would render equal the yield of each member of the pair.

Am I to presume that, in order to carry out these calculations, you have assumed the new FixedFloater rate to be set accoding to the five-year interest-rate swap, as you mention in your response?No. For the purposes of this calculation, all you need to know is that the elements of the Strong Pair are interconvertible on Date X; therefore, the only difference between the two is the dividends to be received prior to Date X; therefore the required average prime rate until Date X can be calculated from the known fixed dividend rate until Date X.

See my article on Strong Pairs.

And now I notice that you’d worked this out yourself in your later post, but I’ll leave this answer here for the benefit of those who didn’t.

isn’t BCE.PR.F a “fixed reset” rather than a “fixed floater”?No. The ability of the issuer to, for all intents and purposes, to force conversion into a Ratchet Rate issue is an important difference – especially since RatchetRate issues do not necessarily pay 100% of prime.