BCE.PR.Z / BCE.PR.Y : Convert or Hold?

As previously reported, BCE has sent conversion notices for BCE.PR.Z and BCE.PR.Y. The new dividend rate on BCE.PR.Z has not yet been announced:

As of December 1, 2017, the Series Z Preferred Shares, should they remain outstanding, will pay, on a quarterly basis, as and when declared by the Board of Directors of BCE Inc., a fixed cash dividend for the following five years that will be based on a fixed rate equal to the product of: (a) the yield to maturity compounded semi-annually (the “Government of Canada Yield”), computed on November 10, 2017 by two investment dealers appointed by BCE Inc., that would be carried by non-callable Government of Canada bonds with a 5-year maturity, multiplied by (b) the “Selected Percentage Rate”. The “Selected Percentage Rate” determined by BCE Inc. is 231%. The annual dividend rate applicable to the Series Z Preferred Shares will be published on November 14, 2017 in the national edition of The Globe and Mail, the Montreal Gazette and Le Devoir and will be posted on BCE Inc.’s website at www.bce.ca.

I would greatly prefer to delay a recommendation until the announcement of the rate, but (emphasis added) …

In order to convert their shares, holders must exercise their right of conversion during the conversion period which runs from October 17, 2017 until 5:00 p.m. (Eastern time) on November 17, 2017.

… which doesn’t leave a lot of time for dissemination of my recommendation between the rate announcement and the notification deadline!

So for the purposes of this recommendation, I am assuming the five-year Canada rate, currently at 1.67%, will not change between now and the rate calculation date. Thus, since the rate will be set at 231% of the five-year Canada yield, I am assuming that BCE.PR.Z will reset at 3.858%. (note: actual rate reset to 3.904%)

In my terminology, BCE.PR.Y is a Ratchet Rate preferred, currently paying 100% of Prime, reset quarterly. BCE.PR.Z is a FixedFloater currently paying $0.788 p.a., or 3.152% of its $25 par value. The latter rate resets every Exchange Date; the next exchange date is imminent – 2017-12-1. Both issues have been relegated to the Scraps subindex on credit concerns.

The most logical way to analyze the question of whether or not to convert is through the theory of Preferred Pairs, for which a calculator is available. Briefly, a Strong Pair is defined as a pair of securities that can be interconverted in the future (e.g., BCE.PR.Z and BCE.PR.Y). Since they will be interconvertible on this future date, it may be assumed that they will be priced identically on this date (if they aren’t then holders will simply convert en masse to the higher-priced issue). And since they will be priced identically on a given date in the future, any current difference in price must be offset by expectations of an equal and opposite value of dividends to be received in the interim. And since the dividend rate on one element of the pair is both fixed and known, the implied average rate of the other, floating rate, instrument can be determined. Finally, we say, we may compare these average rates and take a view regarding the actual future course of that rate relative to the implied rate, which will provide us with guidance on which element of the pair is likely to outperform the other until the next interconversion date, at which time the process will be repeated.

We can show the break-even rates for each FixedFloater / RatchetRate Strong Pair graphically by plotting the implied average Prime rate against the next Exchange Date (which is the date to which the average will be calculated).

Click for Big

The average break-even rate for the BCE pairs is 4.18%, while the average for all FixedFloater – RatchetRate pairs is 4.01%; the latter figure has been brought down by the very low reading for BBD.PR.D / BBD.PR.B.

Predictions are difficult, particularly when they are about the future! It will be remembered that Prime is currently at 3.20%; therefore, if we assume that future hikes are evenly sized and spaced, an average of 4.18% implies an end-value in five years of about 5.15%. I’m inclined to believe that it will turn out to be less than that, but if you disagree I won’t put up much of an argument!

Since credit quality of each element of the pair is equal to the other element, it should not make any difference whether the pair examined is investment-grade or junk, although we might expect greater variation of implied rates between junk issues on grounds of lower liquidity, and this is just what we see.

If we plug in the current bid price of the BCE.PR.Z FixedFloater, we may construct the following table showing consistent prices for its soon-to-be-issued FloatingReset counterpart given a variety of Implied Breakeven yields consistent with issues currently trading:

Estimate of BCE.PR.Y (received in exchange for BCE.PR.Z) Trading Price In Current Conditions
  Assumed RatchetRate
Price if Implied Prime
is equal to
FixedFloater Bid Price Fixed Rate +3.75% 4.25% 4.75%
BCE.PR.Z 19.22 3.858%
19.11 19.62 20.12
(note: actual rate reset to 3.904%)

Based on current market conditions and the estimated reset rate for the FixedFloater, I suggest that BCE.PR.Z will likely trade at somewhat less than the price of BCE.PR.Y, its RatchetRate counterpart. Therefore, I recommend holders retain, or switch to, BCE.PR.Y. Those with strong convictions regarding future movements in Prime will, of course, have an equally strong preference for one of the two issues; other investors may wish to select which of the pair they wish to hold for the next five years based on their personal circumstances (e.g., if you’re hedging a prime-linked mortgage with this issue [not a wise move], you will want to hold BCE.PR.Y).

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