Liquidity Fears for PerpetualDiscounts?

An Assiduous Reader writes in and says:

You are very bullish on Perpetual Discount preferred shares.

No I’m not. I’m neither bullish nor bearish. I will go so far as to say that at this moment in time and speaking very generally, I prefer PerpetualDiscounts to other preferred share classes as I believe their net present value of future cash flows and market price exceeds the net present value of future cash flows and market price of the other classes.

Are you not concerned with the reduction of liquidity that is caused by the issuer buying the shares at market prices versus purchasing them at the Call price? Some of those shares also have American style Call options that make them even uglier.

It is possible that issuers could buy up their extant PerpetualDiscount issues to the extent that trading volume would suffer; but I am not aware of this ever having happened.

However, just because something has never happened before doesn’t mean it will never happen – just ask a sub-prime paper mogul contemplating housing prices 25% below peak! So it’s always worthwhile to consider.

The issue of issuer repurchases was last discussed on PrefBlog last fall, in the post Repurchase of Preferred Shares by Issuer, in which I mentioned one of the rare non-split-share issuer bids, Great-West bidding for GWO.PR.E & GWO.PR.X, large issues that will retract in the relatively near future. That particular repurchase was a fizzle.

If the majority of the issued shares have been purchased back by the issuer then you are left stranded and have to hope that they purchase the rest to get rid of the nuisance.

The following example displays the benefit to the issuer:

Issue Dividend Net Price Shares Issued Cash Dividend Yearly
New Issue 0.40625 24.25 16,000,000 388,000,000 6,500,000 6.70%
Perpetual Discount 0.29375 15.88 16,000,000 254,080,000 4,700,000
New Cash     16,000,000 133,920,000 1,800,000 5.38%

If I am interpeting this table correctly, my interlocutor is saying that a new issue of 16-million shares of Fixed-Resets could be issued with an initial coupon of 6.70% for a cash receipt after underwriting costs of $388-million. These funds could then be used to buy up an extant issue of 16-million shares of PerpetualDiscounts with an original coupon of 4.7% that is trading at 15.88 to yield 7.4%.

The net effect of this action would be $134-million net new cash to the issuer with a net increase in dividend expenses of $1.8-million quarterly, or 5.38% p.a., which would be a nice way to finance.

Well, all I can say is that it’s not happening yet! I can think of several reasons for this:

  • Inability to purchase significant stock at a 7.4% yield. If the price of the PerpetualDiscount in the example went up to $17.54, it would have a current yield of 6.7%, the same as the putative new issue. All that would happen, I think, is that you’d see a pop in the market price for the duration of the buying programme and people like me would say ‘thank you very much’ and swap into other issues.
  • There would be no change in Tier 1 Regulatory Capital, except to the extent that a profit on cancellation was recorded. While the market price of the PerpetualDiscounts may only be about $16, it’s still on the books as $25.
  • Even at 7.4%, the interest-equivalent yield is only about 10.4%. The banks are targetting a ROE in excess of this figure; therefore they would rather repurchase common equity than the PerpetualDiscount

I am not discounting the notion that liquidity might eventually dry up in the PerpetualDiscount market. In a recent post I highlighted the downward trend in PerpetualDiscount Average Trading Value and Assiduous Reader prefhound commented that It sure looks like the fixed reset pref has stolen some of the trading volume from discount prefs.. This may or may not be a factor in the recent elevated spreads against corporates. I suspect not, but it’s something of a chicken-and-egg problem and I’ll reserve judgement until the credit crunch is over!

Volumes are – to date! – sufficient to allow active trading, but we’ll see. It is possible – unlikely, I think, but nevertheless possible – that PerpetualDiscounts could go down the same road travelled by banks’ 100-year floating rate bonds, that were so popular in the eighties and now trade by appointment only at an enormous spread.

Obviously, the fixed resets can suffer the same fate! The only saving grace is that they have a floor on the yield that makes the probability of the option being called higher and saving you from being orphaned.

It would be interesting to know what the median lifetime of a Canadian Bank preferred share before total purchase/recall.

In my essay Are Floating Prefs Money Market Vehicles?, I reported that the average life of called straight perpetual issue was 10.2 years; i.e., just a little over the normal 9-year period before an issue with standard terms can be called at par (a call at $26 is normal after five years, declining by $0.25 annually).

So there you have it, such as it is! Forecasting future prices is chancy enough; forecasting liquidity is worse. All you can do is stay alert for changes and stay diversified.

3 Responses to “Liquidity Fears for PerpetualDiscounts?”

  1. prefhound says:

    I would just note that the average life of a perpetual may have been 10 years in a 25 year environment of falling yields, but due to Mr Hymas’ relative youth, his data base does not go back to the days of $50 prefs trading in the 1970s at 50% or less of par. At that time of rising interest rates, perpetual prefs may have lasted a lot longer.

    Indeed, if there is a secular rise in interest rates (or even if pref yields stay where they are), perpetuals may only be called (and only in some cases) in a takeover. Once they become truly perpetual (like the 100 year floating rate bonds), and once there hasn’t been a new issue in a dog’s age, the public may forget they exist.

  2. GAndreone says:

    Thank you ‘prefhound’. Do you know of any prefs that exceeded 20 years?
    Do the prefs get delisted when the volume gets too low? That is, are there any prefs issued ages ago that just cannot get sold because there is no active market?

  3. jiHymas says:

    There are many prefs in the HIMIPref™ universe that have been in existence for more than twenty years, but none of them are PerpetualDiscounts – they’re basically all floaters.

    Longest outstanding PerpetualDiscounts in HIMIPref™ are:
    CM.PR.P 1997-11-4
    PWF.PR.E 1997-12-16
    BMO.PR.H 1998-2-26
    BNS.PR.J 1998-7-14
    W.PR.H 1998-9-1
    ENB.PR.A 1998-12-1
    POW.PR.A 1999-6-11
    W.PR.J 1999-6-22

    Note that when there is a reorganization, HIMIPref™ creates a “new security” and assigns it a new security code; I don’t recall off-hand this being an issue with PerpetualDiscounts, but it does apply, for instance, to FixedFloaters (and will apply in the future to the Five-year-fixed component of FixedResets).

    The oldest issues in HIMIPref™ under a continuous security code are:
    POW.PR.F 1986-2-18
    PWF.PR.A 1986-12-15
    PWF.PR.D 1997-10-17

    Note as an example that TRI.PR.B, which has been around forever, has a listing date shown as 2008-4-17 – the date the ticker symbol changed.

    The potential delisting of prefs on the basis of traded volume was discussed briefly in connection with HIMIPref™’s discontinuation of BNS.PR.S coverage. It appears that the exchange will not force the delisting of individual issues except in the case when the entire company is delisted.

    Hey, as long as they get paid the listing fee, why should they care?

    Issues in the HIMIPref™ universe with ludicrously small Average Trading Volumes (as defined by HIMIPref™) are:
    BPP.PR.M $43
    BPP.PR.J $353
    YLD.PR.B $855
    BCE.PR.D $1,339
    BPP.PR.G $1,455

Leave a Reply

You must be logged in to post a comment.