Category: Issue Comments

Readers will remember that I have been fascinated by CL.PR.B and its negative yield-to-worst for some time. Apart from very particular portfolio-management factors, there hasn’t seemed to be much rationale for holding it, other than a hope that it would continue to pay an annual dividend of 1.5625 forever.

The chance of this has never seemed too large to me, given that CL (Canada Life) is part of the GWO (Great-West) group of companies which is in turn controlled by PWF (Power Financial) … a conglomerate that has something of a reputation for knowing how many beans make five.

Even four months after I expected them to be redeemed, I am still a little confused, since paying 1.5625 on a perp when new perps are paying 1.125 – and I can’t see a GWO issue having to pay more that 1.30, no matter how sick the Street is of seeing the name – doesn’t make a lot of sense to me. However, as I have mentioned numerous times, the purchase of Putnam still needs to be financed and maybe they’re just delaying a little until they’ve got all that stuff squared away.

Today, however, the bid broke down and while the trading range was 26.31-42 (on volume of 1,950 shares), the closing quotation was 26.09-40, 5×25. So, in celebration, I’ve uploaded a few graphs:

• graph of Yield-to-Worst
• graph of ytwModifiedDuration (this one is fun!)
• graph of pseudoModifiedDurationWorstBid (this illustrates why I like pseudoModifiedDuration more than modifiedDuration for analytical purposes)
• graph of Flat Bid Price

The recent decline in price of CL.PR.B (and consequent increase in yieldToWorst) has had a salutary effect on the calculated mean-average-YTW of the PerpetualPremium index, which now has no members with a negative Yield-to-Worst and consequently a more meaningful mean. Problems with computing the mean – even less meaningful when negatives are included than it is with all positive numbers – has led me to use the median for the official HIMI Preferred Indices … and don’t worry, guys, I’m having scheduling problems at the moment, but will return to those computations in the near future. Unless a piano falls on my head.

Well! It looks like the capital unit-holders of Financial 15 Split Corp. have balked at the proposed term extension of the fund, not wishing to finance their margin at the rate of 5.25% in dividends:

Preferred Shareholders as a class voted 98.9 % in favour of the resolution, however the vote from Class A shareholders did not exceed the minimum required 66 2/3% of the votes cast in favour, and therefore the resolution was not approved at the meeting held earlier today.

Management will continue to consider if any further appropriate action should be taken on this matter.

This is interesting … I suspect that we haven’t seen the last of this issue … but as things stand now, the FTN.PR.A continue to have a redemption date of December 1, 2008.

DBRS has downgraded Loblaw Companies debt from “A” to “A(low)”:

DBRS had placed Loblaw’s long-term ratings Under Review with Negative Implications on February 8, 2007, following the release of 2006 results, which were indicative of a more challenging situation at the Company than previously understood. Sharply lower operating income, net earnings from recurring operations and cash flow for the second year in a row, combined with a significant writedown to goodwill, led to substantially weaker credit metrics (i.e., lease-adjusted cash flow/debt of approximately 20% for 2006) that are not consistent with an “A” rating from DBRS.

The downgrade follows a detailed review, from which DBRS has concluded that Loblaw’s credit risk profile has been affected by the evolving operating and competitive challenges. DBRS believes intensifying competition has been exacerbated by internal problems relating primarily to supply chain management and general merchandise program. These factors have contributed to declining sales growth and operating margins that will not be easily stabilized and reversed.

Preferred share investors will recall that Weston, Loblaw’s parent, is on Credit Watch Negative and DBRS goes on to say:

DBRS ratings for George Weston Limited remain under review with negative implications (where they were placed on February 8, 2007). The review will be completed over the near term.

Weston’s debt is currently rated A(low) … nobody can speak for DBRS except a DBRS spokesman, but I think it’s fair to say that holding companies are more often than not rated at least one notch below their owned operating companies. For example, we can look at the DBRS press release for Weston dated 2006-08-14, after Loblaw was downgraded from A(high):

As such, the one notch differential between Weston and Loblaw is considered sufficient to reflect the structural differences between the parent company (Weston) and the primary operating company (Loblaw).

Should there be further change in the opinion on or ratings of Loblaw, DBRS will assess the impact on Weston at that point in time.

Should Weston’s DEBT be downgraded to BBB, there are not necessarily any implications for the PREFERREDS … but the chance that the prefs will get downgraded have just increased. At least, according to me. We shall see!

Weston issues in the HIMIPref™ universe are: WN.PR.A / WN.PR.B / WN.PR.C / WN.PR.D / WN.PR.E (putting the ticker symbols in posts is my way of tagging them!)

In the first part of this analysis, we got as far as estimating the two fundamental credit quality ratios as:

• Asset Coverage Ratio : 2.3:1
• Income Coverage Ratio: 0.5:1

As noted, the Income Coverage Ratio is a little scary (as the company will, in the absence of other income, have to dip into capital to make the preferred dividend payments), but on the other hand consider that there is a lot of capital to dip into! The shortfall is approximately $0.25 annually; the term of the investment is seven years (since the prospectus notes that the preferred shares will be redeemed at $10.00 on April 30, 2014); and therefore that the shortfall amounts to about $1.75 over the term of the investment.

If we deduct this amount from the capital available (which we previously calculated as approximately $23.55), we are left with $21.80 to cover our $10.00 investment. So, even after setting aside some capital to meet the income requirements, we still have a fair amount of danger space.

We can also take comfort from one of the committments in the prospectus:

No distributions will be paid on the Class A Shares if (i) the distributions payable on the Preferred Shares are in arrears, or (ii) in respect of a cash distribution, after payment of the distribution by the Company, the NAV per Unit would be less than $15.00. In addition, it is intended that the Company will not pay special distributions, meaning distributions in excess of the targeted $0.075 per month in distributions, on the Class A Shares if after payment of the distribution the NAV per Unit would be less than $25.00 unless the Company would need to make such distributions so as to fully recover refundable taxes.

So, if the Asset Coverage Ratio falls below 1.5:1, then at least distributions to the capital unitholders will not be a drain on corporate resources, which is a comfort. The “intention” regarding special distributions is appreciated, but as hard-nosed fixed income investor, we don’t really care a lot about their precious “intentions”. It’s their committments that matter.

In sum, I have no problems with the rating of this issue as Pfd-2(low) by DBRS.

OK, so the issue looks like it’s investment grade. It’s only just investment grade; carnage in their underlying portfolio of life insurance companies could add to our worries; but it’s a reasonable investment and worth looking at further.

The issue is currently quoted on the TSX at $10.55-65. What’s the yield if purchased at $10.65?

Using Keith Betty’s Yield Calculator (remember, we can’t use a generic bond calculator, since bonds trade with accrued interest and preferreds don’t), we plug in the following values:

Some of the above values require explanation … this is a simple generic calculator, not one designed for six decimal places of precision.

I have told the calculator that it will receive payments on the 10th day of February, May, August & November, as promised in the prospectus. This is indeed the date of receipt but the date of accrual is actually the last business day of January, April, July, October. Thus, the final payment has been marked down a bit; the calculator pro-rates the final dividend to what it thinks it will have accrued and not paid to April 30, which underestimates the final payment by ten-day’s-worth of accrual.

In the “Include First Dividend” field, I have indicated to the calculator that I expect to receive a payment on May 10. I won’t, but it’s the best way to indicate to the calculator that the first payment, in August, will be larger than usual ($0.15042, rather than $0.13125).

I have double checked the calculated cash-flows (in the blue highlighted area, cells G2:H31), to ensure that it reflects reality – or, at least, the best approximation of reality achievable with a generic spreadsheet. They look OK to me.

And finally, after looking at the answer (4.2%), I have performed an independent sanity check: it’s a seven year investment. Since I’m buying at 10.65 and being called at 10.00, that’s a total loss of $0.65, or $0.093 annually. I’m getting paid $0.525 annually, so after deducting my projected capital loss, I have a net income of $0.432 from an investment of $10.65 that will decline to an investment of $10.00 over time, which is an average investment of 10.33. Therefore, I can make a very (very!) rough approximation of the total yield as $0.432/$10.33 = 4.18%. OK. I’m happy that the calculator is working properly, especially after looking at the two-digit calculation in cell U105, which is simply copied to the one-digit answer in cell B21.

I can compare this value with bonds by multiplying by my Interest Equivalency Factor of 1.4 … to get the same after-tax income from interest payments, I’d need a yield of about 5.9%. And I can compare this with other comparable preferred shares, such as, for instance, whatever has been recently recommended in PrefLetter.

However, I have to remember the issue size. This issue might be liquid enough now that I can invest everything I want at a price of $10.65. And I might have every intention of simply holding the issue until it’s redeemed. But there’s many a slip twixt the crouch and the leap … if I have a lot of shares, and need to sell them in 2010, will I be able to do it? If I only have a few shares, will the lack of liquidity mean that potential buyers will discount what they would otherwise pay to account for their liquidity problems? These worries must be accounted for at all times, and particularly when the issue capitalization is only $30-million.

All in all, this isn’t a bad issue at the current price. You could do worse.

Update: And never forget credit quality! This is on the very edge of investment grade; while it’s good enough for a conservative investment portfolio, it’s not good enough to be a huge chunk of an investment portfolio.

And, of course, this does not constitute specific investment advice, one way or the other. I am a financial advisor – but I am not necessarily YOUR financial advisor.

Update: On April 30, the issuer announced:

that it has completed the issuance of an additional 150,000 preferred shares at $10 per share and 150,000 Class A shares at $15 per share representing total gross proceeds of $3,750,000. This issuance was pursuant to the exercise of the over-allotment option granted to the agents in connection with the Company’s recently completed initial public offering. With the exercise of the over-allotment option, the total amount raised by the Company was $76,750,000.

I was asked recently to comment on Brompton Lifeco Split Corp., a split share issue that commenced trading yesterday, April 18.

From the first page of the prospectus we learn that:

The Preferred Shares and the Class A Shares are offered separately but will be issued only on the basis that an equal number of each class of shares will be issued and outstanding.

Then, from page 2 we see that the preferreds are being offered at $10.00, with the company paying the agents $0.30 for each one sold, while the capital units are being offered at $15.00 with a commission of $0.90.

Hence, for each matched-pair sold, the company will receive $23.80 net after commission. We also note that:

Before deducting the expenses of issue estimated at $675,000 in the case of the minimum offering and $725,000 in the case of the maximum offering (but not to exceed 1.5% of the gross proceeds of the Offering) which, together with the Agents’ fees, will be paid out of the proceeds of the offering.

. So, for the sake of analysis, let’s assume that the expenses will be $700,000, charged over 3-million units.

Hindsight helps when guessing issue size on this sort of issue, obviously. When you don’t have a precise number, make a conservative guess. In this case, the approximations in the above paragraph lead to an estimate of issue expenses of $0.23 / unit. Round it to $0.25, to be conservative.

Hence, we are estimated that the company will receive a net total of $23.80 – 0.25 = $23.55 after fees and expenses, as assets which will cover the preferred share obligation of $10.00. That’s an Asset Coverage Ratio of 2.3:1 (being conservative!). To compare this with some other issues, look at the posts regarding LBS.PR.A and SXT.PR.A.

When looking at the Asset Coverage Ratio you also have to look at the nature of the assets! In this particular case, the company informs us that the investment portfolio will be four major, equally weighted, life insurance companies. As preferred share investors, we would prefer a more diversified portfolio … but then, perhaps, nobody would want to buy the capital units and therefore not want to borrow our money at all – we can’t have everything! Still, the assets are fairly solid. These aren’t junior uranium explorers who are risking everything on one throw of the dice!

Now we turn to the Income Coverage Ratio. Page one of the prospectus advises that the portfolio generates 2.3% annual dividends. We want to be conservative, so we’ll assume they make no money at all on their options strategy (but we’ll be optimistic and assume that it won’t actually cost them anything!).

When we look for expenses, we find on page 42 of the prospectus that management fees will be 0.60% of portfolio value. Page 43 advises that they are paying a trailer fee of 0.40% on the value of the capital units; since the capital units will have an initial value of $23.55 – $10.00 = $13.55, we can estimate the initially payable trailer as 0.40% * (13.55 / 23.55) = 0.23% of portfolio value … let’s round it to 0.25%, just so we can continue to brag about how conservative we are!

And, finally, the fund will have expenses … for things like audit, filing, reporting and other good things. Page 43 of the prospectus estimates this as $235,000 p.a., based on an issue size of $100-million. We estimated, earlier, an issue size of $75-million. The expenses will be a bit smaller with a $75-million portfolio, but not a lot smaller and certainly not proportionately smaller. To maintain our conservative attitude, we’ll assume that $235,000 will be the actual expenses … which comes to 0.31% on the portfolio.

So: The portfolio as a whole will have income of 2.3%. From this we subtract 0.60% Management Fees, 0.25% Trailer Fees and 0.31% expenses, which comes to a net income of 1.14% on the portfolio.

On a per-unit basis, the portfolio has an initial value of $23.55, so net income per unit will be roughly $0.27. And each unit has one preferred share, paying 5.25% of par, so the income required to cover the dividend is $0.525.

Need $0.525 per year, estimate will get $0.27 per year, income coverage is just over 50%, which is a little scary. It means that to meet their obligations, in the absence of capital gains and options winnings, they’ll have to dip into capital. Which is not the end of the world in and of itself, but it’s not as nice as an income coverage of 200%, for instance!

More Later ….

Well, that didn’t take long!

When CU announced their new issue (which is trading as CIU.PR.A, by the way – I have no idea why it’s not in the “CU” ticker family) I predicted that the CU.PR.T & CU.PR.V would be redeemed (missed the D! But it wasn’t in the HIMIPref™ universe anyway) and, lo and behold, as soon as the new issue settles, CU is announcing:

that, as a result of the successful closing of the CU Inc. issue of $115,000,000 4.60% Cumulative Redeemable Preferred Shares Series 1, it will redeem on May 18, 2007 all of its outstanding Cumulative Redeemable Second Preferred Shares Series Q, R and S at a price of $25.00 per share plus accrued and unpaid dividends per share.

That’s a total of 5,050,105 shares, so it’s a net paydown of debt for them … and a massive decrease in coupon! The average dividend rate on the redeemed shares is just a hair under 5.75% … so payback time on issuance costs won’t come to much.