PrefBlog

From the introduction (hyperlinks added):

This essay builds on previous discussion in the April, 2010, and April, 2011, editions of this newsletter, as well as that contained in my essay Security of Income vs. Security of Principal. The Hymas Investment Management Inc. retirement calculator (old version available on-line at http://www.prefblog.com/xls/retirementWithdrawals.xls new version at http://www.prefblog.com/xls/retirementWithdrawals_2012.xls) has been refined in various ways and the necessity of these changes is discussed; there is a fairly extensive discussion of “Reversion to the Mean” for equity returns, which is particularly important in the light of OSFI’s denial that such a thing exists.

Additionally, I have updated my study of the pricing of annuities to incorporate another year of data collected by Dr. Milevesky’s Individual Finance and Insurance Decisions Centre.

Look for the research link!

In this very brief introduction to the subject, I discuss the variance of dividend-equivalency factors, the effect of the OAS Clawback on these factors and differential taxation.

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There was a good run-up in the pricing of DeemedRetractibles from late 2011 to early 2012. In this essay I look at relative changes in price and attempt to discern what factors were determined relative prices.

As I state in the conclusion:

It is clear that for short term price changes of this magnitude, the ordering of comparable issues by Current Yield is likely to be more stable than orderings by other methods, an observation that is consistent with the FixedReset data examined in the May, 2010, edition of this newsletter.

However, Current Yield is not a particularly good predictor of future performance (as discussed in the November, 2011, edition of this newsletter) and this is particularly the case when the future period contains a great number of calls – as it did on 2005-12-31, when there was negligible correlation between Current Yield and the subsequent year’s performance. This empirical observation is well supported by common sense – Current Yield assumes that the instrument will exist to perpetuity, an assumption that is very difficult to support when so many instruments are trading so far above their call price.

It is certainly now the case, particularly for Bank DeemedRetractibles, that issues are trading well above their call price. This means that details of the call schedules have become critically important to the valuation of these instruments – but these details are ignored in the Current Yield calculation.

This disconnect between short-term preservation of rank by Current Yield and long term performance prediction means that sudden large changes in market levels are often accompanied by trading opportunities. Investors who may be in the habit of reviewing their preferred share portfolio quarterly, or even annually, should definitely be taking an extra look at their portfolio’s composition when prices change substantially.

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The reissue of BCE.PR.K in December, 2011, was one of the most cynical or most ignorant moves by preferred share underwriters and salesmen I have ever seen. So I was prompted to, yet again, implore investors to look at valuation factors more important than Current Yield.

As I state in the conclusion:

Issue Reset Spreads are extremely important in the valuation of FixedReset issues that are not expected to be called – as a rough rule of thumb, I suggest that this includes investment grade issues with an Issue Reset Spread of 200bp or less, and junk issues with an Issue Reset Spread of 300bp or less. I consider the situation for issues with Issue Reset Spreads up to 100bp greater than these thresholds to be unclear, and will depend on relatively minor changes in market conditions.

Investors should pay particular attention to the Issue Reset Spread when selecting issues – even if one does not wish to perform a precise yield analysis for a presumed level of the GOC-5 rate, one should at the very least calculate what the Current Yield will be if the current price is maintained after reset at some reasonable and consistent value of GOC-5.

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Anybody considering investing in preferred shares or corporate bonds should be familiar with the concept of liquidity and its effects on market prices. What happens when liquidity ceases to be merely a contributing factor and becomes dominant?

As I state in the conclusion:

As weary readers will have worked out for themselves by now, this essay does not present any magic formulae that guarantee instant success in the Canadian preferred share market – I simply felt that the concept of “Liquidity Black Holes” was interesting enough that I should pass on the information to assist readers to understand the market, and some of the academic research surrounding the market, a little better.

However, there is one salient investment truism that should be remembered: the price of investment instruments can vary, sometimes very sharply, for reasons that have absolutely nothing to do with the fundamental value of that investment – even when both buyers and sellers have identical views on how that fundamental value can be estimated.

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AS I state in the introduction:

In the July, 2011, edition of this newsletter I reviewed some of the more basic concepts surrounding yield calculations, namely Current Yield (CY), Yield to Maturity (YTM) and Yield to Worst (YTW).

In this issue, I will examine the faults of these measures more closely and introduce some of the measures utilized in HIMIPref™: Portfolio Yield, Cost Yield and Curve Yield and examine how each of these measures compares when used as a predictor of future returns.

Part 1 of this discussion is available via THIS LINK.

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AS I state in the introduction:

In last year’s review of Canadian preferred share funds, I discussed the explosion in the number of decision-makers in the investment market-place; the decline in Defined Benefit pension plans and corresponding increase in Defined Contribution plans and other forms of saving have changed the investment world from one in which the decisions were made by a relatively small group of specialists to a world in which investment management is just another consumer good. This change has resulted in an explosion of consumer choice and a consequent rise in the importance of marketing to the success of any investment product, as opposed to old-fashioned concepts such as risk and return.

In this essay I will discuss

• • the manner in which investment decisions – particularly with respect to index funds – are made
• • the use of derivatives by index funds
• • the explosion in the number of indices in recent years, as the notion of passive investing has become more fashionable

The 2010 comparison is available via THIS LINK.

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A brief review of different types of yield calculation.

Part 2 of this discussion is available via THIS LINK.

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CIBC was able to change the status of some of its preferred shares from DeemedRetractible to NVCC without a shareholder vote in 2011. This short essay looked at the implications of this move for other issues.

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As I state in the introduction to this essay:

Dividend Capture is an investment strategy that is based on the idea that market inefficiencies and differential taxation of capital gains and dividends can be exploited to produce excess returns by owning a security for a short period of time that includes the ex-Dividend date. One recommended strategy is to “Buy the stock the day before it goes X, capture the dividend, and sell it the next day. This is the most common Dividend Capture strategy, and the subject of the most academic research (Campbell and Beranck 1955, Durand and May 1960, etc). While the market is rising, this is the simplest, most efficient and least volatile way to capture dividends.”

I discuss various examples of Dividend Capture and examine the usefulness of the concept in the Canadian preferred share market.

This essay also continues the mathematical work embodied in the June 2010 Prefletter essay “Closed Form Yield Calculation”, using the Exponential Approximation as a simplifying tool.

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Update 2023-3-28: I hadn’t been aware of the following wrinkle, brought to my attention by the 2023 Federal Budget : Tax Measures : Supplementary Information:

The Income Tax Act permits corporations to claim a deduction in respect of dividends received on shares of other corporations resident in Canada. These dividends are effectively excluded from income. The dividend received deduction is intended to limit the imposition of multiple levels of corporate taxation.

The mark-to-market rules in the Income Tax Act recognize the unique nature of certain property (“mark-to-market property”) held by financial institutions in the ordinary course of their business. Under these rules, gains on the disposition of mark-to-market property are included in ordinary income, not capital gains, and unrealized gains are included in computing income annually (in addition to when the property is disposed of). Shares are generally mark-to-market property when a financial institution has less than ten per cent of the votes or value of the corporation that issued the shares (“portfolio shares”).

The policy behind the dividend received deduction conflicts with the policy behind the mark-to-market rules. Although the mark-to-market rules essentially classify gains on portfolio shares as business income, dividends received on those shares remain eligible for the dividend received deduction and are excluded from income. The tax treatment of dividends received by financial institutions on portfolio shares held in the ordinary course of their business is inconsistent with the tax treatment of gains on those shares under the mark-to-market rules.

To align the treatment of dividends and gains on portfolio shares under the mark-to-market rules, Budget 2023 proposes to deny the dividend received deduction in respect of dividends received by financial institutions on shares that are mark-to-market property.

This measure would apply to dividends received after 2023.

It seems that Dividend Capture has been very profitable for trading desks! The revenue impact of this change is estimated at about $800-million per year.