Category: Reader Initiated Comments

Index Construction / Reporting

Split Share Discount

On the thread for April 27, Drew asked:

The YTW of split shares and perpetual premium shares seems to have risen over the last month substantially more than that of perpetual discount shares. My impression is that the bond yield curve has not flattened like this. Am I correct and, if so, do you have a theory?

Well, first off, let’s look at the index data: March 30:

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Op. Retract 4.72% 3.04% 85,479 2.16 17 -0.0828% 1,034.0
Split-Share 5.01% 3.14% 158,951 3.31 14 +0.0234% 1,052.8
Perpetual-Premium 5.02% 3.56% 219,123 5.15 53 -0.0031% 1,059.8
Perpetual-Discount 4.53% 4.54% 762,721 15.37 10 -0.0157% 1,066.8

…and for April 27:

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Op. Retract 4.73% 3.22% 84,115 2.38 17 -0.0108% 1,033.0
Split-Share 5.03% 4.29% 179,611 4.02 12 +0.1756% 1,046.1
Perpetual-Premium 5.07% 4.50% 222,579 6.25 54 -0.1567% 1,051.4
Perpetual-Discount 4.57% 4.59% 924,984 16.22 12 -0.0112% 1,056.4

From these indications, we see huge apparent changes in the yield of split shares. There are, as always, details of the analysis that must be understood before we pat ourselves on the back, however.

Consider the April 27 Split Share Index. Well, it looks like one thing that’s going to happen soon is that MUH.PR.A and ASC.PR.A will be moved to the “Scraps” index, on grounds of insufficient averageTradingValue, but never mind that.

One thing we notice is that DFN.PR.A & FFN.PR.A have much higher YTWs than FTN.PR.A, thanks to the recently approved term extensions on the former two issues. Be sure to write a thank-you note to your friendly neighborhood capital unit holder for the gift! Another thing we notice when looking at the index table is that the Split-Share index has been hit a lot harder than the Operating-Retractible index. This effect is due, I think, to a lack of understanding in the marketplace in general as to the nature of a split-share corporation. For example, one commenter on Financial Webring Forum stated that he was “not interested in … split shares that mature at NAV”.

Well, the preferred share component of a split share corp does not mature at NAV, absent default. The last two words are very important, because as I showed in the article Are Floating Prefs Money Market Vehicles?, Split Shares have, historically, been more susceptible to credit downgrades than other classes of share. However, readers who have read Using Credit Ratings When Buying Preferreds and Split Shares will know how to watch for the signs of an imminent downgrade. It seems to me that DBRS has been tightening its standards for Split Share credit ratings in the past year or two; as well, while the nature of a split share makes the rating more volatile, it also makes credit analysis a lot easier! So, while you have to watch them, so what? You have to watch everything in this uncertain world.

Some institutional investors, as well, don’t like Split Shares: one reasonably good reason is that not only are issue sizes relatively small, but they are rarely available as a new issue bought en bloc unless you also buy the Capital Units. One relatively bad reason is that many institutional guys don’t understand them either, another is that buying them might give the impression that they are sub-contracting asset management to the Split-Share’s sponsor, or at least have to explain to clients why that is not a fair characterization.

So in the end, Split Shares become not just a playground for retail, but for a relatively small component of the retail preferred share buying populace at that. This makes them much more susceptible to volatility and what I currently believe is contagion from the continuing woes of BCE.

I’ve uploaded a graph of the yieldCurvePremiumRetractible and the yieldCurvePremiumSplitShareCorp. On April 27, these values stood at -0.44% and +0.40%, respectively, changing from -0.42% and +0.34%, respectively, on March 30. So, yeah, Split Share spreads have widened quite noticeably over the past month. I’ve also uploaded a graph of the core yield curves at year-end, March month-end and now, for your inspection. All these curves and spreads, I hasten to note before I forget, are AFTER TAX.

Malachite Aggressive Preferred Fund currently has a relatively high exposure to Split Shares, so I could be accused of talking up my inventory. I could also be accused of putting my money where my mouth is. Take your pick – you have been warned!

 

Issue Comments

Asset Coverage Ratio on the SXT.PR.A Split-Share

A perplexed reader of my article on Split-Shares has eMailed to query:

Your article on Split Shares in Canadian Moneysaver indicates that “Asset Coverage Ratio” is an important metric. Could you provide some details on how you calculate the asset coverage ratio? Is it simply the total NAV divided by the call price of the Preferred split?

to which I answer … yes. Although I prefer to state the equation as “Total assets available divided by total assets required.”

For example, let’s look at SXT.PR.A, which gets mentioned in this blog occasionally due to its negative yield-to-worst. Financial data is available to September 15, 2006 from the manager’s website and may be stated as:

Sixty-Split Balance Sheet, September 15, 2006
Assets  
 Investment portolio, at market value 87,536,712
 Distributions receivable 170,277
 Cash and short-term investments 91,207
  87,798,196
Liabilities  
 Due to related party 69,060
 Accrued liabilities 129,280
 Preferred Shares 38,396,950
  38,595,290
Capital Shareholders’ Equity  
 Share capital 30,803,768
 Retained Earnings 18,399,138
  49,202,906
Unit Value
Number of Units Outstanding 1,535,878
Unit Value $57.04
Redemption Value per Preferred Share (25.00)
Net Asset Value per two Capital Shares $32.04
A Unit consists of two Capital Shares and One Preferred Share. Preferred shares are redeemable every March 15 until 2011. All preferred shares outstanding on March 15, 2011 will be redeemed by the Company at a price per share equal to the lesser of $25.00 and the Unit Value.

So that’s the balance sheet, now to calculate the asset coverage ratio: the “Accrued Liabilities” and the “Due to a Related Party” liabilities stand in front of the preferred shareholders at liquidation time, but preferred shareholders stand in front of the Capital Unit Holders.

As it states on the balance sheet, the amount of money required to cover the obligations to Preferred Shareholders is $38,396,950. However, the amount available is the amount set aside, plus whatever is currently allocated to those behind us in line … so the amount available is $38,396,950 + $49,202,906 = $87,599,856.

With $87,599,856 available to cover an obligation of $38,396,950, the asset coverage ratio is 2.28:1, which is to say, for every dollar of obligation, there’s $2.28 in the kitty. Which leaves us preferred shareholders feeling reasonably secure that the company will be able to meet those obligations.

Another way to calculate this number is just as the reader who inspired this post suggested: the NAV per Unit (including the preferred shares) is $57.04; the preferred share obligation is $25.00; division gives 2.28.

DBRS usually expresses this ratio in terms of “Downside Protection”. They are asking essentially the same question but phrasing it as “How much of the total assets of the fund can be lost before the preferred shareholders feel pain”? Therefore, in this example, they are calculating the value:

Downside Protection = 1 – (Pref Obligation / NAVPU)
= 1 – (25 / 57.04)
=1 – 0.438
=0.562

They therefore say the “Downside Protection” is 56.2%.

Try it out! We have $57.04. We lose 56.2% of it, or $32.06. This leaves us with $24.98 (which is just a rounding error for $25.00), just enough to cover the obligation. The company can lose 56.2% on its investments and still cover the preferred share obligation.

Note, however, that “Asset Coverage Ratio” is not the only thing that must looked at! One must also consider the “Income Coverage Ratio” … but that’s dealt with briefly in the article and can be examined in more detail here at another time.

And, of course, one must always bear in mind that these calculations only examine whether the company will be able to meet its obligations. They do not consider whether we can buy the rights to those obligations at an attractive price. Yes, we’re pretty sure that the company is good for the $25.00. However, the SXT.PR.A issue is currently quoted at $25.83-12 in the marketplace and has a negative yield-to-worst.

By way of analogy, let’s say we’ve checked out a five dollar bill very thoroughly. We’ve convinced ourselves that it’s not a forgery. As far as we’ve been able to tell, with all our analysis, we’ll be able to take that $5 bill to the bank or anywhere else we like! But even with all that assurance, we’re not going to pay $5.25 for it!