Archive for the ‘Reader Initiated Comments’ Category

Final Dividend Calculation Questions

Friday, August 30th, 2013

I have received not just one, but two separate inquiries about the calculation of a final dividend lately, so I’ll publish this note to assist those who are too shy to eMail me…

For those unwilling to plough through the following (cough, cough), final dividend calculation may be summarized as:

  • Dividends are paid for a specific period
  • This period usually, but not always, is up to and including the payment date.
  • Ex-date and record date have nothing to do with it – at least, not in any instances of which I am aware
  • For an explanation of the dates, read my essay Dividends and ex-Dates
  • To determine the periods over which dividend payments are earned, read the prospectus with respect to the first dividend … the prospectus will generally include some statement along the lines of: “The first dividend will be paid on XXXX, and will be for $YYY per share, assuming that the issue closes on ZZZZ”. The fraction of a year between XXXX and ZZZZ will generally, but not always be equal to the fraction of the annual dividend paid on ZZZZ.

So, the first inquiry was sent by Assiduous Reader KB:

I wonder if you could clear up a question I have about Fixed Reset shares.

I was reading this months PrefLetter and was a bit confused by a yield calculation, so I went to the prospectus of some Fixed-Reset shares I own.

Both bank fixed-resets (RY.PR.P and TD.PR.K) are worded a particular way that concerns me, yet two non-bank fixed-resets MFC.PR.D and BAM.PR.P) are worded differently.

The bank fixed-resets state that dividends are paid every quarter, but excludes the initial rate on the last dividend for the final reset/call date? (see the pertinent prospectus excerpt reprint below.)

The non-bank fixed-resets include the initial rate on the last dividend for the final reset/call date? (see the pertinent prospectus excerpt reprint below.)

Question: Are the banks indicating that the dividend on the reset/call date (if reset) will be at the new dividend rate, and (if called) will be at the old dividend rate, yet the non-banks pay the old dividend rate on the reset/call dates regardless if called or reset?

RY.PR.P
Our Non-Cumulative 5-Year Rate Reset First Preferred Shares, Series AP (the “Series AP Preferred Shares”) will be entitled to fixed non-cumulative preferential cash dividends, payable quarterly on the 24th day of February, May, August and November in each year, as and when declared by our board of directors, for the initial period from and including the closing date of this offering to, but excluding, February 24, 2014 (the “Initial Fixed Rate Period”) at a per annum rate of 6.25%, or $1.5625 per share per annum. The initial dividend, if declared, will be payable on May 24, 2009 and will be $0.55651 per share, based on an anticipated issue date of January 14, 2009 …………………….. Subject to the provisions of the Bank Act (Canada) (the “Bank Act”) and the consent of the Superintendent of Financial Institutions Canada (the “Superintendent”), on February 24, 2014 and on February 24 every fifth year thereafter, we may redeem the Series AP Preferred Shares in whole or in part by the payment of $25.00 in cash per share together with declared and unpaid dividends to the date fixed for redemption.

MFC.PR.D
This offering (the “Offering”) of Non-cumulative Rate Reset Class A Shares, Series 4 (the “Series 4 Preferred Shares”) of Manulife Financial Corporation (“MFC”) under this prospectus supplement (the “Prospectus Supplement”) consists of 14,000,000 Series 4 Preferred Shares. The holders of Series 4 Preferred Shares will be entitled to receive fixed non-cumulative preferential cash dividends, as and when declared by the board of directors of MFC (the “Board of Directors”), for the initial period commencing on the Closing Date (as defined herein) and ending on and including June 19, 2014 (the “Initial Fixed Rate Period”), payable quarterly on the 19th day of March, June, September and December in each year (each three-month period ending on the 19th day of each such month, a “Quarter”), at an annual rate equal to $1.65 per share. The initial dividend, if declared, will be payable June 19, 2009 and will be $0.4837 per share, based on the anticipated closing date of March 4, 2009 (the “Closing Date”) …………………….. The Series 4 Preferred Shares will not be redeemable by MFC prior to June 19, 2014. On June 19, 2014 and on June 19 every five years thereafter, but subject to the provisions of the Insurance Companies Act (Canada) (the “ICA”), including the requirement of obtaining the prior consent of the Superintendent of Financial Institutions (the “Superintendent”), and subject to certain other restrictions set out in “Details of the Offering — Certain Provisions of the Series 4 Preferred Shares as a Series — Restrictions on Dividends and Retirement of Series 4 Preferred Shares”, MFC may, at its option, on at least 30 days and not more than 60 days prior written notice, redeem for cash all or from time to time any part of the outstanding Series 4 Preferred Shares for $25.00 per Series 4 Preferred Share, together in each case, with an amount equal to the sum (the “Accrued Amount”) of (i) all declared and unpaid dividends in respect of completed Quarters preceding the date fixed for redemption; and (ii) an amount equal to the cash dividend in respect of the Quarter in which the redemption occurs, whether declared or not, pro rated to such date.

Thanks,

I answered with the following:

There is no need to worry.

If you examine the prospectus for TD.PR.S (http://www.td.com/document/PDF/investor/td-investor-s[1].pdf) you will see that it is worded similarly to the other banks: “The holders of the Series S Shares will be entitled to receive fixed quarterly non-cumulative preferential cash dividends, as and when declared by the board of directors of the Bank (the “Board of Directors”), for the initial period from and including the closing date of this offering to but excluding July 31, 2013 (the “Initial Fixed Rate Period”), payable on the last day of January, April, July and October in each year (each three-month period ending on the last day of each such month, a “Quarter”), at a per annum rate of 5.00% per share, or $0.3125 per share per Quarter”

The dividends for the final period were at the old rate:http://td.mediaroom.com/2013-05-23-TD-Bank-Group-Declares-Dividends

I believe that this is simply due to questions about how to count the days and refer to this count, given that interest is actually earned overnight (between the close on day X and the opening on day X+1) rather than during the day.

Every lawyer will have his own idea about whether the interest earning period is day X or day X+1 and draft the prospectus accordingly. And once the first prospectus is drawn up for a given firm, it is used as a template for the next one.

The next question came from Assiduous Reader GK:

Specifically, on BNA.PR.D, I know the call is July 9, 2014, and the last dividend record date is May 22 (or thereabouts).

I am interested in this series for a short term investment.

My question is, is there any accrued interest in the period between May 22 and the call date, July 9?

And my response:

This one is a little tricky and requires us to have a look at the prospectus for the issue, available on SEDAR.

First: “All Series 4 Preferred Shares outstanding on July 9, 2014 (the ‘‘Series 4 Redemption Date’’) will be redeemed for a cash amount equal to the lesser of (i) $25.00 plus any accrued and unpaid dividends, and (ii) the Net Asset Value per Unit.”

So on July 9 we will indeed be paid accrued dividends, if any. Are there any? With respect to the first dividend, the prospectus states: “Based upon the anticipated closing date of July 9, 2009, the initial dividend (which covers the period from closing to August 31, 2009) is expected to be $0.26318 per Series 4 Preferred Share and is expected to be paid on or before September 7, 2009 to holders of record on August 21, 2009.”

So checking: July 9 to August 31 is 22 + 31 = 53 days, and the expected dividend is: quarterly divided * 4 * fraction of year = paid dividend, or

$0.453125 * 4 * (53/365) = 0.263185

Which agrees with their calculation (except they rounded down, the bastards!)

So dividends are paid for quarterly periods ending at month-end February, May, August and November.

Therefore, on redemption July 9, dividends will be owing for the period May 31 – July 9 = 39 days = (39/365) of a year, so:

$0.453125 * 4 * 39/365 = 0.193664.

So it would appear that accrued and unpaid dividends of 0.193664 per share will be paid on redemption July 9, 2014. I urge you to double check this calculation and see if you can get confirmation from the company itself – see contact information at http://www.bamsplit.com/

SplitShare Capital Unit Debate

Thursday, March 3rd, 2011

Assiduous Readers will remember that I was quoted in a recent article by John Heinzl expressing a strong opinion on the Capital Units issues by SplitShare corporations:

For those reasons, Mr. Hymas says the capital shares are only appropriate for “suckers.”

This statement has attracted a certain amount of commentary and I have received some material criticizing my views. All further quotes in this post have been taken, in order, from an eMailed commentary – it has been interspersed with my commentary, but is quoted verbatim and in its entirety.

Response to “Ups and Downs of Doing The Splits” – John Heinzl, Globe and Mail, March 2, 2011

I have had a lot of involvement in split shares over the last two years, and I have to differ markedly from the assessment of Mr. Hymas, who prefers the preferreds to the capital units. I believe the exact opposite to be the case.

The split-share preferreds have limited upside, yet unlimited downside. They are essentially equity investments with a ‘preferred share’ wrapper. Most have downside protection to some degree, but rest assured, they can fall pretty well as much as the equity market can.

Asymmetry of returns is a feature of all fixed income, not simply SplitShare preferreds. Naturally, they can default, and one must take account of the chance of default: but firstly most will have Asset Coverage of at least 2:1 at issue time – meaning that the underlying portfolio can drop by half before the preferred shareholders take any loss at all – and secondly the Capital Unitholders will be wiped out before the preferred shareholders lose a penny.

No, there are no guarantees – there never are. But the preferreds have at issue time a significant amount of first-loss protection provided by the Capital Units.

The capital units are a whole other story. In my view they offer the BEST deal out there.

Imagine if you had a $100,000 portfolio of Canadian equities. You are totally exposed to the performance of the underlying assets, so a market fall of 50% takes an equivalent bite out of your assets. Now suppose instead you invest in a capital share with the following characteristics: leverage factor is 3.75 times. Discount to NAV is 20%. Maturity is 3 years. (These numbers are most assuredly achievable).

These numbers can be illustrated by the following:
Preferred Par Value: $10.00
Whole Unit NAV: $13.64
Price of Capital Units: $2.91

However, the capital units are issued at a premium to NAV (since they absorb all the issue expenses) of 5-10%. Thus, by choosing this example, you are to a degree saying that the Capital Units are only worth buying once they have lost about 25% of their value relative to NAV and have lost most of their NAV as well. I claim that this shows that the guys who paid full price for them are suckers.

While discounts of market price to intrinsic value are not unknown, they are by no means automatic. I gave a seminar on SplitShares in March, 2009 – the very height of the crisis! – and used the following chart to illustrate the fact that, even (or particularly!) when distressed, these things will generally trade at a premium to intrinsic value:


Click for Big

The seminar was videotaped and is available for viewing (and downloading in Apple QuickTime format for personal use) for a small fee.

You could invest $26,667 in the capital units, and put the remainder in cash or investment grade bonds yielding , say, 3.5%. By doing so you get the same upside as the underlying assets.

Actually, it will be a bit better, because at maturity the discount will be made up, so you get an extra kicker of 6% per year. But in the event of a 50% fall in the market, although you would probably lose all of the value of the capital units, your cash would remain at $73,333, plus interest. You have dramatically outperformed on the downside, losing about 27% vs. 50%.

Yes, certainly, but you are not looking at the situation at issue time. You are looking for a distressed situation, in which somebody (the sucker) has already taken an enormous loss, not just on the NAV but also on the market price relative to NAV. Your illustration relies on the same presumption as the attractiveness of the preferred shares: the willingness of the sucker to take the first loss.

Not all split share capital units are attractive: some trade at premiums, and offer little leverage. Remember, these things are effectively long-dated options or warrants, although – even better – they can receive dividends. Any option or warrant calculator will tell you that if the capital units are priced correctly they should trade at a premium, not a discount, especially when leverage increases.

I discussed the valuation of Capital Units as options in my Seminar on SplitShares and provided the following charts. The first shows the theoretical value – given reasonable assumptions regarding volatility – of the capital units as the Whole Unit NAV changes. I will also note that this computation of theoretical value ignores all of the cash effects in the portfolio – dividends in, dividends out, fees and expenses out and portfolio changes to offset these effects – that will, in general, reduce the attractiveness of the Capital Units.


Click for Big

The second shows the premium of expected market price over intrinsic value as the NAV changes:


Click for Big

Instead, over the last few years I have seen cases where capital units offered leverage of up to 20 times, and yet still traded at a discount to NAV. That remarkable set of circumstances enabled investors to replace all-equity portfolios with a capital shares and cash combination portfolio which limited their equity exposure, and hence risk, to a fraction of what would otherwise be the case. Yet without losing any upside.

The remarkable paradox about capital units is that the higher the leverage, and hence the risk, in these things, the more one can reduce portfolio risk.

Scott Swallow, Financial Advisor
Manulife Securities Incorporated

Scott, I suggest that the critical element of your argument is the phrase “remarkable set of circumstances” and that, in the absence of such remarkable circumstances, our views are probably not very different.

Perhaps, as printed, my “sucker” epithet was too general – I certainly did not mean to suggest that all capital units were always bad all the time at all prices. If somebody offers to sell me capital units with an intrinsic value of $10 for a penny each, I’ll back up the truck! As I like to say, at the right price, even a bag of shit can be attractive: I buy fifteen of them every spring for my garden! So, perhaps I can be faulted for not qualifying my statement enough – but the reporter and I were talking about the issuance of these securities and he only had 1,000 words or so to work with – a full investigation of Split Shares takes considerably more space than that.

But your argument, as stated earlier, rests on the assumption that somebody else has taken a double loss – first on NAV, then on market price relative to NAV. I claim, that given the risk-reward profile of capital units at issue time in general, the IPO buyers (and most of those in the secondary market) are suckers.

NXY.PR.U Particulars

Friday, April 2nd, 2010

With an eMail headed NXY.PR.U, I was asked:

Can you please comment on how to classify the subject preferred shares ? How would you rate the credit risk ?

NXY.PR.U is more formally referred to as Nexen 7.35% Subordinated Notes due 2043, which were issued pursant to a Prospectus Supplement dated October 28, 2003, which is available on SEDAR.

The prospectus states:

Our unsecured subordinated debentures due November 1, 2043 (the ‘‘Subordinated Notes’’) will bear interest, payable in U.S. dollars, at an annual rate of 7.35%, accruing from November 4, 2003 and payable quarterly in arrears on February 1, May 1, August 1 and November 1 of each year, commencing February 1, 2004.

The Subordinated Notes will be subordinated to all our present and future senior indebtedness and will be effectively subordinated to all liabilities of our subsidiaries, including partnerships.

This deep subordination means that the only thing they are senior to is equity – which will include preferred equity if Nexen ever issues some. However, they are on the right side of the bond/equity line, which means there are events of default. These events of default are specified on page 32 of the Shelf Prospectus, dated October 22, 2003, and are not over-ridden (as they might be) by the Prospectus Supplement for this particular series. This means that in the event of a missed interest payment, the holders of NXY.PR.U may declare the principal immediately due and payable, effectively placing the company in bankruptcy. This is significantly more protection than is available with preferred shares, although in practice holders of the sub-debt might wish to keep the company out of bankruptcy since they’ll be totally out-gunned and subordinated to the Senior Debt Holders in bankruptcy court.

However, if matters were to become sufficiently dire that the company could not meet its obligation to pay interest, they have the option to forestall such a move by redeeming the issue for common shares. This issue is currently redeemable at par:

We may redeem the Subordinated Notes, in whole or in part, at any time and from time to time on or after November 4, 2008 at a redemption price equal to 100% of the principal amount of the Subordinated Notes to be redeemed plus any accrued and unpaid interest to the date of such redemption.

We may satisfy our obligation to pay the applicable redemption price (excluding any accrued and unpaid interest) or principal amount of the Subordinated Notes by delivering to the Trustee (as defined herein) Common Shares (as defined herein), in which event the holders of the Subordinated Notes shall be entitled to receive cash payments equal to the applicable redemption price (excluding any accrued and unpaid interest) or principal amount from the proceeds of the sale of the requisite Common Shares by the Trustee.

The noteholders will not actually get the shares; they will be sold by the Trustee and the proceeds deposited in trust (see “Common Shares Payment Election” in the Prospectus Supplement). Another wrinkle is that there is no set number of Common Shares that must be delivered:

Notwithstanding the foregoing, we will not be permitted to satisfy our obligations to pay the redemption price (excluding any accrued and unpaid interest) or principal amount of the Subordinated Notes through the delivery of Common Shares if, on the Common Shares Delivery Date, the Common Shares are not then listed on a significant stock exchange in Canada or the United States. Neither our making of the Common Shares Payment Election nor the consummation of sales of Common Shares on the Common Shares Delivery Date will:

) result in the holders of the Subordinated Notes not being entitled to receive cash in an aggregate amount equal to the redemption price or principal amount of the Subordinated Notes plus, in each case, accrued and unpaid interest and other amounts, if any, thereon on the Maturity Date; or

) entitle or oblige such holders to receive any Common Shares in satisfaction of our obligation to pay the redemption price or principal amount of the Subordinated Notes.

So the Common Share Payment Election is a death-spiral conversion. I suspect the company would, 99 times in a hundred, prefer to go bankrupt.

The income distributions (7.35%, remember) are payable quarterly and are taxed as interest.

As far as credit quality is concerned … well, there’s a limit to what I’m going to do for free! DBRS rates them BBB(low), which maps to about maybe Pfd-2(low) / Pfd-3(high), somewhere around there.

There was something of a craze for issues of this nature back in the old days, when men were men.

Preferred Securities
CAD denominated
Ticker Issue Date Redemption Date
AEC.PR.A / ECA.PR.A 1999-8-9 2004-8-10
BNN.PR.S / BAM.PR.S 2001-12-20 2007-1-2
BNN.PR.T / BAM.PR.T 2002-4-22 2007-7-3
ENB.PR.B 1999-7-8 2004-12-16
ENB.PR.C 1999-10-21 2004-12-16
ENB.PR.D 2002-2-15 2007-2-15
MG.PR.A 1999-9-21 2004-10-1
SU.PR.A 1999-3-15 2004-3-15
TA.PR.A 1999-4-13 2005-2-16
TA.PR.B 1999-12-22 2005-2-16
TA.PR.C 2001-11-30 2007-1-2

Given the preponderance of of utilities in the above list, I suspect that this was a mechanism whereby the companies could gain the advantages of preferred shares (better credit ratios on their senior debt) without running afoul of contemporary regulatory restrictions on the issue of preferreds. But I have no definitive information on that point.

It was a nice market, hopelessly inefficient. Then, unfortunately, they continued to trade at enormous premia even as the first redemption date approached, yields declined to derisory (and even negative) levels and when they were called poor old retail got left holding the bag. I discussed the asset class in an article titled Interest Bearing Preferreds.

NXY.PR.U has not been previously discussed on PrefBlog. It is not tracked by HIMIPref™ since it is USD denominated.

Marginal Tax Rates: BC

Tuesday, March 23rd, 2010

An Assiduous Reader of PrefLetter writes in and says:

I believe your Equivalency Factors for taxes (Table 3 in Preletter March) are wrong for low-income earners.

The dividend credit can be applied to other income which results in a negative marginal tax rate on dividends. For example, for BC $30,000, 2009 tax year, this is -14.36% (regular income taxed at 20.06%) so
equivalency is 1.43.

This handy website will give you the marginal rate without capping them at 0% like the E&Y calculator does:

http://taxtips.ca/taxrates/bc.htm

The point is well taken – but unfortunately I do not consider taxtips.ca to be an authoritative source. According to their website:

TaxTips.ca is owned by a small private company located in Cedar, British Columbia. It is prepared by a husband and wife team who are retired from owning and operating a small business, with one being a retired CGA (Certified General Accountant). The goal of the site is to be a reference site for easy to understand tax, financial, and related information.

In order to consider a source authoritative I want to see names. I also want to see that the person making a claim has something at stake in the matter and is pronouncing on a subject on which they are earning a living. I consider it highly important in this wonderful world of looney-tunes in which we live that somebody maing a claim get hurt – either directly in the pocketbook, or (as in the case of academics) in reputation – if they make a mistake. And size helps (although I am realistic enough to recognize that it’s no guarantee): Ernst & Young, for instance, will have many opinionated partners who will jump on any egregious or doubtful claim because E&Y’s reputation is their reputation. While this means that many publicly expressed opinions get diluted to the point of uselessness, it does imply that what they do say has a reasonably good probability of being right.

So, while the Assiduous Reader’s claim has a ring of truth to it, I am – as I always stress – not competent on tax matters and am looking for an authoritative source to substantiate the claim. Any help will be appreciated.

Preferred Shares & Annuities

Tuesday, March 16th, 2010

An Assiduous Reader writes in and says:

My background is in insurance and mathematics {now retired at 56}. I am intrigued by the perpetual preferred shares offered by quality institutions rated Pfd 1 or 2 {about 12 to 15 issuers}. With the higher yield and the Canadian dividend tax credit, I am comparing this investment strategy to purchasing a joint life-time annuity with a guaranteed period of 25 years. On the surface, the rate of return is about 6% annually. I recognize the annuity has a return of capital component.

So here’s my riddle…why wouldn’t I buy the quality perpetual preferreds for the ongoing income whereby I can transfer the shares to my spouse [or vice versa] and, likewise, to our children in perpetuity – unlike the annuity that would cease upon on our last-to-die joint death and/or 25 years. The fluctuation in the capital value of my preferreds would not concern me – anymore than the annuity where the entire capital is ‘lost’ upon the initial purchase.

Lastly, if I wanted to ‘boost’ my yield on my preferred portfolio, I would re-invest the dividends for a few years to a level of income that I would like [eg 10%/year} and then that would be the rate of return in perpetuity. If this 10%/year is approximately the long-term equity stock market return, why would I even bother taking on the extra risk with equities and the aggravation of trying to select the appropriate securities for my portfolio.

If this makes sense, then my entire investment strategy should be with perpetual preferreds. {I have other significant assets}

Maybe I am missing something so, thus, my email to you. This ‘riddle’ is starting to keep me up at night!

I am not particularly comfortable in this field of investment decision-making, so take everything below with a grain of salt and do your own research. But I’ll give it a stab! Any corrections or elaborations will be gratefully received.

But first, let me say that the Inquiring Reader is on the right track. Preservation of Income – as opposed to Preservation of Capital – is what preferred shares are all about.

Morningstar publishes life annuity rates; a sixty-year-old male is looking at an annual payment of about 7.2% of principal; at 70 it’s about 9%; and at 75 it’s about 10.8%.

According to Standard Life, the income is taxed as regular income:

Registered

The annuity payment is fully taxable

Non-registered

Only the interest portion is taxable

The taxable portion can be reported on a “prescribed” or “non-prescribed” basis

  • Prescribed: level taxable portion each year
  • Non-prescribed: taxable portion changes each year (interest reported each year reduces)

The prescribed taxation basis is attractive to taxpayers as it allows for the deferral of taxes. It is regulated and can only be used with specific types of annuities. All other annuities must be on a non-prescribed taxation basis.

To estimate how much of the annuity payment is return of capital, I used the Canadian Business Life Expectancy Calculator with the following data:

Life Expectance Calculations
Data Required Age 60 Age 70 Age 75
Age 60 70 75
Sex Male
Height 6’0″
Weight 190 lbs
Frame Small
Physically Active? Somewhat
Level of Stwess Low
Smoking Less than 2 packs a day
Drinking Habits Never more than three drinks
Eat Saturated Fats How the hell should I know? I’m a GUY, ferchrissake. Call it once or twice a week
Elevated cholesterol No
Normal blood pressure Um … when talking about regulators and politicians? Or other times? Call it yes
Two subquestions skipped
Parents lived long? Yes
Siblings with bum tickers? No
Accidents or speeding tickets? No
Post-Secondary Yes
Not poor? yes
Safety belt? Even in bed!
Estimated Lifespan 80 83 85

So at age 60, we’ll say 20-years to go; 13 years to go at age 70; and 10 years left at age 75.

Some quick work with MS-Excel, with the assumption that the capital is all gone at the end of the annuity results in required yields of 3.6%, 2.3% and 1.4%. We’ll summarize this in another table:

Annuity Rates and Required Return
Age Years Left Annuity Rate IRR
60 20 7.2% 3.6%
70 13 9.0% 2.3%
75 10 10.8% 1.4%

Holy smokes! I’ve definitely made a mistake somewhere … could be the assumptions, the math, or the fact that I didn’t go into the insurance business.

However, before we leap wholeheartedly into PerpetualDiscounts as life-annuity substitutes, let’s take a look at the risks:

Credit Risk: Annuities are a far more senior claim on the insurers than preferred shares, especialy since – as far as the insurers are concerned – an annuity is a claim on the operating companies assets, while a preferred share is a claim on the parent. It is entirely possible that in times of trouble, a preferred shareholder could get nothing while an annuity holder could get paid in full … even in the absence of a government bail-out.

Return Order Risk: An annuity withdraws principal on a steadily increasing basis – even if that basis has to be calculated on a post hoc basis. Thus, if we are performing a direct comparison, we also have to withdraw principal from our preferred share portfolio on a steady basis. This means we are exposed to Order of Returns Risk. And that’s even before we consider:

Principal Evaporation Risk: With an annuity, the insurance company takes the risk that you will last longer than expected, and covers it with their chances that other clients will make up for it. With a preferred share portfolio – or any investment portfolio – you’re the one stuck with that risk.

Call Risk: Say preferred share yields fall dramatically and your shares get called. This will definitely foul up your long-term returns because your returns after the call date will reflect the coupon of your PerpetualDiscount, and not the initial yield – and that’s even before you account for frictional costs of the process.

As noted in the comments, this is overstated. Your yield will go down but, to at least some extent, your capital will have increased on a call. However:

  • There will be capital gains tax to pay
  • There is no guarantee that suitable replacements will be available
  • A call will normally take place when the issuer can refinance cheaper, so there will be a yield hit to reflect “cheaper”.

Tax Risk: The tax regime for dividends could change, eliminating at least some of the dividend advantage

Inflation Risk: This will be about the same for both strategies, but you do have the option to buy an indexed annuity, whereas there are no indexed preferred shares at present. At some point, a deeply discounted FixedReset with a microscopic spread against five-year Canadas might be functionally equivalent, but we don’t have any of those yet. Other floating rate perpetuals (Ratchet, FixedFloater, Floater) might be considered equivalent, but then you have basis risk (either prime or five-year Canadas vs. inflation) and extant non-FixedReset Floating Rate issues don’t have sterling credit quality.

All in all, the risks are significant, but the returns are certainly juicy. I would advise that annuities are good for the bare-bones-beans-on-a-hotplate portion of retirement income, while preferred shares – and other investments – provide the income that you spend in Florida.

There are probabily mistakes in the above – this is not a topic I spend a lot of time on. My job is to take the investor’s allocation to preferreds and do a better job with it than he could himself – not to decide on the allocation. Any commentary will be be appreciated.

Update: See also Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance, Ibbotson, Milevsky, Chen & Zhu, ISBN 978-0-943205-94-6

Update, 2010-3-17: See also the So you are going to buy an annuity. With what? discussion on Financial Webring Forum.

Update, 2010-3-17: Another good article is Annuity Analytics: How Much to Allocate to Annuities? by Moshe A. Milevsky.

Update, 2010-3-19: There’s a good table in Milevsky’s Annuitization: If Not Now, When?:

Value of Unisex Mortality Credits:
Assuming 40m/60f (static) Annuity 2000 Table at 6% net interest.
Age of
Annuitant
Spread Above
Pricing Interest
Rate
(in Basis Points = 1/100 %)
55 35
60 52
65 83
70 138
75 237
80 414
85 725
90 1256
95 2004
100 2978
Source: The IFID Centre calculations

Update, 2010-3-25: Interesting conclusions and charts in Kaplan’s Asset Allocation with Annuities for Retirement Income Management

IFRS and the Assets-to-Capital Multiple

Tuesday, February 16th, 2010

An Assiduous Reader writes in and says:

I know how much you love to play the guess the ACM game. But here’s a new twist: what do you think the ACM of your favourite DTI’s are after OSFI requires all the billions of dollars of CMHC NHA MBS to be consolidated back on balance sheet? [link])

But here are some more interesting questions:

  • -why has no OSFI regulated publicly traded company commented on how this proposed change will affect their ACM? (home capital got through their entire earnings call without any mention of the ACM) they’ve obviously done the work (IFRS has been planned for years) but have chosen not to share their findings with investors.
  • -why has OFSI or the government (although perhaps this is too technical to score political points) not provided any timely clarity on this issue given the importance to the entire mortgage and residential real estate market? (The draft advisory was dated october 2009)
  • -will the government/cmhc allow the mortgage business to simply move into lightly capitalized unregulated vehicles to avoid the new OFSI rules? (i.e. is it OK to setup a shell company with $2MM in it that issues $10B in MBS pools?, do we really want the majority of mortgage origination occurring in the unregulated space as a public policy matter?)

A glossary will be helpful here:
OSFI : Office of the Superintendent of Financial Institutions
DTI: Deposit Taking Institution
FRE: Federally Regulated Entity
MBS: Mortgage Backed Securities
CMHC: Canada Mortgage & Housing Corporation
ACM: Assets to Capital Multiple
CGAAP: Canadian Generally Agreed Accounting Principles

The advisory states:

OSFI notes that off balance sheet assets under CGAAP have, during the recent financial turmoil, resulted in DTIs increasing their balance sheet assets during times of stress in respect of assets that no longer qualified to be derecognized and securitization conduits which were no longer exempted from consolidation. Lessons learned in the recent financial turmoil are that certain securitization structures did not transfer the risk out of the FREs as expected. OSFI is of the view that securitization assets which are not derecognized or which are not exempted from consolidation should be included in the calculation of the ACM.

Given that the implementation of IFRSs is expected to increase FREs’ on balance sheet assets and therefore to increase the ACM of DTIs and the borrowing multiple of cooperative credit associations, OSFI is of the view that, in some cases, an immediate application of those rules may be difficult for FREs to meet.

Insured mortgages securitized through the Canada Mortgage and Housing Corporation’s (CMHC’s) National Housing Act (NHA) Mortgage Backed Securities and Canada Mortgage Bond Programs (MBS/CMB Programs) are unlikely to achieve derecognition and will therefore be brought on balance sheet under IFRSs. To facilitate compliance with the ACM under IFRSs and permit an orderly transition, OSFI will permit mortgages sold through the MBS/CMB Programs up to and including December 31, 2009 to be excluded from the ACM calculation when IFRSs are adopted, regardless of whether they are brought onto the balance sheet under IFRSs. If so, FREs will be required to exclude pre December 31, 2009 MBS/CMB programs from the assets in the ACM calculation. However, to create an ACM which is more consistent and which reflects the lessons from the recent financial turmoil, MBS/CMB exposures occurring after December 31, 2009 will be included in the calculation of the ACM under the current ACM definition and limits; that is, they will be included in the asset definition of the ACM upon implementation of IFRS if (but only if) they are accounted for as on balance sheet exposures under IFRSs. No changes will be made to the non capital regulatory returns and FREs will be required to report in accordance with IFRSs; FRFIs will be required to adjust their assets included in their ACM calculation to give effect to the transition provisions.

Footnote: Irrespective of the IFRS determination of what is on balance sheet, the ACM should reflect the MBS/CMB originator’s risk profile. Where the risk profile of the MBS/CMB originator is not materially improved by participation in such a securitization, continued inclusion in the ACM may be appropriate.

Overall, this is not an enormous problem. OSFI reports that the Assets to Capital Multiple for all domestic banks was 15.58x as of 3Q09, with total capital at about $161-billion. The special NHA MBS buying programme is $25-billion and the CMHC had about $200-billion assets on the 2008 books … so consolidating the securitizations will add another multiple of 1 to the total ACM for the system.

As the Assiduous Reader points out, though, there could be trouble at the margins, particularly with specialty lenders; additionally, OSFI has shown in the past that it is incapable of running stress tests that include attention to the ACM.

This one bears watching …

Tax Impact on FixedResetPremium Yields

Friday, January 29th, 2010

Assiduous Reader pugwash asked on another thread:

The discussion ten days ago on this excellent blog about the impact of tax on premium bonds led me to consider if there is there a tax downside to owning premium resets.

How is the capital loss between the purchase price of say $28 in todays market and the call price of $25 dealt with?

Not many of us have capital gains to use as an offset!

He was referring to a comment by prefhound on my essay The Bond Portfolio Jigsaw Puzzle. And, naturally enough, his use of the phrase “excellent blog” virtually guaranteed a response!

In order to investigate the problem of tax effects, we need:

The last two requirements are permanently linked on the right-hand panel of this blog under the heading “On-Line Resources”. Note that we don’t really need the “FixedResets” version of the calculator; since we’re only going to be calculating yield to the first call, the regular version will do the same job; but we’ll use the souped-up version anyway. Why not?

Calculations will be performed for an Ontario resident with taxable income of $150,000. Ernst & Young claims the marginal rate on capital gains is 23.21% and the marginal rate on dividends is 23.06% (compare to the marginal rate on income of 46.41%, which is not used in this calculation).

pugwash specified a price of $28 for discussion, so for discussion purposes we’ll examine HSB.PR.E, which closed last night at 28.01-15. It pays 1.65 p.a. unitl the first Exchange Date 2014-6-30, when it resets to GOC5+485, or is called at 25.00.

The dividend rate of 1.65 implies quarterly payments of 0.4125. For taxable accounts, we will assume that this is reduced by 23.06% to 0.3173775. Dividends are paid at the end of June/Sept/Dec/Mar and the next ex-date is March 11 (estimated) so we’ll get the next dividend.

It should be noted that a horrifyingly precise calculation will not pay the tax on day of receipt, as assumed in the above paragraph, but pay annual taxes in the following calendar year. HIMIPref™ does this calculation, but the current calculation using the spreadsheet software doesn’t.

The maturity price is 25.00, which is all we need for the non-taxable calculation, but taxable accounts with capital gains will be able to claim the 3.01 capital loss until maturity. The tax rate of 23.21% on capital gains implies that this deduction will be worth 0.698621, so a taxable account with capital gains to offset the loss may use a maturity price of 25.698621.

Having accumulated the data, we can fill in the calculation spreadsheet:

HSB.PR.E Yield-to-Call Calculations
Data Non-Taxable Taxable with Capital Gains to offset loss Taxable without Capital Gains to offset loss
Current Price 28.01
Call Price 25.00 25.698621 25.00
Settlement Date 2010-1-28
Call Date 2014-6-30
Quarterly Dividend 0.4125 0.3173775 0.3173775
Cycle 3
Pay Date 31
Include First Dividend 1
First Dividend Value (if different) [blank]
Reset Date 2014-6-30 (irrelevant)
Quarterly Dividend After Reset 0.4125 0.3173775 0.3173775
(irrelevant)
 
Annualized Quarterly Yield to Call 3.43% 2.61% 2.04%
Effective Tax Rate 0% 23.91% 40.52%

Note that the calculated yield on the taxable account with no capital gains (2.04%) is a little harsh, because it does not reflect the fact that the investor will have a capital loss of 3.01 that may be used at some time to offset future capital gains. However, if he never makes any capital gains, this asset will be worth zero.

Note also that the effective tax rate for a taxable account with capital gains (yield of 2.61%, effective tax rate of 23.91%) is in excess of both the capital gains rate and the dividend rate. This is because the investor is paying tax up-front (when the dividends are received) and receiving the benefit of the capital loss later.

Weston Prefs and a Possible MBO Scenario

Saturday, January 9th, 2010

Assiduous Reader BL writes in and says:

First, congratulations on your blog, an excellent read!

That’s the spirit, BL! You know how to get me to respond to eMail!

I’ve been looking at the George Weston common shares recently and there has been some speculation of a possible management buyout. If that ever were to happen, I’d like to know what you think would happen to the prefs? Do you think they would fall in value (like BCEs) because the company would probably have to take massive leverage to proceed to the MBO or do you think they would be taken out with the common stock at at least face value? Just curious to understand if there is any way to play this possible deal with the prefs.

The answer to that question depends on the structure of the deal.

The BCE deal was structured as a Plan of Arrangement under the Corporations Act. It is my understanding – as a layman in matters of law and tax – that this was done in order to make the deal simpler.

Since it was a Plan of Arrangement, each class of shareholder voted separately; since the preferred shareholders would have seen a marked decline in credit quality if their shares had remained outstanding, they needed to be placated with a redemption offer in order to obtain their assent.

If it had been a regular take-over, with XYZ making a normal offer for the common shares, the preferred shareholders would not have got a vote and would have been squashed by the weight of new debt; this would have been the case had the earlier intention to become an Income Trust come to fruition.

In the case of Weston and its possible MBO – you can rest assured that an army of expensive lawyers and accountants will be making the decisions based on what’s good for the guy paying them. Without expertise in such matters or access to the talks regarding financing of a possible deal, an outsider is simply guessing.

Alpha Trading, Pure and Preferred Shares

Wednesday, October 28th, 2009

Assiduous Reader prefhound writes in and says:

I have a question about two weird pref share trades that ocurred in my [REDACTED BY JH] account today.

I was buying something (after trying other prices) at an offer price of $22.40, so I put in a buy limit price of $22.40. I was filled at 22.39, but my trade volume and price does not show up in the daily quotes (high for this stock is given as 22.27; my volume and trade is not reported by the TSX and my fill made no difference to the offer price of 22.40 and number of lots).

Several hours later, I was selling something (again after trying higher prices) at a bid price of $21.58. I placed a limit sell at $21.58 but was filled at 21.59 (again one penny difference), but my trade volume and price do not show up again.

Is it possible that [REDACTED BY JH] is blindly internally matching bids and offers at a 1 cent difference to the market, then filling by a cross with me and not reporting the trade?

Alternatively, is this a “dark pool” or “rapid trading” issue?

I guess I am not supposed to be unhappy with internal crosses at 1 cent bonus to me, but I’m wondering if unreported trades don’t distort the market — my trade in the second stock is 5X the reported volume!

Your trade was almost certainly filled by an Alternative Trading System such as Alpha Trading Systems, which currently claims overall market share of 20% and challenges to become the primary market in some securities.

Now, it’s very nice to get filled a penny better than you expected – but there are issues for those among us who attempt to sell liquidity. If your limit order has been routed to the Toronto Stock Exchange, for example, and you look at only data feeds from the Exchange, you might be doing yourself out of a little money.

Say you put in a bid at 20.00 at a time when the Exchange is quoting the issue at 19.90-10. Immediatley afterwards, the Exchange will report the quote as 20.00-10 … so far, so good. But there could be ten bazillion market orders to sell coming down the pipe, all of them getting filled on Alpha at the Alpha bid of 20.01. Not only will you not get filled, but you won’t even know about these orders.

Alpha’s October Newsletter contains a discussion of their market data pricing strategy, and their website shows a list of authorized vendors of this data.

To get an idea of volumes and delayed quotes, you may wish to go to the sites of Alternative Trading Systems – I have added a category of links (in the right hand navigation panel) titled “Quotes (Delayed)” with some addresses. For example, the following data can be compiled for GWO.PR.H:

Trading in GWO.PR.H
2009-10-28
Exchange Range Volume Closing Quote
TMX 19.58-70 5,566 19.52-66, 2×1
Pure 19.61-73
(Last 10 Trades)
4,500 None-19.84, 0x5
Alpha Last trade 2009-10-20

Potential for Buy-Backs and Unscheduled Exchanges

Tuesday, October 20th, 2009

Preferred Share buybacks are a perennial topic of interest on PrefBlog and were most recently discussed on the post Split-Share Buy-Backs? WFS.PR.A & FIG.PR.A Examined.

Now, Assiduous Reader PL writes in and says:

Just wondered if companies are allowed to buy back their preferred shares the same way they buy common shares? I am analyzing SLF.PR.A for example. With the redemption at 25 buying as many as you could at around 20 would make sense if you were allowed to and planned to redeem it. Thanks.

There are two items of interest in the prospectus for SLF.PR.A, which may be found on SEDAR, with an issue date of February 17, 2005:

Conversion into a New Series of Preferred Shares

SLF, at any time by resolution of the Board of Directors of SLF, may constitute a separate series of Class A Shares (‘‘New Preferred Shares’’) having rights, privileges, restrictions and conditions attaching to them (other than any option or right to convert into Common Shares) which would qualify such New Preferred Shares as Tier 1 capital of SLF under the then current capital adequacy guidelines established by the Superintendent. In such event, SLF, with any necessary prior consent of the Superintendent, may give registered holders of the Class A Preferred Shares Series 1 notice that they have the right, pursuant to the terms of the Class A Preferred Shares Series 1, at their option, to convert their Class A Preferred Shares Series 1 on the date specified in the notice into fully-paid and non-assessable New Preferred Shares on a share for share basis. SLF will give notice of any option to convert to registered holders not more than 60 days and not less than 30 days prior to the conversion date. See ‘‘Insurance Act Restrictions’’. SLF will ensure that such New Preferred Shares will not, if issued, be or be deemed to be ‘‘short-term preferred shares’’ within the meaning of the Income Tax Act (Canada).

Purchase for Cancellation

Subject to the provisions of the Insurance Act, the prior consent of the Superintendent and the provisions described below under ‘‘Restrictions on Dividends and Retirement of Shares’’, SLF may at any time purchase for cancellation any Class A Preferred Share Series 1 at any price.

So the short answer to AR PL’s question is “yes”.

But under what circumstances would they do this? The funds represent cheap money – cheap Tier 1 money at that. In the ordinary course of business, there would be no reason for them to buy these things back: even if they didn’t need the money now, they’re going to figure that it’s really nice to have it anyway, since it’s cheap and replacing it a few years down the road will not only entail a probably higher coupon, but issuance costs as well.

However, there is the occasional redemption announcement that takes place when the issues are trading below par. The most famous of these announcement was the abortive Teachers’ bid for BCE, in which the preferreds were planned to be redeemed since the take-over was intended to proceed by Plan of Arrangement, to which the Preferred Shareholders voting as a class were allowed veto power under the Corporations Act, which they certainly would have exercised if they hadn’t been given a sweetener under the deal, even considering the dim-bulb nature of many of these holders.

There were a few scattered redemptions of floaters that traded below par in the 1990s (notably TD.PR.D and BNS.PR.A) but these were nowhere near the $20 level at the time of the announcement. While I’m sure holders did not object to the redemption, they didn’t make out like bandits either.

The other extract from the prospectus that I have highlighted is the potential for exchange into a new series of shares … a client asked me about this in connection with TD.PR.O just last week and that prospectus has similar language.

The first thing to note is that the exchange is optional for both parties. SLF doesn’t have to create the new series; holders don’t have to exchange. All I can imagine to justify the clause is a potential smoothing of the way for a redemption and new issue to be done simultaneously.

Say, for instance, straight perpetuals suddenly trade to yield 4% and SLF.PR.A trades at $26 (not the $29.69 implied by the $1.1875 dividend due to the potential for call). What Sun Life could do – for instance – is send preferred shareholders an envelope with two notices in it: the first advises that the issue will be called at par on November 1 and the second advises that they can exchange into a new issue of SLF preferreds paying $1.05 (a nickel in excess of market rates), provided that they do it on October 31.

Presto, SLF achieves its desire of reducing their cost of funds and don’t have to pay $0.75 per share issuance expenses either. I would not consider this a coercive exchange offer, because it has always been understood that the issue could be called at par; it’s not like other offers we’ve seen lately where the company says something like: do this, because we’re going to cancel the dividend.

Having the exchange clause in the prospectus might make this process simpler and less costly should SLF ever wish to do this … but I’m not a securities lawyer. Those among you who ARE securities lawyers – or fancy their legal skills – are invited to come up with better explanations in the comments.

Update: See also Repurchase of Preferred Shares by Issuer, which references the GWO.PR.E / GWO.PR.X Normal Course Issuer Bid.