PrefBlog

An Assiduous Reader writes in and says:

A question: How does a retail investor hedge out interest rate risk on perpetual preferreds?

Is there any simple, or reasonably efficient, way to do this?

Well … they can’t, really, which is one reason why I recommend that no more than 50% of a fixed income portfolio be in preferreds.

However, investors should be aware that the Modified Duration of a PerpetualDiscount is simply the inverse of its yield (see http://www.prefblog.com/?p=2582). With yields at about 7%, this means a MD of about 14 years. Many investors will blithely purchase 30-year strips while fussing about the interest rate sensitivity of perps.

I’ve written an essay on Perpetual Misperceptions (see http://www.prefblog.com/?p=1308) … there will be many more!

Perpetuals do have interest rate risk and – more importantly – inflation risk, but I suggest this be addressed in the rest of their portfolios; common stock in resource companies, for instance, or a shorter-than-otherwise-indicated duration in their bond portfolios. At one point – I haven’t done the calculation recently, it’s probably even better now – a taxable investor could swap his Universe iShares into perps and Short-Term iShares on a duration neutral basis and pick up a point in yield. (see http://www.prefblog.com/?p=2399)

A newly Assiduous Reader who is also new to the market writes in and says:

Today, RY.PR.P did not trade AT ALL until after 12:00! Is the market for prefs that illiquid? The price also swung from being below the value of RY.PR.R to ending above the value for R. In my opinion ONLY, the price for R should be higher then the price for P if you are a long term investor. Therefore I question my understanding of pricing in this marketplace!

You and me both, brother, you and me both.

This month’s edition of PrefLetter (currently at the Graphic Artist’s Spa, having its hair done and nails manicured) will contain a section with a new pricing model for Fixed-Resets … so I won’t discuss it here. Instead, I will refer to my last post on Sloppy, Sloppy Markets and take another look at a not-entirely-randomly chosen example of market inefficiency in the Pereptual Discount sector.

This table presents a difficult question to Efficient Market zealots – who implicitly presume infinite liquidity as part of their efficient market. How on earth is it possible to rationalize the quotation on BMO.PR.H?

We’ll review a little … I estimated in my 2007 essay on convexity that being 15% or more away from the call price was worth about 15bp in yield; that is, a PerpetualDiscount trading at around $21.75 should yield about 15bp less than a similar issue from the same issuer trading at par; the higher coupon / higher price issue should yield more since any gains from a decline in yields should be expected to be called away, while the lower priced issue has a higher potential for capital gains.

We can argue for as long as we like regarding details such as:

• 15bp yield difference?
• 15% price range of effect?
• straight line or curved effect?

but there definitely should be an effect and this effect should be positive. In June of 2008 this relationship went negative … while the curve returned to normal after a little while, it certainly resulted in a poor month for the fund I manage. It is these episodes in which the market defies common sense that make leverage such a dangerous game!

Note also that the ModifiedDuration of PerpetualDiscounts (which is a measure of price sensitivity to yield changes) is – to a first approximation – dependent solely upon the yield of the instrument. Any PerpetualDiscount with a given yield has the same yield risk as any other PerpetualDiscount with the same yield, except as distorted by the potential for calls taking away your winnings. So we can’t use yield-sensitivity as an argument.

In sum, I have to advise my newly Assiduous Reader to relax and enjoy the market inefficiency. Once you have a decent model for prices, you can make good money by exploiting transient anomalies and waiting for them to correct. This will increase your turnover and therefore your commission cost (which concerns a lot of people who are inspired by regulatory emphasis on the Trading Expense Ratio), but all moneymaking endeavors have some kind of cost.

Further examples of inefficiency and pricing models for PerpetualDiscounts will be presented at the seminar on February 26. Or, if you don’t want to do it yourself, you can always consider an investment in my fund, which uses many pricing models to check each other and is always on the prowl for anomalies.

I have received a communication from a novice investor that ties together a lot of things that I’ve been writing about …

I came across the report on TD issuing the tier 1 notes and, in my attempt to find further information, subsequently stumbled on your blog.

I was just wondering if you could provide insights on this issuance. I’m new to the investment game and I’d like to establish a solid fixed-income foundation before looking at equities. Based on a quick overview of the preliminary prospectus, these notes appear to be subordinated debt, exchangeable into preferred stock in case of insolvency. I don’t particularly like this provision; I’d rather own the kind of senior debt that triggers liquidation in the event of defaulted payments.

In any case, could you please lay out the basics of these tier 1 notes and explain how they differ from ‘traditional’ bond debt.

I discussed the new issue of TD CATS earlier today; it is similar to December’s BMO issue.

As far as discussion of the basics of bank debt are concerned, I am sufficiently immodest as to suggest my own essay, titled “A Vale of Tiers”. Note that sometimes assigning seniority to different types of bank debt can be a mug’s game: see BAs or BDNs – What’s the Difference?.

Also, could you comment on the following:

– What do you think of currency risk when it comes to investing in foreign securities? I look at the TSX and it’s really missing the ‘pizzazz’ of stocks from south of the border. My feeling is that I should avoid foreign investments because it adds a dimension (currency risk) that I know little to nothing about; nor do I want to deal with it.

I suggest that most portfolios should have a certain amount of currency exposure. How much of your expected expenditures are foreign-currency dependent? The answer is probably more than you think – oil is traded in USD and we pay for winter fruits and vegetables in USD. However, there is probably a certain amount of exposure in any portfolio anyway … most resource stocks will be USD dependent to at least some extent.

I make no recommendations on currency exposure. It’s just not what I do!

Does Canada have a decent tool for gaining (free) transparency into the bond market, like ‘finra’ in the U.S.?

In the “Canadian Fixed Income Data” section of the links in the right hand panel, I link to both Canadian Bond Indices and Perimeter. That’s the best I know of for Canada … but thanks for mentioning FINRA – I’ve just added that link to the US Fixed Income Data section.

Do you share the view that preferreds are at an inherent disadvantage owing to the lack of upside potential relative to common stock on the one side, and lack of security relative to bonds on the other? This is what I understood from reading Ben Graham’s ‘Security Analysis’. But things may have changed since 1934 😉

I discussed Benjamin Graham’s views recently. Basically, he was writing at a time when tax rules made preferred stocks far more attractive to corporations than to individuals … so by the time that corporations had finished sifting the offerings, there wasn’t much left for retail! A similar situation is found in Canada when considering holding preferred shares in a Registered Plan – taxable investors are so favoured by legislation that there’s rarely anything left available that would be attractive for non-taxable holders.

Any expertise you’d be willing to share would be greatly appreciated. Perhaps you could reply on your blog for the benefit of your readers.

My pleasure – and I hope you become an Assiduous Reader!

I have recently been asked:

At what point will a company redeem its preferred shares, if the yield is high enough at some point the amount of interest they have paid out will be greater than the amount of capital generated from the sale of the preferred share. Is there a point where a preferred share just ceases to be traded, or does a company have to redeem them? My question is basically a pref can’t trade forever so how do you know when it will stop trading? I am assuming it may go on past the redemption date since the information you have provided says usually after 5-10 years.

… to which I respond:

It is true that at some point the amount the total amount of interest/dividend exceeds the original capital invested, but this is true of long term bonds as well. At five percent, money doubles in 15 years … so for a 5% 30-year bond, only one-quarter of the original value is represented by return of capital – three quarters of the value is the income stream. UK Perpetuals issued during the Great War are still trading.

As long as the company can invest the capital to achieve a rate of return higher than their payments, it’s a good deal for them.

There is no reason why a perpetual can’t trade forever. It will be called only when it makes sense for the company – which could be due to cheaper refinancing, simplification of the capital structure, take-over, bankruptcy, any number of things. Most perpetuals issued in the 90’s have been called, but only because refinancing was cheap.

Assiduous Reader louis made a very good suggestion in the comments to October 10 that is worthy of being highlighted – particularly in the light of the extraordinary policy actions taken by government to shore up teetering confidence.

“Unbelievable” indeed but my purpose here is not to cry over spilt milk (there is just so much tears one can produce) but to run by you a possible “solution” to the present turmoil since you are the most knowledgeable and reputable person I know on Economy and Financial matters patient enough to read and reply to its assiduous readers.

The underlying basic idea here is not from me but I will expand a bit on it. Should you find it worth to be explored, discussed and publicised in one of your blog’s daily comments or elsewhere, I would be more than happy. My only purpose here is trying to spread what I do verily believe would greatly assist a prompt mitigation of the damages the present crisis is causing all of us:

Well, I’ll give it a whirl! It is odd, you know, but I don’t consider myself a macro-guy at all; by which I mean somebody who studies the economy with a greater or lesser degree of competence and takes market action based on that analysis. In fact, I don’t think the macro-economic approach works at all in the long term – see, for example, my post on market timing, for instance.

My specialty is on the micro side … I simply weigh bundles of cash flows and try to buy the cheapest bundles. It makes for extremely boring justifications of why I have taken such-and-such market action, but it has, historically, resulted in outperformance against the benchmarks.

1. Whatever is the true cause of the current mess, it is clear to me that loss of confidence and panick is making things worse to a point that this is what be addressed to first.

Agreed. We have nothing to fear but fear itself! What is happening is that fear of asymmetrical information has taken over the valuation process … by which I mean that many investors, confronted with a drop in the price of stock they hold, are not shrugging it off or using it as an opportunity to buy more, they are taking it as evidence that somebody knows more than they do and are selling.

A bank might have to write off, say $1 per share due to the mark-to-market regime … and this is resulting in a $2 decline in their stock price.

2. Anedoctolly but not totally out of topic, the number #1 request received this week over and over by the legal department of a finanical institution here in the Province of Quebec was whether a type of deposit, GIC or other instrument was insured by the Canadian insurance deposit. In my humble opinion, the decision of the US and of some European States to increase deposit insurance to 200k or to an unlimited amount was not a good idea at all. While it may have been justified to increase deposit insurance to a certainl level when a bank in difficulty was raided. It should have been done on a bank by bank basis with a reasonable limit (The US 200k figure in the US is ok in that respect). This being said, I hereby grant the “how-to-exacerbate a panick award” to the Irish government and its followers. In my humble opinion, one effect of their unlimited guarantee on all bank deposits has been to put in everyone’s mind the fear that the banking situation must indeed be so bad that even bank deposits, in whichever bank they are, are in jeopardy. It is also my understanding that having huges some of money in bank deposits rather than directly invested by their depositors into securities (corporate obligations, shares, prefs, etc.) is far less beneficial to the economy since, unlike investors, banks must maintain minimal reserves for each amount deposited and simply do not have the staff to promptly re-invest the remainder of such monies into the market as investors normally do.

While the majority of the educated investors still believe that U.S bonds are an extremely safe investment there might very well be someone in China managing a couple of trillion dollars in value of US bonds who might (rightfully in my opinion) fear that the US deficits, war expenses and trillions invested to salvage their financial system will at some point cause a drop of the US notes credit dropping such that more and more people are now likely to seek shelter in bank deposits. I even read / heard “said to be renowned financial analysts” that putting your savings under your mattress was the safest thing to do… (those too deserve one of my awards, let’s call it the “I-did-help-too-scuttling-our-economy” award).

It used to be that virtually all investment was done through banks. Then, with the rise of mutual funds, reduction of stock commissions and the continued rise of the middle class, “disintermediation” became more normal and the banks started getting cut out of the loop (and the profits).

In bad times, people tend to retreat back to their banks – their good solid banks, that have a branch in the neighborhood and have their names on entertainment facilities – and reintermediation becomes normal. This has been discussed in the post Banks Advantage in Hedging Liquidity Risk.

3. Ironically, govermental insurance is the solution but not on deposits beyond the figure a normal houselhold / small cap company should maintain!

I agree. In fact, as I suggested in Synthetic Extended Deposit Insurance: The Critique, deposit insurance should be keyed to a large fraction of median household income. That will be enough that long lines of small depositors will not form when a bank runs into trouble, as occurred in the Northern Rock episode (I believe that European style minimalist deposit insurance is expecting too much financial analysis from the non-specialist public).

On the other hand, people seem to demand the right never to lose money on short term investments – particularly the ones in which they invested because they paid so much better than boring old bank deposits. Frankly, I was amazed at the enormous effect that the buck-breaking at Reserve Primary Fund (discussed on September 19) had on the commercial paper market.

You can’t educate people. It seems to me, now more than ever, that branded money market funds must attract a capital charge on the banks. This will, naturally, increase the costs of putting together such funds – since the bank will have to hold as much capital against the MMFs as against any other deposit – but so be it. If the public wants guaranteed investments, insists on guaranteed investments, and will destroy the financial system if they don’t get guaranteed investments … well, then, they can have guaranteed investments. But they have to pay.

4. If I understand correctly, the banking system is so nervous itself that banks do not lend to each other at a reasonable costs for short term interbank loans thus depriving again the market of large amounts of much needed liquidities. This situation has all the potential of plunging us in a quick and deep depression. If a company cannot have short term credit as a result of this, it can only lay off employees, cut spendings, what will in turn drag into the same situation their suppliers, etc…

I’m not convinced it’s so much nervousness about lending to each other as it is a desire to hoard cash. The banks have huge committments on undrawn credit lines – just credit cards is enormous, never mind HELOCs and billion-dollar lines to corporations – and they have to ensure that the cash is there should the lines be drawn.

The current experience might mean that undrawn lines should attract a higher capital charge than they do now. This had enormous repercussions in the ABCP market; for various historical reasons, there was a high capital charge against US & International ABCP contingency lines, but no capital charge for a greatly inferior line in Canada. The result was that when the market seized up, money was available for the US/International SIVs, but not for Canadian.

Another illustration was the informal liquidity support given to the auction rate market in the States. Since there was no formal arrangement and no capital charge, there was no money. And so that market siezed up.

The question of liquidity guarantees will keep the Basel Committee busy for some years to come!

5. The TED spread, which is the difference between what banks charge each other for three-month dollar loans (three-month Libor) and what the government pays (three-month T-Bill) is now at 4.64%. For comparison, the TED spread averaged 0.36% in 2006. This is, in my humble opinion(and in the opinion of far more educated & knowledgeable people than I am), what has to be fixed WITHOUT ANY FURTHER DELAYS. Whatever are the merits of Paulson’s 700 billion plan which I still don’t fully understand, its effects are way too slow as evidenced by what we have been through this week.

Part of the problem with the TED spread is that the discount window is wide-open and cheap. But I agree that the enormous TED spread is symptiomatic of huge problems in the banking system.

6. Why then not provide governmental insurance to these interbank loans such that the money between banks resume flowing thus allowing them to resume lending more money at more reasonable prices?

Hmm … to a certain extent, this is what’s been happening for a while, sort of. Bank A has surplus cash; Bank B needs to borrow. However, instead of a direct deal, what is happening (to a certain extent) is that Bank B is borrowing from the Fed through one of its programmes – or the discount window – the Fed is neutralizing the cash injection via sale of T-Bills, and Bank A is buying the T-Bills.

However, I note that on the weekend:

France, Germany and Spain today committed 960 billion euros ($1.3 trillion) to guarantee lending between banks and take stakes in them.

The Guardian reports:

The British interbank guarantee, which looks likely to be adopted in part by Germany and France, effectively allows adequately recapitalised banks to seek government backing for short-term borrowings in return for a fee.

Britain said last week around 250 billion pounds would be available for this backstop. A draft of Germany’s plan on Monday outlined some 400 billion euros of bank borrowing guarantees and media reports said France would provide 300 billion.

There is more information available directly from the Bank of England and from HM Treasury:

Specifically the Government will make available to eligible institutions for an interim period as agreed and on appropriate commercial terms, a Government guarantee of new short and medium term debt issuance to assist in refinancing maturing, wholesale funding obligations as they fall due. Subject to further discussion with eligible institutions, the proposal envisages the issue of senior unsecured debt instruments of varying terms of up to 36 months, in any of sterling, US dollars or Euros. The current expectation is that the guarantee would be issued out of a specifically designated Government-backed English incorporated company. The Government expects the take-up of the guarantee to be of the order of £250bn, and will keep this under review alongside ongoing monitoring of capital positions and lending volumes.

To qualify for this support the relevant institution must raise Tier 1 capital by the amount and in the form the Government considers appropriate whether by Government subscription or from other sources. It is being made available immediately to the eight institutions named above in recognition of their commitment to strengthen their aggregate capital position.

Back to Assiduous Reader louis:

7. My limited contribution to this proposed solution is to expand on it suggesting that this governemental interbank (or inter-financial institutions) loan insurance would provide insurance of the interbank loans up to say 90 or 95% of the loan value (just to make sure that the banks do a little bit of their homeworks) PROVIDED that the loan is made at a maximum TED spread of say 0.50% plus say 0.10% as premium payable to the government for the provision of such insurance. This measure could overnight lower the TED spread from its current 4.6% to 0.60%, using my above figures pulled out from my hat. This would fix what the Central Banks’ joint rate cut of 0.50% of last week failed to achieve.

7. This solution could be put into place in a matter of days thus allowing banks to resume lending to the non-financial market in a more normal way.

Bloomberg reports that LIBOR has fallen:

Money-market rates in London fell after policy makers offered banks unlimited dollar funding and European governments pledged to take “all necessary steps” to shore up confidence among lenders.

The London interbank offered rate, or Libor, for three-month dollar loans dropped 7 basis points to 4.75 percent today, tied for the largest drop since March 17, the British Bankers’ Association said. The one-month dollar rate declined to 4.56 percent, while the one-week euro rate fell to 4.34 percent, the BBA said. There was no overnight dollar price today because of the Columbus Day holiday in the U.S.

… and the market’s on wheels:

Morgan Stanley surged 66 percent after changing terms of its $9 billion investment from Mitsubishi UFJ Financial Group Inc. UBS AG and ING Groep NV gained more than 17 percent in Europe after the region’s leaders said they would guarantee bank debt. The euro rose the most in three weeks against the dollar and yen on speculation the bailout may prevent more bank failures.
…
The Standard & Poor’s 500 Index rose 6.7 percent to 959.07 and the Dow Jones Industrial Average briefly topped 9,000 as of 12:22 p.m. in New York. Both tumbled 18 percent last week. The MSCI World Index added 6.8 percent. Europe’s Dow Jones Stoxx 600 Index advanced 9.9 percent for the biggest daily gain ever. The MSCI Asia Pacific excluding Japan Index rallied 7.4 percent.

Tomorrow should be a most interesting day in the Canadian markets!

Assiduous Reader Annette asks:

I take it that this is amongst the measures taken by the Europeans this Sunday to guarantee interbank loans. Is this something the US should do too?

Only if the fee is punitive, says I, and only if the guaranteed bank is well capitalized. For now, I still like the idea of capital injections via senior preferred shares. But I don’t think we’re yet at the stage where interbank lending needs to be guaranteed in the US, particularly with all the reintermediation being done by the Fed via the discount window and the TAF.

I’m worried about the moral hazard issues. I want the common shareholders – and maybe even the preferred shareholders and sub-debt holders – to take a permanent nasty hit.

Update: Bloomberg puts the total European package at USD 1.8-trillion:

In Germany, Chancellor Angela Merkel pledged to guarantee up to 400 billion euros of lending between banks and set aside 20 billion euros to cover potential losses. It will also provide as much as 80 billion euros to recapitalize banks, about 3.2 percent of the German economy, based on 2008 gross domestic product figures from the International Monetary Fund.
…
In France, President Nicolas Sarkozy said the state will guarantee 320 billion euros of bank debt and set up a fund allowed to spend up to 40 billion euros, or 2 percent of GDP, to recapitalize banks.
…
Spain’s cabinet today approved measures to guarantee up to 100 billion euros of bank debt this year and authorized the government to buy shares in banks in need of capital.
…
The Austrian government will set up an 85 billion-euro clearinghouse run by the Austrian Kontrollbank to provide cash by holding illiquid bank assets as collateral
…
The Dutch government will guarantee up to 200 billion euros of interbank loans, it said in a letter to parliament.

Italy will guarantee some bank debt and buy preferred stock in banks if necessary, Finance Minister Giulio Tremonti said in Rome, without providing any figures.
…
Royal Bank of Scotland, HBOS, and Lloyds TSB Group Plc will get an unprecedented 37 billion-pound ($64 billion) bailout from the U.K. government, equal to 2.5 percent of the economy.

The WSJ is speculating that there may be similar moves by Treasury:

The U.S. government is set to buy preferred equity stakes in nine top financial institutions as part of its new comprehensive plan to tackle the credit crisis, according to people familiar with the situation.

It’s unclear how much would be invested in each institution. The move is designed to remove any stigma that might come with a government investment.

Not all of the banks involved are happy with the move but agreed under pressure from the government.
…
One central plank of these new efforts is a plan for the Treasury to take approximately $250 billion in equity stakes in potentially thousands of banks, according to people familiar with the matter, using funds approved by Congress through the $700 billion bailout bill.

On an unrelated thread, Assiduous Reader DaveJ asks:

I have a question about buying back preferred shares. A company has sold non-cumulative perpetual preferred shares at say 7% yield and $20 par value with an option on the company’s part to redeem them at say $25 after 5 years. The shares are now trading as 1/2 par ($10 and 14% yield). Can the company just announce a buy-back and buy these back on the open market as they would for common shares? Or do they have to redeem that at the agreed upon price of $25? Thanks.

I have never surveyed the universe for this little nugget of information, so I can’t respond in general. However, I had a look at the prospectus for CM.PR.J and found the following language:

Subject to the provisions of the Bank Act, and, if required, the prior consent of the Superintendent, and to the provisions described under ‘‘Bank Act Restrictions and Approvals’’ and ‘‘Restrictions on Dividends and Retirement of Series 32 Shares’’ below, CIBC may at any time purchase for cancellation Series 32 Shares at the lowest price or prices at which in the opinion of CIBC such shares are obtainable.

The latter restrictions are that they can’t do it:

unless all dividends up to and including the dividend payment date for the last completed period for which dividends shall be payable shall have been declared and paid or set apart for payment in respect of each series of cumulative Class A Preferred Shares then issued and outstanding and on all other cumulative shares ranking prior to or pari passu with the Class A Preferred Shares and there shall have been paid or set apart for payment all declared dividends in respect of each series of non-cumulative Class A Preferred Shares (including the Series 32 Shares) then issued and outstanding and on all other shares ranking prior to or pari passu with the Class A Preferred Shares. See also ‘‘Bank Act Restrictions and Approvals’’.

So they can’t play funny little games like cancelling the dividends and buying the share back after they’ve cratered.

The Bank Act restriction is:

CIBC is prohibited under the Bank Act from paying or declaring a dividend if there are reasonable grounds for believing that CIBC is, or the payment would cause CIBC to be, in contravention of any regulation made under the Bank Act respecting the maintenance by banks of adequate capital and adequate and appropriate forms of liquidity, or any direction to CIBC made by the Superintendent pursuant to subsection 485(3) of the Bank Act regarding its capital or its liquidity. As of the date hereof, this limitation would not restrict a payment of dividends on the Series 32 Shares, and no such direction to CIBC has been made. In addition to the foregoing restriction, subsection 79(5) of the Bank Act prohibits CIBC from paying a dividend in any financial year without the approval of the Superintendent if on the day the dividend is declared, the total of all dividends declared by CIBC in that year would exceed the aggregate of: (i) CIBC’s net income up to that day in that year; and (ii) its retained net income for the preceding two financial years.

Update, 2008-10-11: See The Bank Act, Section 79(5):

So, as far as that randomly selected issue is concerned, the answer is “yes”, as long as they get permission from OSFI.

Great-West Lifeco. had a formal issuer bid for its retractibles (GWO.PR.E & GWO.PR.X) which did see some repurchases made.

For other issues … well, until I add that information to my database (and I have no such plans), you’ll have to examine the prospectuses for yourself!

I received the following eMail from a Reader who is not as Assiduous as he should be:

I haven’t been to your blog for a while but I went there today to get your perspective on what was happening with preferred spreads. Sure looks like a buying opportunity at 6%+ as one of your readers commented (RY, SLF , Pow, Pwf …. do not hesitate , do not be afraid , do not analyse to much , BUY !!). Others would analyze as don’t buy to average down. What’s your (long term) perspective on all this? Are you buying (what would be your top 10 list in this market)? Regards,

P.S. Feel free to post on your blog.

The post being referred to is Party Like It’s 1999!, in which I made the point that the interest-equivalent PerpetualDiscount spread was pretty close to a ten year high; the comment quoted was by Assiduous Reader lafontaine. And as far as a “Top 10 List” is concerned … I offer that service – not precisely ‘Top 10’ but the same idea – through my monthly newsletter, PrefLetter.

I don’t like market timing and I don’t do market timing. Financial Markets are chaotic; things that weren’t important a year ago can become the driving force in the blink of an eye; the Law of Unintended Consequences punishes any policy-maker with the temerity to indulge in central planning (and any portfolio manager with the temerity to overlay his own projections on policy changes); and, perhaps most insidiously, there are a lot of players with a vested interest in confusing the issue.

Journalists need something to write about; Dealers want to change your analysis of a situation so you’ll trade. Financial advisors find it easier to convince clients that the account is being aggressively and pro-actively managed in their best interest if there are a few actual trades to point at.

And every trade costs money – commissions and spread and sometimes market impact.

My philosopy is to be fully invested at all times. Make yourself an asset allocation based on your personal needs and your long-term view of expected risks and returns. Review it once a year. Always ask yourself: ‘What if I’m wrong?’

A disdain for market timing does not mean inactivity. My fund does an awful lot of trading … but this is never because of a view that the market is going to go up or down. It’s simply me telling the cowboys: ‘You want to trade? You want to pay the spread? You want to pay the cost of market impact? OK, you can pay that to me. Twist my arm!’ I’m not always right when I agree to a trade. Fortunately, I don’t have to be right every time to do a good job for my clients. Historically, my assessments of relative value have been accurate enough to outperform the market – although, I must point out, that is no guarantee for the future!

The more similar two instruments, the easier it is to identify the cheap one. Two discounted perps from the same issuer are easy to compare. A PerpetualDiscount and a PerpetualPremium from the same issuer is a little harder. A PerpetualDiscount and cash is … difficult in the extreme.

That being said, I think the recent decline in the market is overdone. It has happened without corresponding declines in the broader credit markets; it has happened without particularly horrible news from the issuers [bank common shareholders may well suffer in the coming months. So? I’m buying their prefs on the basis of them being able to (i) continue paying the dividend, and (ii) avoiding a bankruptcy that would impair my capital. I can’t see any but the most infinitesimal changes in the probability of those two outcomes]. Inflation is always a worry, but (a) it appears to be under control, and (b) back on the Central Bankers’ agendas and (c) not considered a major problem by the broader credit markets.

I consider that the extra interest-equivalent yield provided by preferreds handsomely compensates for their additional term risk, liquidity risk and credit risk (provided you don’t overdo it! What if I’m wrong?). As spreads increase without a clear fundamental driver, I suspect that more and more people will eventually agree with me. These people will pile into the market, absorbing spread costs and market impact costs … and I will certainly exert my utmost efforts to put myself in position to say ‘Thank you very much! Ka-Ching!‘

Monday June 23 will be a most interesting day. We can expect BCE issues to skyrocket, as the chances of the deal closing have increased; to the extent that (i) the money that may be received by BCE preferred shareholders will the reinvested in the preferred market and (ii) the market anticipates this tsunami of money; we may well see a good pop in the broader preferred share market. Will I bet on it? Have I bet on it? No and No.