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Home-made Indices with Intra-Day Updating

Thursday, April 17th, 2008

Assiduous Reader kaspu has complained about the volatility of the S&P/TSX Preferred Share Index (TXPR on Bloomberg) – or, at least, the reported volatility.

The problem is that this index is based on actual trades; hence, it can bounce around a lot when 100 shares trade at the ask, $1 above the bid. For instance, today:

This sort of behaviour is endemic to indices created by small shops without much market knowledge or experience. Readers in need of indices with more precision may wish to use the HIMIPref™ Indices, which are, of course, based on much less volatile bid prices.

“Gummy” has announced a new spreadsheet, available from his website. This spreadsheet allows the download of bid and ask prices – and lots of other information – for stocks reported (with a 20 minute delay) by Yahoo. It strikes me that with minimal effort, one could reproduce TXPR (using the defined basket of CPD) and update the index at the touch of a button, with minimal set-up time required.

The Gummy Stuff website, by the way, is reliable AS FAR AS IT GOES. Dr. Ponzo is math-oriented to a much greater degree than investment-oriented and does not always respect hallowed fixed income market conventions. In other words, I have found that things are properly calculated in accordance with the (usually stated) assumptions, but these assumptions are not necessarily the ones I might make when performing a calculation with the same purpose.

With respect to Kaspu‘s question about other indices … the latest CPD literature references the “Desjardins Preferred Share Universe Index”, which is new to me … and I have no further information. Claymore may be preparing for a showdown with the TSX about licensing fees (you should find out what they want for DEX bond data … it’s a scandal).

Additionally, there is the BMO Capital Markets “50” index, but that is available only to Nesbitt clients … maybe at a library, if you have a really good one nearby that gets their preferred share reports.

Update, 2008-5-1: “Gummy” has announced a spreadsheet that does exactly this! Just watch out for dividend ex-Dates!

Posted in Index Construction / Reporting, Miscellaneous News, Reader Initiated Comments | 2 Comments »

MAPF: Response to a Potential Client's Concerns

Friday, April 11th, 2008

There was a very gratifying exchange on FWF about Malachite Aggressive Preferred Fund that (so far!) has included the following concerns about the fund:

The outperformance of Malachite fund is indeed commendable and tempting for a newbie like myself currently investing in CPD. However turnover is very high, about 250 transactions for last year. We invest our non-registered fixed income in preferreds due to dividend tax credit advantage. Malachite’s high turnover seems highly tax inefficient, which would erode its outperformance. While its expense capped at 0.5% and fee of 1% for investment up to $0.5m is reasonable for a well managed active product, passive CPD’s MER is 0.45%. It may be interesting to work out the net outperformance after taking into consideration overall tax considerations and MER for such active versus passive products.

Fair enough. Let’s take the concerns in order:

However turnover is very high, about 250 transactions for last year.

The high turnover is a direct consequence of my philosophy as an active manager. I do not believe it is possible, in the long term, to make excess risk-adjusted returns by making macro-economic market-timing calls. So, for instance, I don’t think it possible that somebody can say “Oil will be going up for the next five years, therefore I’m going to invest in oil stocks” and have a reasonable expectation of making money.

As I never tire of saying, it’s a chaotic world we live in and even if you are able to analyze the world situation perfectly as of TODAY, there is every likelihood that the world will change tomorrow and mess up all your analysis.

There is, however, money to be made by selling liquidity … a rather arcane concept, but I’ll do the best I can.

How does a used car dealer make money? By and large, he’s not actually improving the cars … he’s just buying at one price and selling at another. Which is the key point. If you want to sell your car – you’ll go to him with a car “worth” $7,500 and accept $7,000 for it, because it’s convenient and probably cheaper than taking an ad out in the paper and spending time with potential buyers. If you want to buy a used car “worth” $7,500, you may well be happy to pay him $8,000 because of that same convenience and cost factor. So the dealer has, in this case, made $1,000 by “selling liquidity” – all he’s done is kept a parking lot in operation and been available at his place of business.

It’s the same thing with securities. There are always shifts in supply and demand that change the market price of a security without affecting the “fair” price. HIMIPref™, the proprietary software developed by my firm seeks to determine the fair value of each security in the preferred share universe it tracks. When the market value of something it doesn’t own becomes “sufficiently” cheaper than something it does – it trades. The word “sufficiently” is in quotes because solving that problem is just as hard as solving the “fair price” problem … at what point does the difference in value become so compelling that the possibility of gains outweighs the possibility of losses and the certainty of costs?

Not every trade will work – and I can’t, of course, provide any guarantees about the future – but the system has been sufficiently successful at this evaluation that returns over the first seven years of the fund’s existence have been very gratifying. As long as each trade meets the requirements and has a good potential profit … well, the more trades the better, I say!

Malachite’s high turnover seems highly tax inefficient, which would erode its outperformance.

Well … not really.

The concept of tax inefficiency is of major importance only with equities. An equity can easily double from its IPO price, for instance, while increasing its dividend. Given sufficient time, the price and the dividend can multiply by any amount you wish, with the unrealized capital gain giving rise to deferred tax, which is a lot nicer than having had to pay the tax earlier which would result from trading of the equities.

But preferred shares are fixed income instruments. A preferred share issued at $25 will, almost always, eventually be called at $25 (the exceptions are early calls, for which the issuer pays a slight premium, and defaults, for which a loss is expected which may be total). You do not make money from preferred shares from long term capital gains. Therefore, the concept of tax efficiency – at best – is limited to a few years’ deferral in a bull market.

While its expense capped at 0.5% and fee of 1% for investment up to $0.5m is reasonable for a well managed active product, passive CPD’s MER is 0.45%.

True enough. One generic advantage of MAPF – shared by most funds – is that you have a choice of whether to receive or to reinvest distributions. I’m not sure whether CPD offers a Dividend Reinvestment Plan at this point or not; or what the terms of such a plan might be.

More importantly, MAPF has historically beaten the index by more than the 1.05% difference in costs (the difference will decline as the amount invested gets larger).

An index product, for instance, will not sell a holding even when the yield-to-worst goes negative. An active fund can. An index product will not – usually – subscribe for a new issue, even when the issue has been priced at a substantial concession to extant issues. An active fund can.

I work hard to keep this track record going and have confidence that the fund will outperform in the future. Investors in the fund share that confidence, and I attempt to communicate to unitholders why I am confident. Just how convinced you are is up to you!

I hope this helps – please comment, eMail or call with any other questions you may have.

Posted in MAPF, Reader Initiated Comments | No Comments »

Tax Status of CPD Distribution

Friday, April 11th, 2008

The Internet is aflame with queries about the tax status of the CPD distribution!

Even Financial Webring Forum members have taken time out from their busy schedule of complaining about how useless and expensive investment advice is to ask for investment advice (note to LTR of FWF: I don’t mean anything by that personally. I just think the concept is funny.)

So, because I am such an incredibly nice person, because I like to help out competitors who can’t be bothered to post a simple one pager on their website for the benefit of their clients, and mainly because I’m hoping that the goodwill thus earned will generate a flood of subscriptions to PrefLetter (or, even better, to the fund I manage in competition with CPD), I’ll take a stab at explaining the situation.

We must organize our materials: first the Claymore Tax Information Guide, which confirms that, of the distributions in 2007, $0.3682 was dividends and $0.2720 was return of capital. It is this “return of capital” that is causing consternation. There is some concern that the capital of the fund is being eroded; but, subject to the explanation from Claymore being accurate and there being no silly bookkeeping errors, this is not the case.

Second, we look at Claymore’s explanation (via FWF; since the post is verbatim, from a reliable poster and makes sense, I’ll accept it):

CPD does not and did not pay any distributions above its cash flow. The yield is exactly the yield on the underlying portfolio, less MER. The ROC component of the distributions is due to the structural timing of asset inflows. During the 2007, the fund saw strong asset inflows. When we get a new “creation of units” the fund’s Designated Brokers (DB’s) give the fund the basket of preferred shares, plus any cash in the portfolio from dividends paid on the Prefs since last distribution. The cash received is not allocated as “dividends paid” but rather just cash. So from an accounting perspective, this means the cash is then treated as ROC when we pay it out, even though it represents dividends paid on Pref.

Example would be $1 mm Pref. You received $10,000 in dividends on Monday. So you now have $1.01 mm in portfolio. The next day the DB buys into the fund buy delivering $1mm of Pref position, plus $10k cash. So portfolio is now $2.02 mm, with double shares outstanding.

We pay out the earned yield on portfolio of $20k to shareholders, 50% would be treated as dividends earned on portfolio, 50% treated as ROC. But 100% is actual yield.

Hope this helps clarify this. Please feel free to pass along to the blog sites discussing this. If you have any further questions, please don’t hesitate to call us or ask.

It would appear that the explanation has something to do with the creation of units … so we’ll dig up the prospectus to see how that works:

For each Prescribed Number of Units issued, a Designated Broker or Underwriter must deliver payment consisting of, in the Manager’s discretion, (i) one Basket of Securities and cash in an amount sufficient so that the value of the securities and the cash received is equal to the NAV of the Units next determined following the receipt of the subscription order; (ii) cash in an amount equal to the NAV of the Units next determined following the receipt of the subscription order; or (iii) a combination of securities and cash, as determined by the Manager, in an amount sufficient so that the value of the securities and cash received is equal to the NAV of the Units next determined following the receipt of the subscription order.

And we’ll have a look at the current basket of securities. We note that the CPD, as of 2008-4-10, had a cash component of $0.084735, representing roughly 0.48% of its NAV.

First, let’s make some simplifying assumptions: we’ll assume that there is one issue held in the fund, priced at $25 on every ex-dividend date and paying $0.25 every quarter.

At the start of the cycle, we’ll assume the fund balance sheet looks like this::

Balance Sheet after fund payout
Item Asset Liability
Cash $0.00  
Securities $25.00  
Due to Shareholders   $0.00
Shareholders’ Equity   $25.00

Just before the underlying goes ex-dividend, the fund position is

Balance Sheet before underlying Dividend
Item Asset Liability
Cash $0.00  
Securities $25.25  
Due to Shareholders   $0.00
Shareholders’ Equity   $25.25

Next, the underlying security pays its $0.25 dividend and the price drops correspondingly:

Balance Sheet after underlying Dividend
Item Asset Liability
Cash $0.25  
Securities $25.00  
Due to Shareholders   $0.00
Shareholders’ Equity   $25.25

Next, a week or two later, the fund declares its dividend:

Balance Sheet after fund dividend declared
but before payout
Item Asset Liability
Cash $0.25  
Securities $25.00  
Due to Shareholders   $0.25
Shareholders’ Equity   $25.00

And then pays it out:

Balance Sheet after fund payout
Item Asset Liability
Cash $0.00  
Securities $25.00  
Due to Shareholders   $0.00
Shareholders’ Equity   $25.00

Which is back where we started, but the fund has paid its unitholders $0.25 dividend in the course of the cycle. The income statement for the fund looks like this:

Income Statment
Dividends Received $0.25
Dividends Paid ($0.25)
Fund Profit $0.00

The complicating factor is clients. Damn clients! This would be such a great business if there weren’t any damn clients! For our purposes, a “client” of the fund is a major broker, who can create and destroy units by delivering the underlying security. More particularly, for our purposes, we’ll assume that units have been created AFTER the underlying security has paid its dividend but BEFORE the fund has paid its dividend. In other words, we start here:
:

Balance Sheet after underlying dividend
before fund payout
Item Asset Liability
Cash $0.25  
Securities $25.00  
Due to Shareholders   $0.00
Shareholders’ Equity   $25.25

So the broker comes to the fund and says “Yo! What do I have to deliver for you to give me a unit?”. After a look at the books, the manager says “One share of the underlying and $0.25 cash.”. So this happens and then the books look like this:
:

Balance Sheet after unit creation
Item Asset Liability
Cash $0.50  
Securities $50.00  
Due to Shareholders   $0.00
Shareholders’ Equity
two shares!		   $50.50

and the income statement looks like this (pay attention, this is important):

Income Statment
Dividends Received $0.25
Dividends Paid $0.00
Fund Profit $0.25

The fund wants to pay out sufficient dividends to its shareholders that it is not liable for any tax – in fact, the prospectus makes this committment:

On an annual basis, each Claymore ETF will ensure that all of its income (including income received from special dividends on securities held by that Claymore ETF) and net realized capital gains have been distributed to Unitholders to such an extent that the Claymore ETF will not be liable for ordinary income tax thereon.

So how much should it pay? Should it pay out the precise $0.25 received? Then the balance sheet will look like this::

Balance Sheet after unit creation
and dividend payout of $0.25
Item Asset Liability
Cash $0.25  
Securities $50.00  
Due to Shareholders   $0.00
Shareholders’ Equity
two shares!		   $50.25

In such a case, three things have happened:

  • The NAVPS is now $50.25 / 2 = $25.125, an increase from the base case, despite the fact that the market hasn’t moved
  • Joe Shareholder, who’s owned one share all along, got only $0.125 dividend instead of the $0.25 he was expecting
  • The fund now has $0.25 cash that it should reinvest, but holy smokes, that’s going to be an expensive proposition!

Claymore has decided they don’t want to do this. Keep the dividends constant! So they pay out the expected $0.25 dividend per share to their shareholders and the balance sheet looks like this:::

Balance Sheet after unit creation
and dividend payout of $0.50
Item Asset Liability
Cash $0.00  
Securities $50.00  
Due to Shareholders   $0.00
Shareholders’ Equity
two shares!		   $50.00

The good parts about this are:

  • The dividend rate of $0.25 per period has remained constant, just like the market
  • The NAVPS of $25.00 has remained constant, just like the market. The bad part is what has happened to the income statement:):
    Income Statment
    After Unit Creation
    And Payout of $0.50
    Dividends Received $0.25
    Dividends Paid $0.50
    Fund Profit (loss) ($0.25)

    Oooh, yuck! A loss! And I’m not even sure what the tax status of that loss is … I honestly don’t know whether this could be recovered. I do know, however, that the fund’s shareholders as a group are paying tax on the $0.50 dividend paid out by the fund.

    It’s much more efficient to restate the dividend as return of capital; the balance sheet will be unaffected, but the income statement will now look like this:

    Income Statment
    After Unit Creation
    And Payout of $0.25 dividend
    and $0.25 return of capital
    Dividends Received $0.25
    Dividends Paid $0.25
    Fund Profit (loss) $0.00

    And … the moment you’ve all been waiting for … the characterization of payouts:

    Payout Summary
    After Unit Creation
    And Payout of $0.25 dividend
    and $0.25 return of capital
    Dividends $0.25
    Return of Capital $0.25
    Total Payout $0.50

    I hope this helps. Ask any questions in the comments.

Posted in Miscellaneous News, Reader Initiated Comments | No Comments »

HIMIPref™ Evaluates Trade: TCA.PR.X -> CU.PR.A

Tuesday, March 25th, 2008

This potential trade was discussed in the comments to a post that posed the question: TCA.PR.X & TCA.PR.Y : What’s Keeping Them Up?.

So … just for fun, I created a portfolio which held two issues, TCA.PR.X and TCA.PR.Y, 1,000 shares of each. I defined the portfolio as trading according to the issueMethod, with a desired number of issues equal to 2.

I produced a number of reports, most of which will look like complete gobbledy-gook. You can start tracing their meanings with some help from the glossary:

So … the vital number is the trade score … “100” means the trade is recommended even at bid to full offer; “0” means the trade is recommended at full offer to bid (i.e., OK if you can sell at the offering price and buy at the bid price). In this case the trade score is -1,773 … the trade is so far away from being recommended we might just as well stay home.

Looking at the trade evaluation, though, we do see there’s a pretty good pickup; the trade is not recommended because the required pickup is enormous … ridiculously enormous, in fact. It would be very rare for a potential trade to meet such a hurdle.

Looking at the Risk Measurement report, we find that the required pickup is ridiculously big because the change in pseudoConvexityCost is ridiculously big.

The calculation of pseudoConvexityCost in HIMIPref™ is not something I’m very happy with. It will be changed in the next version of HIMIPref™, but I have to play with it. The problem is that in some conditions, the numbers are implausible and counter-intuitive … this is prevented from fooling the trade recommendation engine by various checks and catches in that part of the programme … but I still don’t like it.

Anyway, the derivation of the extremely high pseudoConvexityCost for TCA.PR.X can be traced (part of the way down the route) with:

There’s more in the system. To understand costYield, you have to look at the cash flows, in which the embedded option is treated as a cash flow adjustment to a permanent revenue stream. In order to understand the pricing of the embedded option, you have to look at that report. But, geez, that’s enough detail for one day, eh?

Suffice it to say that pseudoModifiedDurationCost (that is to say, the modified duration calculated, not formulaicly, but by sampling of yield changes, using costYield as the yield measure) changes a lot for TCA.PR.X given its present price. The system has found (via backtesting) that trades that change this number substantially are riskier (in terms of ultimate results) than trades that do not change this number.

So in this case, the system wants to hang on to the existing issue – even though the valuation of CU.PR.A is higher – because the risk profile is so different.

Astute readers will have noticed that the trade size was reduced to zero due to the low volume on the CU.PR.A anyway!

Posted in HIMIPref News, Reader Initiated Comments | 5 Comments »

Crosses

Wednesday, March 5th, 2008

The following has been copied from the comments to March 4, 2008. The rule of thumb is: if one person asks, twenty want to know! The question was:

I enjoy your blog but I still have a lot to learn. What do you mean by “crossed” in the Notes section of the volume highlights when you write “RBC crossed 15,000 at 19.07″ or “RBC crossed 100,000 at 23.20, then Nesbitt crossed 50,000 at the same price”? I assume you mean they bought the stock at that price but I am just not sure. Thks

 

A dealer “crosses” a trade when he acts for both the buyer and the seller. In institutional trading, it is very common for large trades not to be posted publicly – showing too much size might scare away counterparties, and lead to other traders playing traders’ games. 

There are other, better reasons: say, for instance that you are the investment manager for 100 clients holding varying numbers of shares. If you were to put it up publicly and only get a partial fill – say, 57,600 shares – you’ve got headaches splitting it up fairly and headaches having all those clients with tiny, virtually untradeable positions.

The best reason for doing this is if the order is contingent: maybe you want to sell PWF.PR.K to buy POW.PR.D and take out $0.45 on the switch. In that case, the dealer’s got two orders to fill. Maybe he can sell the PWF.PR.K, but can’t find any POW.PR.D for you (or he finds some, but he can’t put the deal together in such a way that you take out your $0.45). In that case, nothing will happen – and the next day, maybe you’ll call another dealer.

Whatever your reason, if you want to sell 100,000 shares of PWF.PR.K, you will not get your dealer to put this on the board for you. What you will do is ask him to find a buyer. He then checks his rolodex for people who have shown interest in PWF.PR.K in the past – or managers he’s talked to recently who have expressed a longing to purchase a high quality perpetual discount issue of any nature – and start dealing. Once he’s found a buyer who is willing to pay what you’re willing to sell for, he’s happy.

The exchange requires that this trade be recorded on their books. As long as the price is equal to or higher than the posted bid, and equal to or lower than the posted offer, then everything is OK and the trade gets filled as a cross.

A more specialized type of cross is when the dealer is acting for both the buyer and the seller – and so is the investment manager! This is an internal cross. The investment manager might have two funds: Acme Dividend Fund and Acme Preferred Share Fund. These two funds have differing cash flows, such that Dividend Fund needs to raise $2.5-million, and Preferred Fund needs to invest the same amount. In many cases – not all cases, but many cases – it makes sense according to the mandates of both funds that one sells to other. The investment manager gets the dealer to do it for him, the dealer ensures the price is fair, marks the trade as an “internal cross”, and Bob’s your uncle.

There are other specialized cross types as well.

Posted in Primers, Reader Initiated Comments | 1 Comment »

Preferred Shares & Volatility

Saturday, February 23rd, 2008

My name has come up in a Financial Webring discussion of preferreds, with sufficient questions that I’ll address the questions here.

I diligently read Mr. Hymas’s PrefBlog and Pref Info websites. 

Diligently? PrefBlog should be read assiduously!

Creditworthiness, maturity, aside for the moment, would it be wiser to invest in preferreds with a low mean / standard deviation or a high one? Case in point: TD.PR.Q (5.6) has a high of $25.74 and low of $25.00 for a mean of $25.37 and SD of .52. It trades today at $25.64 for yield of 5.46.
TD.PR.O (4.8%) has a high of $26.72, low of $22.01 for a mean of $24.37 and SD of 3.33. It trades at 23.50 for a yield of 5.16. My thoughts, for restful nights, the lower SD would be the way to go but then again, it would stand to reason that the higher SD share would have the greater potential so maybe it would be the way to go, no?

Well, this isn’t a particularly good example, because TD.PR.Q has been trading for less than a month. Having missed the market bottom, it is not surprising that its trading range is significantly less than comparables.

Another thing that makes this not the best example is the big difference in coupons: TD.PR.O pays $1.2125 annually, while TD.PR.Q pays $1.40. This difference makes TD.PR.Q more likely to be called once its call period commences than TD.PR.O (they have similar schedules, by the way; TD.PR.O commences 2010-11-1, TD.PR.Q commences 2013-1-31; both at $26.00 initially, declining by $0.25 annually until they reach $25.00, after that, they’re redeemable forever at the $25.00. price.

The big difference in coupons leads to a major diffence in the manner of calculating yields. It is prudent to suppose (as the initial approximation) that TD.PR.O will never be redeemed – after all, it’s quoted at 23.72-75, if market yields don’t change, why should TD give you a present of $1.25? It is also prudent to suppose that TD.PR.Q – quoted at 25.55-60 – will be redeemed at $25 on the first possible date at this price of 2017-3-2. This will cause a capital loss and represents your worst-case-scenario (short of default, given no change in market yields), which is what one should examine when looking at these things. Always assume that the issuer will do whatever it can to give you the least money it legally can!

In turn, this probability of capital loss should be incorporated into the yield calculation. The quoted yield of 5.46% for TD.PR.Q is the current yield ( = Dividend / Price). But if we account for a redemption, we can use the formula Yield = (Dividend – Return of Capital) / Average Capital Invested. The gross dividend is $1.40; the return of capital is the total expected capital loss ($0.64) divided by the number of years (9) or about 7 cents per year. The average capital invested is 0.5*(25.64 + 25.00) = 25.32. Thus, roughly, Yield to Worst is (1.40 – 0.07) / 25.32 = 5.25%.

The above is only a rough calculation; a precise calculation (by HIMIPref™) that takes into account every cash flow on its precise date indicates that the yield-to-worst is 5.37% (in this case, it’s much higher than the rough calculation, because I’m using the Feb 22 bid of 25.55, and because a full quarter’s dividend will be earned on April 4). To do this calculation, you can always use Shakespeare’s Calculator (broken link redirected 2024-2-1), which I have previously discussed.

Yield-to-Worst is a superior predictor of performance than Current Yield, as I have showed in A Call, too, Harms.

The difference in gross dividends has another effect. When you performed the yield calculation recommended, you are assuming that you will eventually “sell” the TD.PR.Q at a price of $25.00, representing a capital loss. To a certain extent, this gives you protection against market interest rate increases that lower the prices of existing issues – you’ve lost the money already, right? How much do you really care whether you lose it now or lose it on redemption? This concept was discussed in yet another article, Perpetual Hockey Sticks. Note, however, that TD.PR.Q, while above the line that separates PerpetualPremiums from PerpetualDiscounts, is still relatively close to it and, in general, you want to be as far away from that line as possible (unless enticed by large mounds of extra yield). I discuss this in (you guessed it!) an article about Convexity.

One more question: Given the new eligible dividend credit tax scheme, would one be wise/foolish to put all their non-registered funds into quality preferreds? Thinking not only of the tax but principal preservation/safety as well.

I generally recommend that no more than 50% of total fixed income assets be held in preferred shares. The total should include all your interest-rate-sensitive assets, including the bonds and GICs, etc., you have socked away in your RRSP. Why 50%? Well, why not 50%? If you’re looking for pages of math that use some kind of correlation matrix to prove that it should actually be 49.5842%, rounded to 50%, you won’t find it here! 50% is simply a figure that I feel comfortable putting my name on.

Firstly, Prefs are very much a retail product and more sensitive to the vagaries of fashion than bonds, which have a high institutional following. We certainly learned this in 2007 (which … wait for it … has been discussed in an article) a year in which preferred share spreads to bonds rose dramatically and prices got thumped big-time. Anybody who held 100% prefs last year and had to sell something to raise cash is less happy than they would have been had they been 50/50.

Secondly, Prefs are less liquid than bonds. If you need to sell a pref in a hurry, you’re taking your chances – there might not be any bids on the board at that moment in time, and you may not be willing just to sit on the offer side of the market for a week.With bonds, your dealer will (almost!) always make a market for you and charge you a spread against the institutional market that, while appalling, will at least be at least sort-of reasonable.

Thirdly, there’s taxation risk in prefs. If dividends were taxed as income, prices would fall dramatically. I’m as sure as I am of most things that the dividend-tax-credit-and-gross-up is safe … but I don’t feel like eating cat food for the rest of my life if I’m wrong. Remember, the Canadian public has seen fit to elect a grossly incompetent, mindlessly partisan Prime Minister – and if anybody ever mentions to him that the Dividend Tax Credit was introduced in 1971 by Pierre Trudeau … we’re in trouble.

Fourthly, bonds are senior to prefs in the event of bankruptcy. This can have an effect on prices in times of stress and an effect on recovery in times of … er … extreme stress. Pref Holders of Quebecor World will, I’m sure, be happy to explain this at length, with charts and diagrams.

This is not an exhaustive list of risks. There are many investment managers who, to their chagrin, did not include “global financial meltdown” on their list of things to worry about at this time last year. The thing about risk, you see, is that it’s risky. Diversify!

My thoughts were to get ones with a low SD (low volatility) and “hang on”.

Well, I don’t have much reliance on measure of Standard Deviation at the best of times, and this is not the best of times. Preferreds have just emerged (I hope) from their biggest bear market of the 15 years or so I have on record … probably not the worst ever, but there probably weren’t too many fixed-rate perps around in the 70’s. Any measure of SD that is reliant on the recent past is going to grossly overestimate the market risk of prefs going forward.

Also, I suggest an experiment: do the SD calculation on corporates vs. Canadas … or, if you don’t have the data (I don’t either, so don’t feel bad), look at the yields for all governments and all corporates from Canadian Bond Indices. Speaking very generally, the yield action in the past year has happened in governments … corporate yields have increased, to be sure, but rather sedately. It’s the spread that’s gone nuts, not the yield! Just off the top of your head, are you willing to compare the safety of governments vs. corporates based on SD of price or yield?

Take a more pro-active approach: read some of my articles where I talk about the various classes of preferred shares, understand the investment and likely sensitivity to various scenarios, and choose from there. Maybe use SD as a ballpark guide / second opinion, but don’t take it too seriously.

As AltaRed and Shakes point out prefs move with long term interest rates. A 1% increase in long term rates would decrease the value of a bank pref 18%, where the duration is 18 years.

True enough, but I must point out – as hinted at above – that long spreads are just as important as long rates, if not more so. I … all together now, 1, 2, 3! – write about spreads from time to time.

And, having spent more time than I really expected on this post, I will reward myself with an ad: Consider a subscription to PrefLetter to help with individual security selection or, perhaps, consider an investment in Malachite Aggressive Preferred Fund.

Posted in Reader Initiated Comments | 8 Comments »

EPP.PR.A and WN.PR.E : Coupled? Decoupled?

Wednesday, February 6th, 2008

Assiduous Reader madequota asked about EPP.PR.A in the comments to February 5 … since he is an Assiduous Writer as well … let’s indulge him, shall we? It has been a long time since I last looked at this issue.

EPP.PR.A was issued last spring and received an extremely hostile reception from the market, as by the time it commenced trading the market was way down. It is my understanding that the underwriters had a really hard time selling it and took a bath. Problems with such issues can persist for a long, long time, especially in the preferred market: many preferred share investors buy an issue when issued and never look at it again. Those issues that have trouble finding such a “real money” home at issue time find themselves perpetually in the hands of hot money.

Anyway … this is another split-rated issue, as is the CCS.PR.C examined yesterday; it’s rated Pfd-3(high) by DBRS and P-2(low) by S&P.

I’m not going to say much one way or the other. Issues with this kind of credit carry a larger proportion than usual of specific risk – and my firm avoids this for the most part. I don’t want to analyze companies! I analyze the yield curve! This means I concentrate on high quality instruments in which specific risk is minimized.

However, I’ve prepared some graphs that may provide some context for those who want to analyze the company’s financials and, at least to some extent, take a view on the credit:

Readers will note the precipituous decline in averageTradingValue for EPP.PR.A after its issue … recall that it starts with a pre-set $2.5-million presumed value and declines exponentially to a long-term average of actual trading volumes.

Also note that the Quality Spread graphed is between Pfd-2 and Pfd-3: no allowance is made in this graph for “high” and “low” modifiers.

Posted in Issue Comments, Reader Initiated Comments | 4 Comments »

CCS.PR.C : An Attractive Speculation?

Tuesday, February 5th, 2008

Assiduous Readers Kaspu and madequota have been watching CCS.PR.C very carefully recently – see the comments to February 1, the comments to the January Index Rebalancing and the comments to February 4.

My contribution will be mainly the note that a reasonable comparator to CCS.PR.C is FTS.PR.F:

CCS.PR.C / FTS.PR.F
Comparison
Issue CCS.PR.C FTS.PR.F
Dividend  1.25 1.225 
Redemption
Period
Begins		  2012-6-30 2011-12-1
Initial
Redemption
Price		  $26.00  $26.00
DBRS
Rating		 Pfd-3   Pfd-3(high)
S&P
Rating		 P-2(low)   P-2

I will also note that Co-Operators’ financial statements are available at SEDAR (remember the hyphen when searching!) 

And a graph of a graph of their YTWs since CCS.PR.C’s first day of trading and the differences thereof. Fortis was upgraded a notch by S&P during the period.

The comparison may not be GREAT, but I think it’s PRETTY GOOD. And the graphs are amazing.

 

Posted in Issue Comments, Reader Initiated Comments | 4 Comments »

A Bear Checks In

Wednesday, October 31st, 2007

After having given so much attention to the neighborhood bull, it seems only fair to allow some comments from the bears!

Hi James:

Here is the result of a little calculation I did with Royal Bank bond yields and pref yields.  It looks similar (today at least) for other banks, but I don’t have lots of historical bond data.

Comparing RY Bonds and Prefs
  11-May-07 26-Oct-07
Bond Yield (Dur = 5) 4.21% 5.14%
Discount Pref Yield 4.50% 5.49%
Disc Pref Duration 22.1 18.6
Spread 0.29% 0.35%
Yield Ratio 1.069 1.068

Although we seem to be comparing bond apples (duration 5) to pref oranges (duration 18-22), the arithmetic spread, and especially the yield ratio (which I like better for many things and many reasons) is basically the same today as it was 5 months ago.  I happen to have some data from May 11 for two RY bonds, but have no older data.

Perhaps you have access to more historical bond and pref data to investigate this further, but one conclusion I would draw is that pref yields are not currently out of line with bond yields.  Furthermore, a 5.14% bond yield is consistent with (perhaps slightly below) US bond yields.  If the corporate yields hold, then discount prefs will NOT recover, so investors today should only expect the yield component, and give up hoping for capital gains — and could suffer more losses if corporate yields increase.  I wish I knew more about this apparent relationship over the past couple of years of Pref purchasing!

I also note that the bond equivalent yield ratio (at least at this wildly different duration) is 1.07 in the market, rather than 1.40 for taxable investors.  No reason they should be the same because the buyers and sellers of prefs and bonds are quite different. You are welcome to use this with attribution, if you like. ******************************************

[Later] One minor glitch on this, the 1.07 Yield ratio is the inverse of the 1.40 bond equivalent yield, so for direct comparison should be more like 0.93.  Thus there is a 50% (1.40/0.93) after-tax yield advantage to pref shares compared with Duration = 5 bonds.

Well! The first problem I see is with the data. I looked up the issue Royal Bank 4.53% May 7, 2012. This is a deposit note, the most senior bank debt issued (and thus, in terms of credit quality, as far as you can get from a preferred while remaining with the same issuer). It’s basically a liquid institutional GIC and there is $950-million outstanding. According to Bloomberg, the yield on 5/11 was 4.53%.

This is quite the discrepency! If we go to Canadian Bond Indices, we can look at a graph of short-term yields – for both corporates and Canadas. The quoted figure, 4.21%, looks more like a plausible yield for a Canada 5-year, while 4.53% looks like an entirely reasonable value for a 5-year Royal Bank DN.

I suggest it’s better to compare long indices with the PerpetualDiscount index; this reduces the duration mis-match and diversifies away the asystemic risk introduced by using a single corporate for a comparison. Using data from the Bank of Canada we see that the Scotia / PC-Bond / Dex long-term all-corporate index was yielding 5.42% on May 9; going back to Canadian Bond Indices, we can say it’s about 5.8% now; and construct the following table:

Comparing Corporate Bonds and Prefs
  27-Dec-2006 9-May-07 30-Oct-07
Bond Yield 5.18% 5.42% ~5.80%
Bond Duration ~11.7 ~11.6 ~11.3
Discount Pref Yield 4.51% 4.65% 5.64%
Disc Pref Duration 11.73 16.12 14.45
Disc Pref
Interest
Equivalent		 6.31% 6.51% 7.90%
Interest-
Equivalent
Yield Ratio
(Prefs : Bonds)		 1.22:1 1.20:1  1.36:1
Interest-
Equivalent
Yield Spread
(Prefs – Bonds)		 113bp 109bp 210bp 

So, pending further discussion, it does not appear to me that a bearish argument based on yield spreads in the current year is very convincing!

Update: My correspondent was the commentator prefhound. The delay in attribution was due to my wanting to check how he wanted the attribution made.

Posted in Reader Initiated Comments, Spreads to Bonds | 7 Comments »

Question Regarding BAM.PR.N

Monday, October 29th, 2007

I recently received the following communication from an Assiduous Reader:

Hello James

I have recently discovered your website and your excellent coverage of preferreds.  As an investor I am always, it seems, at loss for research and information sources on the subject so your website is a welcome surprise.

Like many I am the (not so) proud owner of a handful of perpetuals including the infamous BAM.PR.N.  As you have mentioned in your blog it is difficult for many investors to understand and make sense of the brutal price drop of this and other similar issues.

I understand the nature of perpetuals and their strong sensitivity to interest rate movements (or even the hint) so I am not surprised by the drop.  The way I look at it the yield is a leveraged function of the share price.  If current dividends are now 20% higher than new issues in the summer then it makes sense that share prices are 20% lower too.

Alternatively if interest rates drop in the future it should result in a return to higher valuations.

It’s never easy to live with drastic downward fluctuations in price and especially so with preferreds as we tend to buy them for their stability and preferential tax treatment.  I can live more easily with significant price drops from issuers like major Canadian banks and insurance companies because I am confident that the drop is a reaction to interest rates or, in the current environment, the asset backed commercial paper issue rather than some fundamental problem.  The situation with BAM.PR.N is perplexing though.  The price drop has gone beyond annoying into the realm of worrisome.

I guess I am asking your opinion on this issue in particular as it seems to have been singled out for brutal punishment.  From what I have read in your blog this price drop is way overdone.  Does that mean that we should stand firm and tough it out?  If this dramatic price drop is strictly a result of the asset backed commercial paper debacle then it makes sense to weather the storm until the problem runs it’s course.  If, on the other hand there are fundamental problems with BAM then does it make sense to cut and run?

I don’t mind waiting out the storm if it’s going to end up sunny.

Thanks for listening.

Frankly, I hate getting this kind of communication. The reader is not a client, I know nothing about his financial situation, I know nothing about his portfolio, I’m not making any money attempting to answer his question and there’s no good answer to his question anyway!

However, pretending to answer the question about the prospects for BAM.PR.N gives me a vehicle to reiterate my favourite themes … so here goes!

I wish I knew! If I knew for sure that BAM.PR.N was going to pay every single one of its projected dividends until Doomsday, I’d give up on this boring diversification routine I keep harping on and just lever up on the damn things 30:1 (assuming I could!).

If I knew for sure that BAM.PR.N was going to go bankrupt in two years, then I’d be shorting it 30:1. Why not?

Unfortunately, I don’t know anything for sure and, what’s more, I won’t claim that I do.

Life would be so much easier if I was stockbroker! If I was a stockbroker, all I’d have to do is ask a few questions to determine what the inquirer wants to hear and tell it to him!

Was this issue recommended by the inquirer’s current stockbroker and the inquirer is now alarmed and upset that it’s down so much? “Well, Mr. Blank, I consider this issue to be extremely risky. The yield is high, but it’s high for very good reasons! Why don’t you move your account over to me and I’ll keep a good eye on your investments?”

Or does the client like the investment, and is just looking for reassurance? “Well, Mr. Blank, I think you’ve made a very astute purchase … it’s just too bad that your timing was off. I was able to determine through my contacts that a period of turbulence was on its way and delayed my recommendation.”

Unfortunately, I’m an asset manager and my historical results are an open book. I’ve discussed the BAM issues before and I’ll probably be discussing them many times in the future. For those who are interested, I’ve uploaded a graph of prices and graph of YTW differences for BAM.PR.N and RY.PR.G for the period since the former’s issue on May 9. Note that by “price” in the graph, I mean “flatBidPrice“. I’ve also updated the same information (price and YTW difference) for BAM.PR.M and RY.PR.G for the period since the latter’s issue on April 26. Note that BAM.PR.N and BAM.PR.M are a Preferred Pair of the weak variety.

Credit quality? Brookfield was last reviewed by DBRS on June 11, 2007, and confirmed at Pfd-2(low). S&P rates the preferreds at P-2. Moody’s does not rate the preferreds, but upgraded the bonds a notch on February 27 to Baa2. Fitch has the bonds at BBB+. Brookfield has a lot of debt on its books, but the vast majority of it is secured by specific properties – or issued by a subsidiary – and is non-recourse to BAM. BAM could certainly lose their equity in each specific property if there were problems, but the non-recourse provision does give some comfort that problems in one area will not become so large that they drag down the whole company. I see nothing in the financials that lead me to suspect that the credit ratings agencies are being wildly optomistic.

Keep your eye on the news. Not the chatter; the news. Yahoo has a perfectly good clipping service available for free. Whatever BAM’s problems are at the moment, it doesn’t appear that headline risk is a factor.

As always, diversification is the answer. The world would be quite complicated enough if it was static, but it doesn’t even make us that concession; it changes in a dynamic and chaotic manner. It’s perfectly normal to be concerned about an investment that loses value for mysterious reasons; but if you go beyond concern to the point of worry, you own too much. Cut your holdings to the point where you’re merely interested.

Don’t make just a few big bets. The risks of such a strategy are legion. Make lots of small bets.

And for what I consider to be an excellent source of recommendations for buy-and-hold retail investors … subscribe to PrefLetter! Qualified investors who want me to do ALL the work may invest in Malachite Aggressive Preferred Fund.

Posted in Issue Comments, Reader Initiated Comments | 1 Comment »

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