PrefBlog

After the Globe and Mail published an article on Distressed Preferreds, I received another interesting eMail from another correspondent:

I wondered if you could advise me if you consider any of these “distressed preferreds” worthy of investment?

For the average preferred share investor seeking a source of tax-efficient fixed income, the advice I have regarding a potential investment in distressed preferreds is a BIG FAT NO!

Distressed preferreds – distressed anything – should not be considered as part of a fixed income portfolio. There is sufficient uncertainty regarding the ability of the issuing companies to meet the committments made in the prospectus that they should be regarded as equity substitutes … in other words, once you’ve reviewed the company and decided you wanted to buy the stock, you would then look at these preferreds and decide whether or not you’d be better off with the prefs … the upside on the prefs will be limited, but the dividends would be more assured and there’d be a chance of better recovery if things went wrong.

This is simply another way of stating Carrick’s note in the article:

Arguably, distressed preferreds are a smarter way to play a troubled company than buying its common shares. Common shares will almost certainly offer a better pop when a company rebounds, but preferred shareholders get paid while they wait for the turnaround with high-yielding dividends.

… except that I would replace the word “Arguably” with the phrase “Sometimes, depending on the price and terms of the alternatives to common equity and the investor’s informed view of the prospects for the company,”.

I am willing to consider Pfd-3 issues as “sort-of” fixed income, but only on condition that the total allocation to Pfd-3 is less than 10% of the total preferred portfolio, and the allocation to any single name is less than 5%. This sort of exposure can give a little extra yield without exposing the portfolio as a whole to an undue amount of risk.

I am rather surprised that Brookfield issues were mentioned in the story, but Carrick makes it plain that price is the sole consideration – credit-worthiness is given lip-service, but lip-service only:

Brookfield and Weston are higher quality companies based on their financials and credit ratings. But conditions in the preferred share market today are such that some of their issues are getting squeezed to a point where they’re trading at borderline distressed prices.

Part of the problem is rising interest rates. Pref shares are like bonds in that they fall in price as rates rise, and vice versa. Another factor is the twitchiness in financial markets that was caused by problems in the U.S. subprime mortgage market. Investors have become more risk sensitive and they’re shying away from preferreds that make them nervous.
…
The typical preferred share has a par value of $25, which is the value of assets each share is worth in the event the issuing company is liquidated. A distressed preferred trades below $20, which implies a 20-per-cent price decline, and it usually has a credit rating of less than pfd-3 (low) from DBRS Inc.

I cannot accept this definition of distress – especially since the rating consideration is cheerfully ignored by two of the issues discussed in the article, BAM.PR.M & WN.PR.E.

Let’s look at a bond: General Electric Capital Corp., 4.125% Sep 19/2035, ISIN XS0229567440, priced right now, at this very moment, at 81.9085-3965 to yield 5.39-35. Admittedly, this does not quite reach the 80%-of-par-value condition … but any definition of “distressed” that comes this close to encompassing GE … is a nonsensical definition. Canada had a perpetual bond with a 3% coupon, issued in 1936; the yield was a little different in 1975:

Further, I would emphasize for the hon. member’s benefit that the yield of these bonds since April 1974 compares favourably in my view with the prevailing market rates.

To illustrate, the interest rate was 8.33 per cent on April 30, 1974. It had decreased to 7.79 per cent in November 1974, it was up again to 8 per cent on February 28, 1975, that is three months ago, and since April 25, 1975 it has been 9 per cent

Hmm… if a perpetual bond with a 3% coupon was trading to yield 9% … therefore priced at maybe one-third of par value …  should it be characterized as “distressed”?

If one wishes to include a market-based element in a definition of “distressed”, it should be with relation to prevailing yields of high quality issuers. Altman’s comprehensive definition is good enough and, as far as I know, widely accepted:

Distressed securities can be defined narrowly as those publicly held and traded debt and equity securities of firms that have defaulted on their debt obligations and/or have filed for protection under Chapter 11 of the U.S. Bankruptcy Code. A more comprehensive definition would include those publicly held debt securities selling at sufficiently discounted prices so as to be yielding, should they not default, a significant premium over comparable duration U.S. Treasury bonds. For this segment, I have chosen a premium of a minimum of 10 percent over comparable U.S.Treasuries. With interest rates falling as much as they have by late-1998, this definition would currently include bonds yielding at least 15.0%.

Anyway … I will accept the inclusion of BBD and NT in lists of distressed preferreds, but not WN & BAM.

I don’t like the trading advice much, either:

The hard part in buying preferred shares is that you often have to pay a premium over market price to get your hands on some. Given that your yield shrinks as your purchase price rises, this is a crucial issue when buying low-yielding traditional preferreds. With distressed shares, you can be a bit more flexible in how much you pay because the yields are so much higher than usual.

Well, by me, overpaying by $0.25 on distressed preferreds is as bad as overpaying by $0.25 on rock-solid investment-grade issues. Worse, in fact, because it will represent a larger fraction of the amount invested.

So … my answer to my correspondent has four minor points:

• Nortel: No! Not as a fixed income investment, anyway.
• Bombardier: No! Not as a fixed income investment, anyway.
• Weston: Maybe just a little bit, if you can get it at a fat spread.
• Brookfield: I’ve speculated about Brookfield issues before. They have investment-grade credit quality, but often trade as speculatives. Often worthwhile, my fund often holds them.

Unfortunately, the question is too general to be answered with any precision. Before I knew whether to recommend a particular issue, I’d have to know the price of what was being sold and what was being bought. It’s the old story … Google, to name but one, is a good company; fairly well run and profitable. Whether or not I’d pay USD 700 for one of its shares is a different question entirely.

I make specific monthly recommendations for buy-and-hold investors in PrefLetter. Subscriptions are still being accepted!

Update, 2007-10-18: After all this talk about yields, I should really give numeric examples!

So – not even Quebecor or Nortel are “distressed” by conventional definitions. Junk, yes. Distressed, no – although Nortel’s 9.70%, when multiplied by an equivalency factor of 1.4, is equivalent to interest yield of 13.6%, which is getting awfully close to long-Canadas-plus-ten-percent! And Weston and Brookfield are merely trading at spreads to top-quality (as represented by RY.PR.F) that investors may decide are good or bad, as they choose.

As mentioned yesterday, I received some interesting correspondence recently:

Love your blog !

I have been buying preferred shares for the last 10 years and discovered your site last month…

My porfolio of pref ( middle six figures ) consist only of bank shares and Power Corp /Power Financial, all perpetual discount.

Sometime I  try to balance my portfolio with the ups and down of the market but I buy for the long term. 

But these days I do not understand the pref market : today I  bought PWF.PR.G 5,90 perpetual at par ( $25,06) ( in Qc X 1.35 : 7,965 % ), last week NA.PR.K 5,85 at par ( $25)(QC X 1,35 : : 7,90%) .

Meanwhile you are lucky if you get 5% on a 10 years municipal bond and 5,5% on a 20 years bonds ( ex: Greater Toronto Airport .) and the bank are signing 5 years morgage for 5,69%.

I understand the risks and the nature of the Pref , but   I wonder if I am missing something ( market disruption /Subprime /long term inflation )or if this is the buying opportunity of the decade ?
   
Thank you for your blog

Well, this is obviously a very sensible, wise and discerning correspondent – that’s obvious, because he likes the blog.

But let’s just take a VERY quick look at his question regarding “buying opportunity of the decade”. We’ll compare current yields with those of October 31, 2000, with help from the Bank of Canada’s yield look-up service, CanadianBondIndices, the HIMIPref™ Indices for October 31, 2000 and yesterday’s values:

So … I have to agree with my correspondent that spreads look pretty attractive now!

Note that all this is very approximate. At some indeterminate time in the future, HIMIPref™ 2006 2007 2008 will be ready for testing. This new version of the programme will extend the analytics to bonds; enormous quantities of data will be purchased at ruinous expense; the analysis will allow for swaps between investment universes (although this feature might have to wait until HIMIPref™ 2009 is ready) and at that time, with lots of testing and data and controls to ensure that, for instance, there’s nothing fishy going on with the credit quality of the sampled universes, I will be much happier about saying whether spreads are wide.

But it does look pretty good, doesn’t it?

There have been some questions about this issue recently, both on FWF:

My limited understanding of prefs is that they are a lot less volatile than commons and trade in a “short” range. TD is on its way up. They just bought Commerce Bancorp at a time when our loonie is worth huge. If they do well, even their prefs are going to appreciate somewhat. Even if they don’t do so well, the US. $ will eventually find it’s way back and they’re going to make it on the exchange.

and in my eMail:

The one thing I don’t understand about preferreds is how their shared price is affected.  I assume like bonds they trend inverse to the prime rate and I get that part of the discount. Over the past several years I have held preferreds and noticed very little fluctuation in the share price but lately they are falling and I don’t fundamentally understand why as interest rates appear stable (or am I wrong here?).  Further, some hold their value better than others (e.g., MFC.PR.A versus PWF.PR.F – I’d consider ManuLife and Power Financial equally sound companies for the long term yet one share price is falling while the other is not).  How concerned does one need to be about share price and if they do go down what are the factors that will bring them back to book value (e.g., something is making ManuLife more stable than Power and I don’t understand what that is).  Sorry, if the question comes across as naive but I find it hard to get my head around all the factors affecting these preferreds.  Thanks in advance.

Well, let’s begin with the first statement: the thing to remember about preferred shares is that they are fixed income investments. A $25.00 par-value preferred share paying $1.3125 annually to yield 5.25% will never change its dividend just because the company is doing well. Whether the issue is priced at $30 (to yield 4.375% of market price) or at $20 (to yield 6.5625% of market price) is another matter entirely.

‘They never change their dividends?’, you ask, ‘What, never?’ Well … hardly ever. Every now and then a company will seek to change the terms of a preferred share issue (extending the maturity date of a split-share preferred is a recent example) and sweeten the dividend to make the change more palatable. Such examples are notable mainly for their rarity.

Another exception is “fixed-reset” issues, in which the company resets the fixed-rate every five years and gives the holder the option to convert to floating rate. BCE.PR.A / BCE.PR.B is an example of such a pair. The company’s motives in setting the rate, however, will be to minimize their expense, not to ‘share the wealth’ if they do well.

The price of preferreds will be affected by the fortunes of the company only to the extent that the company’s ability to pay the agreed dividends and principal changes. In the case of TD Bank, an improvement in their financial position will have an extremely limited effect, because both the markets and the credit rating agencies agree that the probability of them being able to meet their committments is pretty close to 100% right now; therefore, any possible increase in this probability is extremely small and therefore will have a very limited effect on market price.

On the other hand, a deterioration in the company’s ability to pay can have a very marked effect on market price. Recently, for instance, Weston has run into difficulties – not as exciting as the fears of imminent bankruptcy that plagued Nortel a few years back, or the silliness that affected Bombardier preferreds, but difficulties nevertheless, and their ability to pay the agreed dividends is not considered to be as secure as it once was.

WN.PR.E is very similar in its terms to SLF.PR.A, and therefore it should respond similarly to general financial market pressures – any differences will be almost entirely due to company-specific factors. I have graphed the flatBidPrice of these issues … you can see that the detioration in Weston’s credit quality has had a huge effect. Credit, credit, credit! You always have to pay attention to credit!

As far as Weston is concerned, an investor might well look at what they’re doing and take the view that they’re going to do so well that market perceptions of their ability to pay will become much rosier; in such a case, we’d expect the spread between SLF.PR.A and WN.PR.E to narrow; and hence, WN.PR.E would (if the analysis is correct!) outperform. This type of analysis is called Credit Anticipation and represents a blurring of the lines between fixed income and equity analysis. As far as TD is concerned though, they’re recognized as such a strong company already that “ability to pay” simply doesn’t have much room to improve.

OK – on to the second question!

My correspondent is quite correct in his understanding about the inverse relationship between interest rates and preferred share prices, but I have to quibble over the use of the “Prime” interest rate.

“Prime” is for very short term loans and is related to the Bank of Canada’s overnight target rate. Preferreds, particularly perpetual preferreds, will be related to the long rate – and the corporate long rate at that.

The two are not necessarily directly related. Long term bonds – those maturing in 20-30 years – are sensitive to perceptions of inflation, while short term bonds – those maturing in less than 5 years – are sensitive to monetary policy as executed via the overnight rate. The Bank of Canada might, for instance, cut overnight rates to 1% … not very likely, perhaps, but possible! In such a case, short rates would decline (trading at a relatively constant spread to overnight), but long rates would almost certainly skyrocket, as investors decided that such easy money would fuel inflation.

Additionally, I will stress that it is Corporate long rates that we are concerned with when analyzing perpetual prefs. According to CanadianBondIndices.com, corporate long bonds have returned -3.82% in the year to October 9 and the yield is about 5.9%, compared to about 5.2% at the beginning of the year. Government long bonds, on the other hand, have returned -1.25% … a fair loss, but the fact that this is so much less than the loss on corporates indicates that spreads have increased. In other words, the perceived risk of holding corporates has increased and investors want more money in compensation.

Additionally, there will be a spread between Corporate Long Bonds and Perpetual Preferreds due simply to the fact that there is a different pool of investors. Pension funds, for instance, will not normally hold preferreds; since pension funds are not taxable, there are no tax advantages to be gained by receiving dividend income rather than interest. And retail panics a lot, besides; since there is no institutional hot money (or less of it, at any rate) cruising around looking for a cheap buy in the preferred mariket place, price swings can be more pronounced.

With respect to the two specific issues mentioned in the eMail: MFC.PR.A is a retractible issue; in December 2015, holders are entitled to get their $25 capital back from the company. There are some details to be understood about this – holders might actually get $26.00 worth of common stock, which they would then have to sell – but basically, an investment in MFC.PR.A is roughly comparable to an eight-year bond. I wrote an article comparing perpetuals to retractibles a while ago; and a more recent one comparing retractibles to bonds. PWF.PR.F is a perpetual; a fair number of perpetuals have been issued in the past year; and the recent credit crunch has scared off a few investors who are more concerned with price fluctuations than with income.

There are many investors who want only retractibles; they will not look at perpetuals regardless of price. Which is why retractibles of operating companies are usually so expensive and not worth buying!

Information regarding the attributes of preferred share issues is almost always available on SEDAR (as long as the prospectus was issued within the last 10-odd years); mostly available on my summary website PrefInfo.com (I track almost all of the liquid issues … the tiny little guys are a bit more hit-and-miss); and often available on the company website, as either a summary or a full prospectus – sometimes both! To find a company website, get a quote for the issue from the TSX, then click “Company Information”.

I received the following communication recently:

new BMO & BNS preferred shares
These are apparently bought issues, but if you recommend them I would  consider a purchase. I have taken an interest and a position in  various preferred since reading your articles in the Canadian Money  Saver. Until then, I was nothing more than a passive observer. I am  76 years old, wife is 71 this year and our pensions are inadequate to replace my income before retiring more than 10 years ago. Now a  considerable portion of my investments are in bank, insurance and  utility companies common and more recently preferred shares.  Unfortunately I also have about 10% in BCE bonds in RRIF. Would you consider the new issues at 5.25% a good investment in a non- registered account? Except for CU all other preferred shares that I  have are below par with approx 4.5% coupon. I have more than 10% cash  to invest. Would it be prudent to wait?

Well, I’ll take a stab at it, but I have the horrible sinking feeling that I am not only going to frustrate my inquirer, but I’ll probably offend him as well.

The basic problem with the query is the implicit assumption that market-timing is possible – if you recommend them I would  consider a purchase … Would it be prudent to wait?.

I can’t time the markets. Neither can anybody else. There is no shortage of bozos who will claim that they can time the markets on behalf of their clients – and even believe it themselves – but when you look at their justification for such belief, you will invariably find that they have been looking at the past with rose-coloured glasses and making excuses for the times that they got it wrong. The way to unmask these people is to ask them for a “CFA Institute compliant composite performance report from inception to present”. Information about what this means is readily available. Essentially, the standards insist that every single dollar under management be assigned to a particular composite and that clients be informed of the existence of each composite. You won’t find many stockbrokers or advisors who have such a thing – and most of those guys will get fairly huffy when asked.

Market-timing is not possible, but this does not mean investors should just buy a generic batch of index funds and forget about it. There are two mechanisms whereby professional money management can add value:

• Tayloring of asset allocation to suit the client’s specific needs
• Outperformance within each asset class

And yes, this discourse is relevant to the original question! My correspondent is asking for advice on market timing, but he should really be asking himself two questions:

• How much of my portfolio should be allocated to preferred shares?
• Once I’ve made that decision, which preferred shares should I buy?

Let’s try to answer the first part of that question. The couple is retired; in their seventies; they have at least some investments; they need income. There is a fair bit of detail missing from the query:

• How big is the investment portfolio?
• How much income do they need (as opposed to “want”, which is another matter entirely)?
• What are their plans for the capital – are they planning to run it down to zero, or do they have bequests in mind that are important to them?
• And finally, the distasteful question: what’s their health like? Is it prudent to plan for 25 years, or can we get away with ten?

It is impossible, for me or anybody else, to provide investment advice without knowledge of these issues … well, I shouldn’t say “impossible”, because it’s done all the time. A better word is “reckless”.

So lets make a few generic points:

• A 10% position in BCE bonds? The remaining term to maturity of these bonds is not given in the eMail, but the client is now learning the purpose of diversification the hard way. Bell Canada and BCE have been “A” credits for the past ten years. My correspondent is most assuredly not the only person to find himself in this predicament, but a client who is
  • Retail, and therefore subject to the tender mercies of the retail bonds desk at his brokers, and therefore highly illiquid
  • With insufficient portfolio size to diversify properly
  • Unable or unwilling to devote a lot of time to watching the market

  …should stick to names rated “AA” or better.

• The “bank, insurance and utility companies common” is a good, high quality, high yielding equity allocation, but there is no indication of the percentage allocation. Using the famous “100 minus your age” formula indicates an allocation of 20-25%, but there are other variables. Basically, this allocation should be as high as possible, subject to:
  • generating sufficient income from the portfolio that there will not be forced sales to raise cash
  • a maximum desired portfolio volatility based on needs – the chance that a major liquidation will be required
  • a maximum desired portfolio volatility based on wants – how much sleep will you lose if these stocks go down 30%?
• The allocation to preferred shares should be no more than half the allocation to fixed income generally. Preferred shares do, indeed, provide a significantly greater after-tax income than bonds, but they also have special risks of their own. Most of the ones worth buying are perpetuals, with a potentially volatile price; and the universe of investors is smaller than with bonds, which brings with it liquidity risk.
• Given that
  • The bond portfolio is – probably – of relatively low quality (due to its exposure to BCE), and
  • the allocation to preferred shares will probably be of insufficient size to allow for efficient diversification, and
  • the inquirer is not a professional investor

  I recommend that investments in preferred shares be restricted to those names rated Pfd-1(low) or better.

Which, at long last, brings us back to the subject of the inquiry: the BMO & BNS new issues. My correspondent notes that they are “bought issues”, but this indicates nothing more than that the underwriters have guaranteed to the issuers that the issue will be sold … in other words, they have agreed to buy the entire issue for resale, rather than acting on an agency ‘best efforts’ basis.

They are both highly rated, meeting the quality needs I outlined above. And when they were first announced, they were far superior to most issues on the market … but then the market fell. At present, I estimate the fair value of both of these issues to be a little above $24.80, which means there is other stuff out there that might yield a little bit more with comparable risk.

My correspondent is in the unfortunate position of being protected from rapacious Ontario-based portfolio managers by the brave heroes of his provincial securities commission – and I have not yet been able to extract sufficient expressions of interest in his province to make it worth my while to register with his commission. So, unfortunately, I cannot offer him a subscription to PrefLetter, which was developed to be useful to investors finding themselves in precisely his position – that is, having money allocated to preferred shares, but not sure which ones.

I suggest, however, that he may wish to keep an eye on this blog, watch the commentaries for mention of good yields, check out the characteristics of the issues of interest on PrefInfo … and to get some professional advice on asset allocation, based on his own particular circumstances.

Update, 2007-10-5: I forgot the ad for the fund! While PrefLetter is designed for do-it-yourself investors who want a place to start, there are funds available: I reviewed three funds last year and another last spring … but I trust I won’t be criticized too severely for recommending my own fund for those investors who seek to outperform the indices and  are either “accredited” or have $150,000 to invest. Unlike PrefLetter, Malachite Aggressive Preferred Fund is available to all such investors in Canada.

Update, 2007-10-19: I should also link to two of my other posts on this general topic: One Bull Checks in and Reflections on a Bull

On the July 27, 2007 post, assiduous reader kaspu asked: 

Your point about not owning junk bonds is well taken. And I fervently hope that your loyal readers have taken your past advice and are watching all this sturm und drang from a viewpoint of relative safety.

But the eternal pessimist within me forces me to ask you this:If there is a complete corporate credit debacle, other than cash and gold, are there any other safe havens that will preserve capital value? Will even those of us who invest in the quality canadian prefs (P2h and higher) escape the hysterical fleeing from corporate debt? after all, the covenant of bank prefs in canada specificies that they are non-cumulative. The market might decide that this is an unacceptable risk and demand a wider spread. Lower yielding Canadas (yes…this time I do remember to call them Canadas) don’t have tjis provision. American bank prefs of even higher quality (AAA) almost always have in there convenants that they can defer dividend payments for as much as 20 quarters.

So will all the money flee to government bonds, with the spreads between them and prefs widening to a ridiculous degree?

Y’know, kaspu, without meaning any offense: I hate this sort of question.

It’s completely open-ended and the only parameters that you’re giving me are “complete corporate credit debacle” – which is a very open ended kind of thing. For any scenario I propose as a base case, for any scenario I propose as a worst case, you can say “Well, yeah, but what if … “. One of my favourite pieces of economic trivia is the fact that the during the Great Depression, there were instances of US Treasury Bills trading above par. Why shouldn’t they? Put your money in a bank, it’ll go bust. Put your money under your mattress, it will get stolen. Buy US T-bills above par and at least you know how much you’ll be losing…

What I’m trying to say is … you might not be satisfied with my answer!

I don’t think the current situation is as bad as all that. It’s certainly bad enough, for those who bought junk mortgage paper and those who had indirect, but highly leveraged, exposure via hedge funds, but I don’t see the world ending any time soon.

We are definitely heading into a period during which junk yields will be higher than they have been in the past few years; this will choke off leveraged buy-outs (at least until the next frenzy) and thereby blow a little froth of the equity markets. This is happening right now … according to Markit’s daily wrap-up:

Panic set in yesterday in the credit markets, with indices worldwide experiencing massive daily movements. Both the CDX NA HY and iTraxx Crossover indices broke through key levels yesterday, the former rising above 500bp and the latter 400bp. Investment grade indices also widened sharply. The turmoil has been sparked by a crisis in the US sub-prime mortgage market, which in turn has led to a broad increase in risk aversion. This has created hostile conditions for borrowers, particularly private equity companies. Their arrangers have had difficulty, to put it mildly, in enticing investors into buying LBO financing. Alliance Boots in Europe and Chrysler were set up as barometers of the leveraged loan market. If so, the market is in a poor state indeed as the arrangers pulled large chunks of the debt packages and took big losses on their fees. HCA led the high-yield sector yesterday in its rapid decline. The hospital operator was acquired last year in what at the time was the largest LBO in history. It is now laden with large amounts of secured financing that have also declined in recent days (see chart below). Like another totemic deal, KKR’s buyout of RJR Nabisco in the 1980s, the HCA LBO may come to embody the hubris of the times.

According to this wrap-up, credit derivative swaps on HCA blew wider by 102bp to 555bp, while GMAC LLC was 94bp wider to 480bp. I do not profess to be an expert on CDS history – or even to have a huge amount of expertise in the field – but it seems to me that this kind of move, in the absence of company specific news, must be some kind of record. We are in the panic phase, and spreads might even go as high as they were in 2001!

2001? Have a look at what the Federal Reserve Bank of San Francisco had to say in 2001, when spreads spiked into the +1000bp area:

Before the terrorist attacks on September 11, the yield spread of the Merrill Lynch junk bond index had risen more than 300 basis points since the beginning of 2000 (Figure 1). This was accompanied by a gradual increase in the comovement of bond yield spreads. These patterns seem to suggest that before the attacks, the run-up in junk bond spreads was driven by concerns about rising credit risk. However, following the attacks, the spread skyrocketed almost 200 basis points to 968 basis points, just 46 basis points shy of the peak recorded during the 1990–1991 recession. While there is no question that a large part of the rise in junk bond yields reflects investors’ reassessment of credit risk, the comovement in bond yield spreads, shown in Figure 2, shot up to a level not seen before. Both the rate of the increase and the level of comovement in yield spreads after September 11 indicate that some of the sizable jump in yield spreads may be attributable to the limited liquidity in the junk bond market.

In other words … it’s all about liquidity. We have just been through a period in which every brain-dead retail stockbroker in the world was telling his clients that an extra 300bp on bonds was free and easy … we are now entering a period in which they are calling their clients and triumphantly telling them that they were able to get out at only +500. The more time I spend in this business, the more influence I attribute to the brain-dead retail stockbroker!

Now, none of this can really be called a direct answer to your question, but I’ll start trying now. There will be an influence on investment grade corporate bond spreads – and there already has been. Spreads moved wider on the week, because credit quality is a continuum. There is no magic line between Investment Grade and Junk … if Junk yields move higher, then Investment Grade will, to some extent, follow them, because investors will connect the dots and say ‘Gee … I can pick up a whole bunch of extra yield by accepting a relatively small amount of extra credit risk! When I divide return by risk, I get a big number! Time to trade!’

Spreads on paper of the quality you were talking about are something of a conundrum. Bank perp prefs are now yielding 5%-odd, interest equivalent of 7%-odd, which is basically Canadas +250bp, which is basically OK by me. I have previously expressed surprise at the very narrow spreads the market gives to Innovative Tier One Capital – which is basically a pref sold in the bond market, and these spreads have a long way to go before they’re even close.

If anything, I think a flight to quality corporates should be good for the high-quality end of the preferred share market, but I’m not going to hold my breath. The bank-perp-pref tax-equivalent spread to Canadas could very well vary by 50bp – up or down – and trying to outguess that is a mug’s game. If one of the banks gets into trouble with Junk exposure, we could very well see a spike in yields of those – but at that point, I’ll probably be in there buying!

Update 2007-07-30: More comment … Tom Graff’s headline is “We’re doomed” … but the post itself is at least a little bit more cheerful.

On a completely unrelated thread, assiduous reader kaspu asked:

While I know that this letter deals only with canadian prefs, I have a question regarding both canadian and us prefs. With all the fooferall in the US regarding sub-prime problems, and perhaps prime problems, it seems that corporate preferred shares, even good investment grade (BBB+), have seen their spreads relative to the Benchmark US 10 year has widened quite a bit. My questions are:

1. Even with the US 10 years going back below 5%, there has been no similar lowering of high credit pref yields. Is this due to a general creditor boycott in regard to preferred shares, which can be illiquid, or is is this a wiespread phenomenom to all non-goverment debt?

2. are the canadian preferreds affected by this US credit fea? or do they trade more closely to how the canadian treasuries fare?

3. There has been quite a bit of talk about the ratings agencies goofing up regarding junk-bonds. Yet it seems to me that this scepticism has also spread to the investment grades. Is this your impression as well? And if so, how are to trust the various rating agencies?

4. Back to the US. There are many different types are highly rated synthetic preferred shares (STRATS, SPARQS etc.) These are usually backed by investment grade bonds, and the prospectus seems fairly clean. Are there any canadian equivalents? As well, can these be classified as CDO-type investments, even though many are rated A and higher.

Thanks in advance,. I know this is quite a bit to ask. But what the heck…..

Well, kaspu, I have to say … I’m not familiar enough with the US Market to address these questions with much confidence, but I’ll give some of the questions the old college try:

1. You should not expect to see the corporate market track Treasuries as closely as all that, especially with the financial sector feeling such stress. In the absence of a good website providing credit spread averages, have a look at the CBOT 10-year swap contract. I’ve discussed swaps on this blog before, in the context of converting perpetuals into synthetic floaters, so if you need to refresh your memory regarding swaps, that’s a good place to start. I note that the 10-year swap contract closed at 102-29 today, which CBOT’s spreadsheet converts to a fixed rate of 5.62% … but there will be settlement date adjustments to make to that figure. You can also get the Federal Reserve’s H15 statistical release which shows 5.64% as of July 24. You should mark prefs off of bonds of comparable quality, not governments.

2. “Canadian Treasuries”? tee-hee … you’re not one of the cool guys! Say “Canadas” … that’s what the cool guys say. Us cool guys also refer to UK government bonds as “Gilts”, just so you know. The Canadian preferred market is dominated by retail. They should trade such that high-quality (read: Bank) discount perpetuals trade at a relatively constant interest-equivalent spread to comparable 30-year paper, but they don’t. Spreads are all over the map and congruence with bond yields can only be detected in very broad terms … for instance, Pfd-3 issues have been trading at an increasing spread to Pfd-2 issues over the past month or so.

3. Rating agencies do not speak with the voice of God and it is a mistake to take them too seriously. It is also a mistake to take them too lightly. Think of credit ratings from major agencies as having the same relevence as market prices … inefficient, yes, and it is entirely rational to disagree with them from time to time … but if you are going to disagree with them, you’d better have a pretty good reason and be prepared to be wrong a lot of the time! They move slowly … perhaps too slowly. A recognized form of bond portfolio management is “Credit Anticipation”, in which you attempt to recognize fundamental changes in companies’ risk profiles before they are highlighted by the rating agencies and subsequently reflected in market price by those who did not anticipate the rating change. One thing that is happening now is that the CDS market is going nuts speculating on which bank holds the most toxic waste … anticipating future changes to rating as the sub-prime situation clarifies.

4. I’m not familiar with these products at all. Sorry! I don’t know of any Canadian preferred products explicitly backed by bonds – that would probably require some fancy footwork with derivatives if the funds were to pay out dividends.

Update: Good spread data is available from Markit Group Limited which administers the CDX Indices

It’s been quite the day of eMails for me! In addition to the relatively technical questions about PrefLetter, I received one that asked:

Can you tell me if there is a rule of thumb in determining rates companies offer for new preferred offerings as it relates to the BOC key rate?

In a word: No.

When a company thinks it might wish to offer preferreds, they contact their Corporate Finance guys at the dealers and ask them where they think they might sell a deal. After looking at comparables, thinking about the tone of the market, talking to the people on the front lines who will actually be selling the deal, all that kind of thing, Corporate Finance comes up with a guess and then the company decides if it makes sense for them.

That being said, there is usually some consistency – look at all the recent Pfd-1 perpetuals done lately with a 4.5% coupon, for example.

At some point, I’m going to get out my records and write an article about the historical trend of perpetual issuance, comparing the grossed-up interest rate equivalent with long Canadas – which is as close to the standard as exists.

In 2005, the new issue spread (according to some third party information I have) varied in a range of Canadas +140bp to Canadas +200bp.

In 2006, it was more like Canadas +200 to Canadas +250.

In 2007 … well, let’s see. High quality perps have been going at 4.50% … use 1.4x to gross that up, that’s 6.30% interest-equivalent. Long Canadas spent the first quarter in the 4.10%-4.30% range, mostly, so that’s a spread of Canadas +200 to Canadas +220, roughly in line with 2006.

Long Canadas are – taking today’s sell-off into account – trading in the 4.45% area, so we’ll say that perpetual prefs should be in the 6.55% interest-equivalent area, which is the 4.68% dividend area, which is more or less where they actually are, as of last night.

The major weaknesses of this back-of-the-envelope calculation are:

• Spreads could change due to perceived corporate weakness, particularly in the banking sector. They certainly changed in 2005/06!
• Ranges of the spreads are very large: 50bp!
• Those are new issue spreads I’m talking about. Logically, spreads on (deep) discount perpetuals should be smaller, as there is the opportunity to make a significant capital gain before your have to worry about the potential of a call.
• Preferreds are dominated by retail, which is prone to panic.

But, all that being said … let’s make a deal: You guess where long Canadas are going to be, and I’ll guess where perpetuals are going to be!