PrefBlog

It will not have escaped notice that equities got crushed today:

Canadian stocks tumbled the most in almost eight years, led by a record drop in raw-material shares, as tighter credit, rising unemployment and lower home prices threatened to tip the U.S. into a recession.

Potash Corp. of Saskatchewan Inc. fell the most since 1989 after rival Mosaic Co. posted profit that missed analysts’ estimates and cut its sales forecast. Barrick Gold Corp. plunged the most in two decades as bullion declined on speculation the U.S. will approve a $700 billion plan to revive credit markets, reducing the metal’s appeal.

Suncor Energy Inc. touched the lowest in 15 years, leading oil and gas producers lower as crude fell below $95 a barrel and Merrill Lynch & Co. said it may drop to $50. The Standard & Poor’s/TSX Composite Index fell 7 percent to 10,900.54 in Toronto, the most since Oct. 25, 2000.

Preferreds were not immune, although the TXPR’s loss of 1.02% looks a whole better than ‘first-loss’ equities!

But the really illuminating thing about the action is just how SLOPPY this market is. I mean, look … if you want to tell me that the proper yield for preferreds in this environment is X, I’ll listen! For a while, anyway. That sort of speculation is simply market timing and I don’t put much credence in it.

But surely similar securities from the same issuer should trade somewhere around each other! But that’s not the case today … the yield curve has been getting sloppier and sloppier over the past couple of weeks and today … well, I haven’t checked, but it must be some kind of record!

Speaking very generally, there appears to be some positive correlation between Average Daily Trading Value and Yield – that is, the higher the average volume, the higher the yield, which is to say: the liquidity premium is negative … which really shouldn’t happen.

This behavior is consistent with people simply reducing exposure by selling whatever’s easiest to sell, regardless of price.

The weighted mean average pre-tax bid-YTW of the PerpetualDiscount index is now 6.37%, which is about where it was on July 11 (going up) and July 28 (going down). This is equivalent to 8.92% interest at the standard conversion factor of 1.4x. Long corporates now yield about 6.7%, so the PTIE spread is now about 220bp.

Given the recent skyrocketting of PerpetualDiscount yields, I’ve been thinking a bit about how the spread – which I consider quite excessive, but what do I know? – might be traded away by investors unwilling to time the markets.

OK, so let’s consider the following data:

For PerpetualDiscounts, the Modified Duration is reported as it is on HIMIPref™, which assumes repayment of principal in 30-years. This isn’t quite accurate, but it’s close enough for horseshoes.

So let’s consider an investor who is holding XBB in a taxable account. There are going to be strange tax effects if we do it properly (since the average COUPON is far higher than the average YIELD: he will be paying tax on the coupon, which is partially a return of capital and, logically, getting some of this tax back via a projected capital loss), but we’re not going to do it properly. We’re going to do it on the back of an envelope; those wishing precision can either do it themselves, or pay me a huge amount of money to do it for them.

Anyway, this investor is holding XBB. He wants a duration-neutral switch into a portfolio comprised of XSB and PerpetualDiscount Preferreds, so he solves the equation (let P be the fraction of the new portfolio invested in Preferreds)

Old Portfolio Weighted Duration = New Portfolio Weighted Duration
6.4 = 2.8 (1-P) + 13.05 P
6.4 = 2.8 – 2.8P + 13.05 P
And therefore
3.6 = 10.5P
And therefore
P = 0.34.

Check!
6.4 = 2.8 * (1 – 0.34) + 13.05 * 0.34
6.4 = 2.8 * 0.66 + 13.05 * 0.34
6.4 = 1.8 + 4.4
Close enough!

So basically, a taxable investor holding XBB can swap 2/3 of his holdings into XSB and 1/3 into PerpetualDiscounts and remain duration neutral. Note that other risk-elements are not risk neutral! The portfolio is a barbell, and will underperform expectations if the curve steepens; there is a higher weight of corporates in the new portfolio; there is tax-effect-risk in the new portfolio; there is spread risk on the preferred (the spread can go to a million basis points and nobody will go to jail); there’s a whole list of things that could go wrong and would be listed in a prospectus. All I will say is that the duration-neutrality goes a long, long way towards making the portfolios equal, since to a first approximation the investor will have the same risk relative to parallel shifts in the yield curve, up or down.

OK, so what’s that done to his yield?

His old yield was 4.07% net of MER; his new yield, NY, after deduction of the MER on his perpetualDiscount position (MERP) is:
NY = 0.66*(3.96% – 0.25%) + 0.34*(9.28 – MERP)
= 0.66*(3.71%) + 0.34*9.28% – 0.34*MERP
= 2.44% + 3.16% – 0.34*MERP
= 5.60% – 0.34*MERP

Let’s assume he puts the money in my fund, MAPF, and that he assumes the fund will deliver the PerpetualDiscount yield less 1% fee and less 50bp expenses and no trading gains. Then

NY = 5.60% – 0.34*1.50%
= 5.09%

So … back of an envelope, an investor with a taxable position in XBB can make reasonably conservative assumptions and figure to pick up 100bp pre-tax yield without changing duration by putting 1/3 of his portfolio into perpetualDiscounts and keeping duration constant by swapping the other 2/3 to XSB. You could do your own calculation for the exchange traded funds, CPD and DPS.UN (these are not entirely perpetualDiscounts, so be careful!) or by using direct investment (zero MER!) on the preferred portfolio of your choice.

There was an interesting comment on FWF today:

I would always expect variation in daily value for a bond or a bond fund. What strikes me as not “fixed income” about preferreds is that they have noticeably deviated from any bond indice comparison. And corporate bonds have held up; so this is a preferred-specific issue. The market seems to be saying the risk factor in preferreds is much higher than comparable corporate bonds.

This was in the context of a discussion about the investment merits of bank preferreds vs. bank common, given that many Canadian banks’ common are trading with unheard of dividend yields in the current depressed market.

This is simply another example of trader-mentality vs. investor-mentality. I have nothing against traders. Trading is a useful skill and can be a lucrative skill … if I had a trader’s mentality, I’d still be counting my winnings from the Tech boom. Unfortunately (in this particular case, anyway) I have an investor mentality and simply would not be able to sleep at night, knowing that I held a piece of garbage for the sole reason that the price was rising.

For investors, it is important to look through trading behavior into the actual investment characteristics of a particular vehicle. I will certainly not deny that bank prefs are behaving a lot more like bank common nowadays than like bank bonds, but this observation does not constitute a solid ground for an investment strategy.

What do I always say? The investment world is chaotic, and things that were not even slightly important a year ago can become a driving force in the blink of an eye. It is not enough to look at price behaviour alone. At this time last year, non-bank ABCP with a General Market Disruption liquidity guarantee was just the same as bank ABCP with a Global liquidity guarantee. And, what’s more, the two classes had been trading in lockstep for years. Until, one day, they didn’t.

Preferred shares may, in times of stress, over-react to bad news about the common. There are many among us who have very fond memories of what happened to TRP.PR.X and TRP.PR.Y at the time that TRP common halved its dividend. Call me polyanna, but the fund loaded up on TRP Preferreds … because although the common dividend had halved, the preferred dividend looked … well … perhaps to say “as solid as ever” would be overstating the case, but “almost as solid as ever” seems to understate it! Assiduous Readers will know what I mean, anyway.

So by all means, prefs will often trade more like common than they trade like stock. An investor must look through that and realize that prefs are not common. Prefs are also not bonds. They’re preferreds. I feel it is appropriate to benchmark them (at least, the high quality ones) against long corporates because that is what their risk most resembles; but I recognize that sometimes markets will go blahooey, if for no other reason than their investor universe is different. Times when things are going blahooey is when I earn my pay – largely by doing nothing. Nice work, if you can get it.

I will note that the fact that things can go blahooey is a major reason behind my exhortations to limit preferred exposure to 50% maximum of a fixed income portfolio. The spreads are juicy, and sometimes they’re very juicy indeed … but when you need to raise cash for non-investment reasons, you really don’t want to be a forced seller.

PerpetualDiscounts finished the day with an average yield of 6.40%, equivalent to 8.96% at the standard conversion factor of 1.4x. Long corporates – which have been basically ignoring all this kerfuffle about financials, having priced it in months ago – continue to yield about 6.1%; the PerpetualDiscount / Long Corporate PTIE spread is therefore about 286bp. This is wild!

An old thread regarding preferreds has come to life on Financial Webring Forum, with one poster speculating that the Swoon In June is tax-driven – there are two tax changes scheduled to have an effect on preferreds in the next few years, Federal Bad and Ontario Good, netting out to a modest negative.

It is my feeling that the recent decline is driven more by portfolio window-dressing by retail stockbrokers more than any fundamental factor.

If fundamental factors were to blame – or even if they were fundamental factors mis-applied! – I would expect to see that the market would retain some degree of internal consistency.

This is not what’s happening. Deeply-discounted perpetuals are being hit harder than slightly-discounted perpetuals (the discount of market price relative to potential call price, that is) – I gave the example of the CM issues on June 26 and two RY issues more recently.

This has happened to the extent that deeply discounted perps yield more than slightly-discounted perps. This simply should not happen (see the links in the June 26 post) and, I will emphasize, is not due to any historic spread relations or anything like that … the causation is the other way round. Convexity is a pretty basic fixed-income analytical tool, with a negligible effect for normal bonds, but a huge factor in callables (or other type of embedded option).

You can, if you like, make an argument that convexity has zero value and that therefore any perpetual discount from a given issuer should trade at the same yield, regardless of its combination of price and dividend. I might laugh at your pathetic little arguments, but you can make them with some semblance of rationality. But it is not possible to argue that convexity has a negative value and that therefore a discounted perpetual with a relatively high coupon should trade at a lower yield than its lower-coupon, otherwise identical, sibling. There might possibly be other things going on that would lead to that effect – but it wouldn’t be a direct effect and I haven’t been able to come up with any actual evidence that such an effect is even remotely possible.

The fact that it has happened anyway has convinced me that it’s retail window-dressing. We are approaching quarter-end and stockbrokers do not want to remind their clients, yet again, that the new issue they bought at $25 is now trading at $20. So, of the two or three issues in the client’s portfolio, they sell the lowest priced one, regardless of yield.

It’s only a hypothesis and it’s completely untestable … but I have not been able to think of anything else!

The fact that the relative prices are out of whack – and not based on any kind of normal fixed-income analysis – causes me to be very suspicious of the fundamental underpinnings of the overall decline.

If we plug in the projected Ontario tax rate on dividends for 2012 of 26.7% and the projected rate on income of 46.41%, we arrive at an equivalency factor of (1-0.267)/(1-0.4641) = 1.37. This is marginally lower than current, but PerpetualDiscounts now yield 6.04%, while long corporates are about 6.1%. Even the lower equivalency factor results in a spread of about 215bp, well in excess of historical norms and very hard to justify in fundamental terms (although, it should be noted, you can always justify anything you like in fundamental terms).

When the market re-establishes some degree of internal consistency (as far as the pref market ever is internally consistent!) we can have a look and see what the spreads really are. Until then, the situation is too clouded by clear signs of panic to allow any conclusions to be drawn.

Assiduous Reader madequota has asked on another post:

OK, one more question that’s easy to ask, and hard to answer:

In very general terms, I’ve always believed that prefs (of the so-called perp variety especially) should behave, more or less, in sync with the 30 year bond. I’m aware of the variety of specific differences between the two vehicles, but at the end of the day, these two investments are very similar in that the occurances of the daily market should have identical impact on both of them. Hence they should, at the very least, move in the same direction.

Assuming my generalization is correct, why then do these things trade so often in opposite directions? For example, the US retail number came out today, and because it was marginally “better than analyst’s expectations”, bonds got punished both in the US and Canada. But the prefs had a great day in Canada.

Specifically then, why is the long bond getting creamed over the past week, while at the same time, thirst for perp prefs seems to be unquenchable?

madequota

I am on the verge of doing serious work on spreads … though what I am calling “serious work” is what I would normally term as a product of the “Look, Mummy, I got a spreadsheet!” school of security analysis.

One more month and I should have the HIMIPref™ indices up to date, which will give the data I require to draw long term spread graphs. PerpetualDiscounts SHOULD trade like long corporates (NOT long Canadas!), PerpetualPremiums, Retractibles & OpRets SHOULD trade like short corporates – the first of these with a little slippage due to negative convexity.

All I can really say is: spreads are volatile. And without some hot institutional money (even lukewarm institutional would be a help) to arbitrage corporates/prefs, they’re going to stay volatile.

Note that long corporates are down about 2.52% YTD, while perpetualDiscounts are up about 2.67%. So go figure.