Interesting External Papers

More Theory on Bank Sub-Debt Spreads

Bank Sub-Debt has been in the news lately, with Deutsche Bank’s refusal to execute a pretend-maturity, and I have dug up another theoretical paper: What does the Yield on Subordinated Bank Debt Measure, by Urs W. Birchler (Swiss National Bank) & Diana Hancock (Federal Reserve):

We provide evidence that the yield spread on banks’ subordinated debt is not a good measure of bank risk. First, we use a model with heterogeneous investors in which subordinated debt is primarily held by investors with superior knowledge (i.e., the“informed investor hypothesis”). Subordinated debt, by definition, coexists with non-subordinated, or “senior,” debt. The yield spread on subordinated debt thus must not only compensate investors for expected risk (i.e., to satisfy their participation constraint), but also offer an “incentive premium” above a “fair” return to induce informed investors to prefer it to senior debt (i.e., to satisfy an incentive constraint). Second, we test the model using data we collected on the timing and pricing of public debt issues made by large U.S. banking organizations in the 1986-1999 period. Findings with respect to issuance decisions lend strong support for the informed investor hypothesis. But rival explanations for the use of subordinated debt, such as differences in investor risk aversionor such as the signaling of earnings prospects by the bank, are rejected.A sample selection model on observed issuance spreads provides evidence for the existence of the postulated subordinated incentive premium. In line with predictions from the model, the influence of sophisticated investors’ information on the subordinated yield spread became weaker after the introduction of prompt corrective actions and depositor preference regulatory reforms, while the influence of public risk perception grew stronger. Finally, our model explains some results from the empirical literature on subordinated debt spreads and from market interviews — such as limited spread sensitivity to bank specific-risk or of the “ballooning” of spreads in bad times.

The conclusions are consistent with those of other researchers.

There’s a good line in the discussion:

These results are consistent with the “informed investor hypothesis” that claims that banking organizations would issue debt of different priority status to separate investors with different, yet unobservable, beliefs on the probability of bank failure.

I claim that a good definition of an “informed investor”, suitable for ex ante assignment of investors into different groups is: “one who knows that there is a difference”. The authors would not, I think, disagree too violently with this definition:

Paradoxically, the quality of the subordinated debt spread to measure banking organizations’ risks as they are perceived by most sophisticated investors has deteriorated after the introduction of FDICIA or, more precisely, of depositor preference rules. With depositor preference rules, the risk characteristics of senior debt have become more similar to those of subordinated debt; at the same time, the subordinated debt spread has become (even) more dependent on factors influencing the senior spread.

The deterioration of the risk measurement quality of the subordinated spread after the introduction of depositor preference, however, is likely to understate the longer term virtues of the reform. Once senior debtors realize that their claims are subordinated to depositors, senior spreads may well more fully reflect specialist information. Therefore, we expect that senior debt will be held by more sophisticated investors in the future.

Assiduous Readers will remember that in my essay on Fixed-Reset Analysis I pointed out a very low spread between deposit notes and sub-debt in February 2007.

Interesting External Papers

US Bank Deposits Increasing

The FDIC has released its December edition of the FDIC Quarterly, which contains an article on Highlights from the 2008 Summary of Deposits Data:

To better understand the industry’s level of expansion, it is useful to look at various measures of deposit and office growth in relation to demographic trends. For example, trends in deposit growth and population can be compared to the number of bank offices. As shown in Chart 2, banks continue to expand their retail presence at a faster pace than population growth at the national level. Both the number of offices per million people and the volume of deposits per office continue to increase. However, the pace of this growth is slowing. Indeed, the annual growth in both domestic deposits per office and offices per million people were below their respective five-year averages.

This will be another data point to support the thesis of Banks’ Advantage in Hedging Liquidity Risk.

Regulation

Convertible Preferreds? In Canada?

Another hot tip from Assiduous Reader tobyone leads to more musings from Barry Critchley of the Financial Post:Flurry of Share Offerings:

And it seems OSFI is interested in other types of securities that would constitute Tier 1 capital. In yesterday’s column we mused the market was speculating that soft retractable pref shares — which used to count as Tier 1 capital before OSFI ruled to make them Tier 2 capital — would be on the list. The chance of such a return is low if issuers are talking about the former type of soft retractables. (OSFI ruled against them in part because of the potentially huge increase in common shares outstanding, in the rare event that the issuer opted to pay in stock and not cash.) However, if they come with new bells and whistles, then OSFI may be interested — but only after the security has undergone the normal review process. “Part of OSFI’s mandate is to see what they come up with and figure out if it works or not,” said the OSFI spokesperson.

One type of pref share that may cut the mustard is convertible pref shares.

An OSFI spokesperson said it would be interested in such a security counting as Tier 1 capital “if it had the right kind of features for capital. Convertibles is something that’s been floated. It has been discussed,” added the spokesperson, noting that issues of mandatory convertible prefs, are part of Tier 1 capital in some countries.

What else could OSFI be looking at?

Underwriters report that issuers would like an increase in the percentage of Tier 1 capital allocated to innovative instruments. Currently 15% of Tier 1 capital can be in the form of such securities. But that percentage hasn’t changed — despite the recent 10-percentage-point increase, to 40%, in the share of preferred shares in Tier 1 capital. (At the start of the year, the percentage was 25%, meaning a 15-percentage-point increase for the year.)

“Investors are more interested in taking the 15% stake up to 25% because the innovative Tier 1 market is an institutional market,” said one market participant, noting that the change would allow larger issues, certainly larger than issues of rate reset preferred shares which are largely bought by retail investors.

Mandatory convertibles have certain advantages for all issuers:

A relatively large proportion of convertibles are currently issued as mandatory convertibles. A mandatory convertible is automatically converted into equity at a specific maturity date, thus removing the optionality for the buyer of the convertible. The transfer of risk to the buyer is usually compensated by a higher yield. Companies want to issue mandatory
convertibles in order to avoid their experiences of 1999 and 2000, when many telecoms companies issued convertibles in the expectation that they would be converted into equity at the time of redemption. In most cases the conversion did not take place due to the sharp decline in equity prices, leaving them with much higher than expected debt/equity ratios. Another attractive feature for the issuer of mandatory convertibles is that they are in general not treated by the rating agencies as pure debt. The biggest mandatory convertible issues in the
first quarter of 2003 were a €2.3 billion offering by Deutsche Telekom and one of ¥345 billion ($2.9 billion) by Sumitomo Mitsui Financial Group.

As far as BIS is concerned, banking implications of convertible preferreds are (largely?) limited to the United States

Cumulative preference shares, having these characteristics, would be eligible for inclusion in [Tier 2]. In addition, the following are examples of instruments that may be eligible for inclusion: long-term preferred shares in Canada, titres participatifs and titres subordonnés à durée indéterminée in France, Genusscheine in Germany, perpetual subordinated debt and preference shares in the United Kingdom and mandatory convertible debt instruments in the United States.

… but I note a recent issuance by UBS:

At UBS, the government package provided significant relief to the balance sheet from the burden of illiquid positions particularly affected by the crisis. With this package, the SNB made it possible for UBS to transfer illiquid positions to a special purpose vehicle. The UBS provided this special purpose vehicle with equity amounting to USD 6 billion. The Confederation compensated UBS for the capital requirement arising for this purpose by subscribing to mandatory convertible notes (MCN). Since the announcement of the package, the UBS liquidity situation has stabilised.

The recent issue by Morgan Stanley gives an important clue as to the value of Convertible Preferreds in times of stress:

Under the revised terms of the transaction, MUFG has acquired $7.8 billion of perpetual non-cumulative convertible preferred stock with a 10 percent dividend and a conversion price of $25.25 per share, and $1.2 billion of perpetual non-cumulative non-convertible preferred stock with a 10 percent dividend.

Half of the convertible preferred stock automatically converts after one year into common stock when Morgan Stanley’s stock trades above 150 percent of the conversion price for a certain period and the other half converts on the same basis after year two. The non-convertible preferred stock is callable after year three at 110 percent of the purchase price.

With other examples from Citigroup, we may conclude that Convertible Preferreds can be very useful in times when the common dividend is in doubt, or is otherwise thought to be insufficient for the risk of holding the common.

The Federal Reserve allows inclusion of convertible preferreds in Tier 1 in a manner analogous to the Canadian treatment of perpetuals:

The Board has also decided to exempt qualifying mandatory convertible preferred securities from the 15 percent tier 1 capital sub-limit applicable to internationally active BHCs. Accordingly, under the final rule, the aggregate amount of restricted core capital elements (excluding mandatory convertible preferred securities) that an internationally active BHC may include in tier 1 capital must not exceed the 15 percent limit applicable to such BHCs, whereas the aggregate amount of restricted core capital elements (including mandatory convertible preferred securities) that an internationally active BHC may include in tier 1 capital must not exceed the 25 percent limit applicable to all BHCs.

Qualifying mandatory convertible preferred securities generally consist of the joint issuance by a BHC to investors of trust preferred securities and a forward purchase contract, which the investors fully collateralize with the securities, that obligates the investors to purchase a fixed amount of the BHC’s common stock, generally in three years. Typically, prior to exercise of the purchase contract in three years, the trust preferred securities are remarketed by the initial investors to new investors and the cash proceeds are used to satisfy the initial investors’ obligation to buy the BHC’s common stock. The common stock replaces the initial trust preferred securities as a component of the BHC’s tier 1 capital, and the remarketed trust preferred securities are excluded from the BHC’s regulatory capital [footnote].

Allowing internationally active BHCs to include these instruments in tier 1 capital above the 15 percent sub-limit (but subject to the 25 percent sub-limit) is prudential and consistent with safety and soundness. These securities provide a source of capital that is generally superior to other restricted core capital elements because they are effectively replaced by common stock, the highest form of tier 1 capital, within a few years of issuance. The high quality of these instruments is indicated by the rating agencies’ assignment of greater equity strength to mandatory convertible trust preferred securities than to cumulative or noncumulative perpetual preferred stock, even though mandatory convertible preferred securities, unlike perpetual preferred securities, are not included in GAAP equity until the common stock is issued.

Nonetheless, organizations wishing to issue such instruments are cautioned to have their structure reviewed by the Federal Reserve prior to issuance to ensure that they do not contain features that detract from its high capital quality.

Footnote: The reasons for this exclusion include the fact that the terms of the remarketed securities frequently are changed to shorten the maturity of the securities and include more debt-like features in the securities, thereby no longer meeting the characteristics for capital instruments includable in regulatory capital.

Section 4060.3.9.1 of the Fed’s Bank Holding Company Supervision Manual extends this treatment to convertible preferreds that convert to perpetual non-cumulative preferreds.

I have no problem from a public policy perspective of allowing the inclusion of Convertible Preferreds into Tier 1 capital, provided they meet the basic requirements of subordination and the potential for having their income suspended on a non-cumulative basis without recourse for the holders.

If such are issued, however, they will almost certainly not be included in the HIMIPref™ database, as there is considerable potential for such issues to “sell off the stock”. In fact, I would consider such issues – in the absence of even more innovation – to be equivalent to common stock with a bonus dividend; not fixed income at all.

I have a much bigger problem with the second proposal in Mr. Critchley’s column – the expansion of the Innovative Tier 1 limit to 25% from its current 15%. I will not accept that further debasement of bank credit quality is justified by prior debasement; let’s see a little more analysis and stress-testing than that!

Market Action

December 17, 2008

Ha-ha! Gone fishin’!

Toronto Stock Exchange and TSX Venture Exchange will not resume trading today due to continuing technical issues with its data feeds.

The market will be put into a Pre-Open state from 3:00PM to 5:00PM to allow participants the option of cancelling, adding or changing orders.

The company intends to open the exchanges tomorrow morning.

Additional information on the nature of the problem will be provided when the investigation is complete.

and:

TMX Group technology team has isolated the issue that resulted in the halt of trading on Toronto Stock Exchange and TSX Venture Exchange. Remedial action was taken to restore all data feeds at 3:41PM, and the company confirms that the Exchanges will open on Thursday, December 18, 2008 as per normal.

Initial findings indicate a network firmware issue resulted in complications with data sequencing, which impacted the delivery of the Level 1 data feeds.

Interesting External Papers

Liquidity & Credit Limitations in FX Market

I forget where I read it, but sombody at sometime held up the forwards market on foreign exchange as being the most efficient market anywhere. Plug in the spot rate and the two relevant risk-free rates for any two currencies and presto! you have the forward rate to as many decimal places as you want.

Like everything else in this market, this model is no longer as valid as it used to be: the implicit assumptions in the model are infinite liquidity and counterparty strength, neither of which are as very nearly true as they used to be. The Bank for International Settlements has released Working Paper #267 titled Interpreting deviations from covered interest parity during the financial market turmoil of 2007–08:

This paper investigates the spillover effects of money market turbulence in 2007–08 on the short-term covered interest parity (CIP) condition between the US dollar and the euro through the foreign exchange (FX) swap market. Sharp and persistent deviations from the CIP condition observed during the turmoil are found to be significantly associated with differences in the counterparty risk between European and US financial institutions. Furthermore, evidence is found that dollar term funding auctions by the ECB, supported by dollar swap lines with the Federal Reserve, have stabilized the FX swap market by lowering the volatility of deviations from CIP.

Our finding bears similarities with the Japan premium episode in the late 1990s. At that time, due to a substantial deterioration of their creditworthiness relative to that of other financial institutions in advanced nations, Japanese banks found it extremely difficult to raise dollars in global money markets, and a so-called Japan premium arose between dollar cash rates paid by Japanese banks and by other banks (Covrig, Low, and Melvin 2004; and Peek and Rosengren 2001). As suggested in Nishioka and Baba (2004) and Baba and Amatatsu (2008), Japanese banks then turned to the FX swap and longer-term cross-currency markets for dollar funding, which resulted in substantial deviations from the CIP condition in its traditional sense. The dislocations in the FX swap market that have been triggered by the turmoil may be understood in a similar context.

finding is consistent with the view that the demand for dollar liquidity in FX swap markets under the turmoil came from a wider array of financial institutions than just dollar Libor panel banks. A similar observation can be made for the Libor-OIS (euro-dollar) variable: it always has a significantly positive effect on the FX swap deviation under the turmoil but not so in all cases before the turmoil. The estimated coefficients during the period of turmoil are larger, more significant, and closer to the value of 1 suggested by the earlier decomposition (equation (3)). This is consistent with the view that relative liquidity conditions in the Libor funding markets mattered more to FX swap markets during the turmoil than before.

This paper has empirically investigated spillovers to the FX swap market from the money market turbulence that began in the summer of 2007. As documented in Baba, Packer, and Nagano (2008), an important aspect of the turmoil was a shortage of dollar funding for many financial institutions, particularly European institutions that needed to support US conduits for which they had committed backup liquidity facilities. At the same time, financial institutions on the dollar-lending side became more cautious because of their own growing needs for dollar funds and increased concerns over counterparty risk. Facing these unfavourable conditions in interbank markets, non-US institutions turned to the FX swap market to convert euros into dollars.

Our empirical results show a striking change in the relationship between perceptions of counterparty risk and FX swap prices after the onset of financial turmoil. That is, CDS spread differences between European and US financial institutions have a positive and statistically significant relationship with the deviations from [Covered Interest Parity] observed in the FX swap market. The result holds when we consider the CDS spreads of a range of financial institutions wider than that of the Libor panel. Our findings suggest that concern over the counterparty risk of European financial institutions was one of the important drivers of the deviation from covered interest parity in the FX swap market.

While not significantly reducing the level of FX swap deviations over the period, the ECB’s US dollar liquidity-providing operations to Eurosystem counterparties do appear to have lowered the volatility (and thus the associated uncertainty) of the FX swap deviations. Our estimation results thus support the view that the dollar term funding auctions conducted by the ECB, supported by dollar swap lines with the Federal Reserve, played a positive role in stabilizing the euro/dollar FX swap market.

This study covers a period that ends in September 2008 shortly before the bankruptcy of Lehman Brothers. After the Lehman failure, the turmoil in many markets become much more pronounced. In currency and money markets, what had principally been a dollar liquidity problem for European banks deepened into a phenomenon of global dollar shortage. The provision of dollar funds by central banks, supported in some cases by unlimited dollar swap lines with the Federal Reserve, expanded greatly. One promising line of research would focus on the effectiveness of the diverse array of policy measures taken in this recent, more severe stage of the financial crisis.

Regulation

OSFI to Consider New Bank Soft-Retractibles?

Barry Critchley writes in today’s Financial Post:

Are so-called soft retractable preferred shares — a security that allows the issuer, at maturity, to pay in common shares or cash– the next type of Tier 1 capital financial institutions will be allowed to issue as part of the overall thrust of strengthening their balance sheets?

There is talk that the federal regulator, the Office of the Superintendent of Financial Institutions (OSFI), has been approached.

Soft retractables come with features that make them akin to Tier 1 or permanent capital: They are noncumulative in relation to dividends, and they have a term to maturity that can be extended to perpetuity if the issuer decides to pay not in cash but in common shares. (If that did happen, the pref share issue would be dilutive.) And they have the ability to absorb losses. But rule changes a few years back mean the capital raised now counts as Tier 2 capital. Accordingly, they receive the same treatment as debt securities. Since those changes were implemented, no financial institution has issued soft retractables. “If you have soft retractables that count as debt and are dilutive, it’s the worst of both worlds,” noted one underwriter, who added OSFI has “never really liked soft retractables.”

So how could OSFI make soft retractables more attractive for financial institutions to issue? The easiest way would be to overlook recent accounting changes and have the capital raised count as equity, not as debt.

Certainly institutional investors would like the regulators to change the rules to allow soft retractables to count as Tier 1 capital. Institutions would be buying a term security, a feature that allows them to match the investment against a liability.

The crux of the issue is the last paragraph: pretend-managers wanting securities with pretend-maturities … just like Deutsche Bank’s sub-debt! I will certainly not deny that, should there be new bank OpRet issues, they will be included in the HIMIPref™ portfolio and they will be considered for recommendation to clients.

But from a public policy perspective, these issues would be a disaster. In times of trouble they will be dilutive to the shareholders and get the bank into even more trouble – as has happened recently with the Quebecor World issue, IQW.PR.C. This is not what tier 1 capital is supposed to do!

Tier 1 Capital must participate in losses and must not be procyclical – that seems to me to be quite intuitive. There has been quite enough debasement of bank capital quality recently, with the recent approval of a rule to allow cumulative innovative Tier 1 Capital.

Such tinkering may well meet the objective of decreasing the probability of trouble, by increasing the funding sources available for Tier 1 capital. But the piper must eventually be paid: the corollary is that in times of trouble you increase the potential for crowded trades and cliff risk.

Hat Tip: Assiduous Reader tobyone.

Banking Crisis 2008

Deutsche Bank Ignores Sub-Debt Pretend-Maturity

The Financial Post reports:

Deutsche Bank’s decision to skip an opportunity to redeem €1-billion of subordinated bonds at the first scheduled call date because replacing them would be more expensive has rattled the bond market. Some suggested the European investment bank’s move, which surprised both investors and experts, has transformed the subordinated debt market. They fear that other banks will follow, which could threaten their relationships with investors and trigger losses.

Deutsche Bank is the first major bank not to call a Lower Tier 2 issue, which rank just below senior bonds. The move has implications for the wider subordinated debt market was well as for extension risk of Tier 1 securities, Mr. Adamson. said.

I, for one, am very happy with this move. As I wrote in A Vale of Tiers:

Investors tend to trade sub-debt as if it will definitely mature on their step-up date – dealer quotations will often reflect a spread to a Canada bond maturing on the step-up date. However, while one may count on them being called, as expected in good times, this will not necessarily be the case in times of trouble. In times of trouble, three-month BAs + 100bp might look awfully skimpy! Investors should tread very carefully when purchasing debt of this nature.

For years, pseudo-managers have been able to outperform actual bonds simply by purchasing sub-debt and Innovative Tier 1 Capital, justifying these moves on the grounds that the tiered structures are included in the Scotia (now DEX) index. The largest corporate holding in XBB, for instance, is RBC Trust Subordinated Notes, with a pretend-maturity of 2012-4-30.

Sub-Debt has been discussed on PrefBlog, particularly in the posts Cracks Appear in European Sub-Debt Market and Banks and Subordinated Debt.

Market Action

December 16, 2008

Next step, quantitative easing! The FOMC announced:

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.

As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.

In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The Board also established interest rates on required and excess reserve balances of 1/4 percent.

The Fed also announced:

The federal banking and thrift regulatory agencies today approved a final rule that would permit a banking organization to reduce the amount of goodwill it must deduct from tier 1 capital by any associated deferred tax liability.
Under the final rule, the regulatory capital deduction for goodwill would be equal to the maximum capital reduction that could occur as a result of a complete write-off of the goodwill under generally accepted accounting principles (GAAP). The final rule is in substance the same as the proposal issued in September. The final rule will be effective 30 days after publication in the Federal Register. However, banking organizations may adopt its provisions for purposes of regulatory capital reporting for the period ending December 31, 2008.

The final rule was approved by the Federal Reserve Board, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision. The draft Federal Register notice is attached.

The uninformed reporting of this rule change was discussed by PrefBlog when the rule was proposed.

In a sign of the times, redemptions on a real-estate seg fund have been suspended:

The Great-West Life Assurance Company today announced a temporary moratorium on redemptions from its Canadian Real Estate Investment Fund No. 1 effective close of business (4:00 p.m. EST) December 15, 2008.

The Great-West Life Real Estate Fund is a Segregated Fund which holds a diversified portfolio of high-quality income producing properties. Given the current economic environment, redemption requests have recently increased. Real estate assets are generally less liquid than other major asset classes and cannot be rapidly liquidated. Therefore, in accordance with the terms of
the Information Folder governing the Fund, it has been determined that a temporary moratorium on redemptions is necessary to ensure equitable treatment for all investors in the Fund.

I have a good illustration of why preferreds in general and BAM in particular are down so much this year. It’s in a post on Financial Webring Forum:

I am continuously amazed at the prices for BAM retractables. Forgetting the dividend for a moment, the O series are priced to return a 52% capital gain by August 2013 (assuming a $25 payout). That’s 9.4% annualized, and that’s just the capital gain. The YTW which James calculated yesterday is 16.65% based on a price of $16.

That’s ifBrookfield Assets Management can pay up in 2013, right ? And if Brookfield is still in business in 2013.

I hate to sound like the voice of doom, but these days anything can happen, and often does.

Voice of doom? Voice of ignorance is more like it. Look at that post: ZERO discussion, ZERO analysis, ZERO accountability. The quoted poster has a bright future ahead of him in the financial services industry, because he’s got the sales pitch down pat.

If somebody does an analysis of BAM and doesn’t like it, that’s fine. Maybe they’ve got too much exposure to real estate. Maybe they’ve got too much debt. Maybe … you name it, we can think about it and discuss it.

On the other hand, maybe somebody does an analysis of BAM, takes a view on what yield it should have, compares it to the yields available elsewhere with similar risk profile, and says Holy Smokes! Buy! Maybe the exposure to real-estate isn’t the totality of the company. Maybe the real-estate assets can be jettisoned (BAM has, effectively, a put on BPO. BPO has a put on the individual properties) with damage done, to be sure, but not life-threatening. Maybe since all that debt is secured by individual properties with no recourse and with well staggered maturities, it’s not as scary as it looks at first. Maybe … you name it, we can discuss it.

And if you like it, you can plunk a little money down (not too much because you might be wrong) and if you’ve done your homework properly you’ll make a good return – not necessarily on every investment, but on the totality of your portfolio.

Because, contrary to the ravings of efficient market zealots, the market is not efficient. The market is not comprised solely of highly intelligent people who work hard. The market is comprised of guys like the Mr. Voice of Doom quoted above – and poor performance does not weed them out. They just come back with a new line of patter and a new client list. Markets are moved by salesmen, not analysts.

Another down day on very heavy volume – but PerpetualDiscounts are still a little ahead on the month-to-date. SplitShares seem to be hesitantly recovering, and BNA activity appears to be dominated by retractors.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30.
The Fixed-Reset index was added effective 2008-9-5 at that day’s closing value of 1,119.4 for the Fixed-Floater index.
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet N/A N/A N/A N/A 0 N/A N/A
Fixed-Floater 7.96% 8.34% 123,030 12.24 7 +0.7086% 661.3
Floater 9.34% 9.41% 81,910 10.10 2 +0.9429% 346.6
Op. Retract 5.51% 6.53% 155,761 3.95 15 -0.1060% 985.6
Split-Share 6.72% 12.51% 89,541 3.94 15 +1.6721% 916.6
Interest Bearing 9.76% 20.56% 55,265 2.76 3 +2.1727% 757.8
Perpetual-Premium N/A N/A N/A N/A N/A N/A N/A
Perpetual-Discount 7.98% 8.11% 225,316 11.30 71 -0.5672% 695.0
Fixed-Reset 6.01% 5.36% 1,188,072 13.87 18 +0.1118% 1,004.9
Major Price Changes
Issue Index Change Notes
NA.PR.K PerpetualDiscount -9.0186% Now with a pre-tax bid-YTW of 8.69% based on a bid of 17.15 and a limitMaturity. Closing quote 17.15-18.22 (!), 3×1. Day’s range of 17.56-18.99.
BAM.PR.J OpRet -5.8908% Now with a pre-tax bid-YTW of 15.19% based on a bid of 13.10 and a softMaturity 2018-3-30 at 15.19%. Closing quote of 13.10-73, 1×6. Day’s range of 12.75-97.
POW.PR.C PerpetualDiscount -4.4275% Now with a pre-tax bid-YTW of 7.91% based on a bid of 18.78 and a limitMaturity. Closing quote 17.15-18.22 (!), 3×1. Day’s range of 17.56-18.99.
SLF.PR.C PerpetualDiscount -4.1825% Now with a pre-tax bid-YTW of 8.89% based on a bid of 12.60 and a limitMaturity. Closing quote 12.60-70, 14×29. Day’s range of 12.55-39.
BAM.PR.N PerpetualDiscount -4.1801% Now with a pre-tax bid-YTW of 13.44% based on a bid of 8.94 and a limitMaturity. Closing quote 8.93-00, 3×1. Day’s range of 8.74-60.
BAM.PR.M PerpetualDiscount -4.1667% Now with a pre-tax bid-YTW of 13.39% based on a bid of 8.97 and a limitMaturity. Closing quote 8.97-24, 3×5. Day’s range of 8.95-41.
SLF.PR.E PerpetualDiscount -4.1198% Now with a pre-tax bid-YTW of 8.85% based on a bid of 12.80 and a limitMaturity. Closing quote 12.80-00, 6×4. Day’s range of 12.66-26.
SLF.PR.D PerpetualDiscount -3.9786% Now with a pre-tax bid-YTW of 8.93% based on a bid of 12.55 and a limitMaturity. Closing quote 12.55-97, 5×5. Day’s range of 12.55-30.
BCE.PR.F FixFloat -3.4483% Huh. I add it to the database and this is the thanks I get.
ELF.PR.F PerpetualDiscount -3.4483% Now with a pre-tax bid-YTW of 9.74% based on a bid of 14.00 and a limitMaturity. Closing quote 14.00-30, 51×5. Day’s range of 14.00-44.
BNA.PR.C SplitShare -3.0573% Asset coverage of 1.7+:1, based on BAM.A at 17.94 and 2.4 BAM.A per preferred. Now with a pre-tax bid-YTW of 21.84% based on a bid of 7.61 and a hardMaturity 2019-01-10 at 25.00. Closing quote of 7.61-79, 4×1. Day’s range of 7.31-10.
BCE.PR.A FixFloat +3.1507%  
BSD.PR.A InterestBearing +3.7647% Asset coverage of 0.8-:1 as of December 12, according to Brookfield Funds. Now with a (currently dubious) yield of 23.74% based on a bid of 4.41 and a hardMaturity 2015-3-31 at (a currently dubious value of) 10.00. Closing quote of 4.41-66, 3×3. Day’s range of 4.27-50.
BAM.PR.K Floater +3.8519%  
MFC.PR.C PerpetualDiscount +4.7312% Now with a pre-tax bid-YTW of 7.71% based on a bid of 14.61 and a limitMaturity. Closing quote 14.61-00, 10×3. Day’s range of 13.97-80.
PPL.PR.A SplitShare +4.9936% Added to database today. Asset coverage of 1.6+:1 as of November 28 according to the company. Now with a pre-tax bid-YTW of 10.78% based on a bid of 8.20 and a hardMaturity 2012-12-1 at 10.00. Closing quote of 8.20-39, 20×1. Day’s range of 7.66-24.
FFN.PR.A SplitShare +5.4896% Asset coverage of 1.3+:1 as of November 28 according to the company. Now with a pre-tax bid-YTW of 12.41% based on a bid of 7.11 and a hardMaturity 2014-12-1 at 10.00. Closing quote of 7.11-49, 45×3. Day’s range of 6.87-25.
HSB.PR.D PerpetualDiscount +5.8901% Now with a pre-tax bid-YTW of 7.86% based on a bid of 16.00 and a limitMaturity. Closing quote 16.00-49, 21×21. Day’s range of 15.10-49.
DF.PR.A SplitShare +7.5817% Asset coverage of 1.4+:1 as of November 28 according to the company. Now with a pre-tax bid-YTW of 9.31% based on a bid of 8.23 and a hardMaturity 2014-12-1 at 10.00. Closing quote of 8.23-74, 1×23. Day’s range of 7.91-75.
BCE.PR.G FixFloat +7.6923%  
Volume Highlights
Issue Index Volume Notes
MFC.PR.C PerpetualDiscount 178,223 Now with a pre-tax bid-YTW of 7.77% based on a bid of 14.61 and a limitMaturity.
BNA.PR.A SplitShare 129,071 Now with a pre-tax bid-YTW of 23.77% based on a bid of 19.01 and a hardMaturity 2010-9-30 at 25.00
MFC.PR.B PerpetualDiscount 383,419 Now with a pre-tax bid-YTW of 7.57% based on a bid of 15.50 and a limitMaturity.
GWO.PR.I PerpetualDiscount 74,220 Now with a pre-tax bid-YTW of 8.31% based on a bid of 13.63 and a limitMaturity.
BNS.PR.I PerpetualDiscount 73,012 Now with a pre-tax bid-YTW of 7.78% based on a bid of 14.75 and a limitMaturity.

There were ninety-five index-included $25-pv-equivalent issues trading over 10,000 shares today

Data Changes

BCE.PR.F & PPL.PR.A Added to HIMIPref™ Database

I have bowed to overwhelming popular demand and added the captioned issues to the database.

BCE.PR.F is a FixedFloater, paying $1.10 annually (paid quarterly) until 2010-2-1, at which point the rate gets reset and it becomes exchangeable with BCE.PR.E. Exchange Dates recur every five years thereafter. For analytical purposes, it is assumed that the conversion to ratchet rate is automatic – this is a valid worst-case assumption, since BCE has the discretion to set the five-year rate to a very low value. It is callable on exchange dates at 25.00 and (when ratcheting) at 25.50 at other times. For analytical purposes this is simplified to two calls at $25.00, on 2010-2-1 and 2015-2-1. Dividends are cumulative. There is no retraction.

PPL.PR.A is a split share based on Canadian banks, paying dividends at a rate of Prime, capped at 7%, collared at 5%. It matures 2012-12-1 at $10.00. There is a special monthly retraction provision with the formula 96%(NAV – C). Dividends are cumulative and paid monthly. Current NAV is $16.08 according to the company. Income coverage, according to May’s semi-annual report is a hair over 1.0:1. Maturity is 2012-12-1; there are no embedded redemptions. Distributions to Capital Units will be halted if the NAV falls below 15.00 (asset coverage of 1.5:1).

Documentation

What is the Yield on BCE.PR.Y?

I was recently taken to task for a claim that the yield on BCE.PR.Y was 8.18% based on a dividend of $1.05715 and an end value of $25.00 – my correspondent stated – quite rightly – that:

the most recent monthly dividend, declared Oct 28, 2008, was $0.8333 or $1.00 per year. Also Prime has dropped to 3.5% from 4% earlier this month, (according to the BOC website), indicating a further cut in the dividend in the near future. Even at the rates and prices you quote I make the yield out to be 7.3%.

My defense is as follows:

They system estimates the average future rate of prime by looking at the past. If we stay at 3.5% prime for long enough, the estimated future rate will drop to this level, but for now it’s higher.

Additionally, the system estimates the end-value (a “limitMaturity” is treated as thirty years, remember) by determining the price at which the instrument is fairly valued; determining fairness by comparison with other floating-rate dependent issues. This was the result of some experimentation and proved to be a better predictor than assuming a constant price (as is done with fixed-rate perpetuals).

Basically, the assumption is that an Investment Grade issue will not pay 100% of prime forever. There will be shocks, of course, and every now and then such an issue will be downgraded and quite properly pay 100% of prime; but over the long term such a rate is not sustainable.

I will admit that this analytical framework was formulated when deviations were relatively small; an investment grade issue paying (25.00 / 14.25) = 175% of prime is not something that happens often enough to permit testing!

All the above is not very satisfactory, I know: but there are a lot of moving parts in the analysis of these ratchet rate issues and the framework was determined empirically. In some cases, to my chagrin, the results are not even internally consistent (e.g., I might be estimating a ratchet yield of less than 100% of prime with end values well below par).

All I can say is that the empirically derived system, while having theoretical holes in it, does have a statistical ability to rank the various issues with significantly better-than-random accuracy, which is all I ever wanted it to do.

Now lets do the cash flow analysis! I have uploaded the full HIMIPref™ output; the last part is:

2038-12-16 MATURITY 25.00 0.080242 2.01

Total Cash Flows 56.6052
Total Present Value 13.5028
Discounting Rate 8.5887 % (Annual rate compounded semi-annually)

So for starters, we see that the the discounted present value of the $25.00 maturity is only $2.01. It’s not a particularly important variable.

But compare four bonds priced at par, each one paying $12 p.a., but with differing frequencies (annual, semi-annual, quarterly, monthly). Each one is described by fixed income convention as having a yield-to-maturity of 12%. Which would you rather have? Obviously, the monthly payer, since then you get your money faster … and this is borne out when we look at the annualized internal rate of return for the four bonds: 12.00%, 12.36%, 12.55% and 12.69%, respectively. The limiting case is an infinite number of infinitesimally small payments totalling $12 and has an IRR of exp(0.12) – 1 = 12.75%.

We note from the HIMIPref™ report that the 30-year discounting factor is 0.080242 so
1 / (1 + I)^30 = 0.080242
(1 + I)^30 = 1 / 0.080242 = 12.4623
I = 8.7727%

To convert this annual value to semi-annual, bond-equivalent yield, we note:
1+I = (1+i)*(1+i)
(1+i) = 1.042942
i = 4.2942
and therefore, the bond-equivalent yield is 2*i = 8.5884%, which is slightly different from the quoted figure, but we’ll attribute that to rounding.

But how to calculate this ourselves? The “ratchet yield” is 4.1997% of par, which implies total payments of $1.049925. These are made monthly, so monthly payments are $0.087494, which has been shown as a rounded value of $0.09 in the HIMIPref™ report.

The normal quick-n-dirty calculation is:
i = [Annual Income + Annual Capital Gain]/[Average of Beginning and Ending Price]
Annual Income = oh hell, let’s just call it $1.05, shall we?
Annual Capital Gain = Total Capital Gain / Term = (25.00 – 13.50) / 30 = $0.38333
Average of Beginning and Ending Price = (25.00 + 13.50) / 2 = 19.25

resulting in a quick-n-dirty estimate of (1.05 + 0.3833) / 19.25 = 7.45%.

It’s a lousy estimate. Terrible. Why?

Mainly because the beginning and ending prices are so different. The calculation assumes that the capital gain is realized in a linear fashion … but in fact, if it accrues at a constant rate, nearly twice as much is accruing at the end of the period as at the beginning. Conversely, the $1.05 income is much more interesting at the beginning of the period (current yield = 1.05 / 13.50 = 7.78%) than at the end (current yield = 1.05 / 25 = 4.20%.

When the capital gain through the period is massive, simple methods become simplistic. Such is life! Fortunately, yield calculators and Excel Spreadsheets will be readily available to most people.

Related discussions may be found in the posts regarding Research: Modified Duration and Research: Yield from on-line Calculator.

Listen, take it from an old bond guy: if anybody ever tells you yield is simple, don’t listen to him!