A perplexed reader of my article on Split-Shares has eMailed to query:
Your article on Split Shares in Canadian Moneysaver indicates that “Asset Coverage Ratio” is an important metric. Could you provide some details on how you calculate the asset coverage ratio? Is it simply the total NAV divided by the call price of the Preferred split?
to which I answer … yes. Although I prefer to state the equation as “Total assets available divided by total assets required.”
For example, let’s look at SXT.PR.A, which gets mentioned in this blog occasionally due to its negative yield-to-worst. Financial data is available to September 15, 2006 from the manager’s website and may be stated as:
| Sixty-Split Balance Sheet, September 15, 2006 | |
| Assets | |
| Investment portolio, at market value | 87,536,712 |
| Distributions receivable | 170,277 |
| Cash and short-term investments | 91,207 |
| 87,798,196 | |
| Liabilities | |
| Due to related party | 69,060 |
| Accrued liabilities | 129,280 |
| Preferred Shares | 38,396,950 |
| 38,595,290 | |
| Capital Shareholders’ Equity | |
| Share capital | 30,803,768 |
| Retained Earnings | 18,399,138 |
| 49,202,906 | |
| Unit Value | |
| Number of Units Outstanding | 1,535,878 |
| Unit Value | $57.04 |
| Redemption Value per Preferred Share | (25.00) |
| Net Asset Value per two Capital Shares | $32.04 |
| A Unit consists of two Capital Shares and One Preferred Share. Preferred shares are redeemable every March 15 until 2011. All preferred shares outstanding on March 15, 2011 will be redeemed by the Company at a price per share equal to the lesser of $25.00 and the Unit Value. | |
So that’s the balance sheet, now to calculate the asset coverage ratio: the “Accrued Liabilities” and the “Due to a Related Party” liabilities stand in front of the preferred shareholders at liquidation time, but preferred shareholders stand in front of the Capital Unit Holders.
As it states on the balance sheet, the amount of money required to cover the obligations to Preferred Shareholders is $38,396,950. However, the amount available is the amount set aside, plus whatever is currently allocated to those behind us in line … so the amount available is $38,396,950 + $49,202,906 = $87,599,856.
With $87,599,856 available to cover an obligation of $38,396,950, the asset coverage ratio is 2.28:1, which is to say, for every dollar of obligation, there’s $2.28 in the kitty. Which leaves us preferred shareholders feeling reasonably secure that the company will be able to meet those obligations.
Another way to calculate this number is just as the reader who inspired this post suggested: the NAV per Unit (including the preferred shares) is $57.04; the preferred share obligation is $25.00; division gives 2.28.
DBRS usually expresses this ratio in terms of “Downside Protection”. They are asking essentially the same question but phrasing it as “How much of the total assets of the fund can be lost before the preferred shareholders feel pain”? Therefore, in this example, they are calculating the value:
= 1 – (25 / 57.04)
=1 – 0.438
=0.562
They therefore say the “Downside Protection” is 56.2%.
Try it out! We have $57.04. We lose 56.2% of it, or $32.06. This leaves us with $24.98 (which is just a rounding error for $25.00), just enough to cover the obligation. The company can lose 56.2% on its investments and still cover the preferred share obligation.
Note, however, that “Asset Coverage Ratio” is not the only thing that must looked at! One must also consider the “Income Coverage Ratio” … but that’s dealt with briefly in the article and can be examined in more detail here at another time.
And, of course, one must always bear in mind that these calculations only examine whether the company will be able to meet its obligations. They do not consider whether we can buy the rights to those obligations at an attractive price. Yes, we’re pretty sure that the company is good for the $25.00. However, the SXT.PR.A issue is currently quoted at $25.83-12 in the marketplace and has a negative yield-to-worst.
By way of analogy, let’s say we’ve checked out a five dollar bill very thoroughly. We’ve convinced ourselves that it’s not a forgery. As far as we’ve been able to tell, with all our analysis, we’ll be able to take that $5 bill to the bank or anywhere else we like! But even with all that assurance, we’re not going to pay $5.25 for it!