PrefBlog

Well, what are we to make of this yield curve?

This yield curve was plotted from the data prepared for the ‘Operating Retractible’ Index on 2006-07-26. The x-axis is modified duration, the y-axis is the pre-tax yield to maturity. Both data elements are obtained from the “YTW Scenario” – i.e., assuming a maturity-date and associate redemption price that reflects the worst-case-scenario (given current conditions) for the shareholder.

Retractible prefs are the class of prefs that behave most like bonds (an assertion I’ll prove at some point in the future, probably in a published article … for now, just trust me!) so one would expect that a yield curve would be a relatively smooth looking thing.

No such luck! BAM.PR.J, with a yield of 4.54% until its presumed redemption in March 2018, well above the curve, while PWF.PR.D seems well below its peers, having a YTW of only 1.87% based on a call at $26.00 in November 2007.

Could it be that the market is pricing the latter issue based on a redemption at $25.00 immediately prior to the retraction date in October 2012? Its yield based on the 2012 call is currently 3.72%, which is much closer to what comparable issues are paying. It is, perhaps, due to this sort of behaviour that HIMIPref finds the concept of portfolio yield useful in preferred share valuation.

The graph shown isn’t definitive, of course. No allowance has been made for credit rating and it is certainly possible to argue that the yield premium available on BAM.PR.J is mere compensation for the risk that its Pfd-2(low) rating from DBRS implies relative to the other labelled data points, which are all Pfd-1(low) – or simply that its extremely long time until its retraction privilege becomes exercisable make the other data points irrelevant for pricing purposes. It is also entirely valid to argue that the market is pricing in higher yields for the future, which will make the earlier redemption of PWF.PR.D less likely.

Arguments, arguments … that’s what makes a market!

I just don’t understand the DBRS credit rating on this issue at all.

 Essentially, the company has two classes of preferred shares and one class of “common”. They have invested the proceeds in a portfolio … part of this portfolio has been sold forward to a counterparty in order to guarantee the return of principal for the senior preferred shares. Got that?

 OK, a simplified balance sheet, as of December 31, 2005, of this Split Share Corporation looks like this:

Now, maybe to you and me, things look pretty dicey for the “Junior Preferreds” (Note that these are really called the “Series 2”). After all, they’re owed $19,445M on redemption and there’s only $20,505 to cover it – a coverage ratio of just 1.05:1.

But DBRS claims that the coverage ratio is 1.46:1 and, as far as I have been able to tell (and confirmed in a telephone call last March), here’s how they’ve done it: the amount due on maturity to the senior prefs is $33,068M, right? And that’s covered off by the forward agreement, right? And the portfolio to be delivered under the forward agreement is on the balance sheet for $25,173M, right?

 Therefore, DBRS concludes, there’s $7,895M guaranteed capital appreciation sitting right there! The forward contract has an intrinsic value of $7,895M ! So, for analytical purposes, in order to calculate the coverage for the Junior prefs, just stick another $7,895M into equity against the notional forward contract value, and then come up with a coverage ratio of:

Now, this calculation is absolutely nonsensical, of course, but as far as I could tell from the DBRS press release and from talking to their analyst, that’s exactly what they did.

‘Why is this nonsensical?’, you ask.

Well, there’s the small matter of the dividends that have to be paid on the Senior prefs. If you’re going to defease the principal repayment on the seniors, you can’t just forget all about the dividends due. They pay 5.85% annually …. they’re not due until June 29, 2012 …. where’s Mr. Calculator? … essentially, that payment stream of $0.1218 monthly has a present value of about $7.50 / share, or a total of about $10-million when discounted at 5.85%.

Knock $10-million off the amount available to cover the Juniors … and, hey, looky-looky! They’re in the red, with an asset coverage ratio of 0.95:1 !

Let’s try it another way, since that doesn’t look so good. Let’s just forget about the damn forward agreement and assign it a value of $0. That’s almost as bad: there is now $20,505 to cover $19,445 … asset coverage is 1.05:1.

It just doesn’t work. If you’re going to consider the Senior’s defeased, you have to defease all of it, not just the principal, and the dividend stream is just way too much.

 So what does an asset coverage of 1:1-ish mean for most companies? Let’s put it this way: on August 19, 2002, Sixty Split (SXT.PR.A) got downgraded to Pfd-4 when its coverage ration reached 1.28:1.

How these HPF.PR.Bs are maintaining their DBRS rating of Pfd-2(low) [Stable] is something I just don’t understand.

Note Added: In case anybody has the idea that dividends on the securing portfolio will offset the dividends to be paid on the senior shares, I’ll quote from the prospectus:

Under the Series 1 Forward Agreement, all dividends and distributions, including extraordinary distributions, declared and paid on the Series 1 Repayment Portfolio securities will be paid to the Company and the amount payable on the Termination Date may be correspondingly reduced. In order to minimize the likelihood that such dividends or distributions will be paid, the Company intends to acquire non-dividend paying shares of Canadian public companies for the Series 1 Repayment Portfolio. If any such dividends or distributions are declared on securities in the Series 1 Repayment Portfolio, the Series 1 Forward Agreement may be amended to provide that replacement securities acceptable to the Counterparty be substituted for the securities in respect of which the dividend or distribution has been declared to preserve the value of the forward transaction prior to the occurrence of such event.

Note also that:

The Company will pay dividends on the Offered Shares primarily from net realized capital gains, including premiums from writing covered call options on the securities held in the Managed Portfolio in which it is permitted to invest and from distributions and interest received on that portion of the Managed Portfolio invested in securities of Income Funds and debt securities.

In other words, they’re not going to get any covered call income from the securing portfolio, either, and finally: 

In order to achieve the Company’s regular monthly dividends on the Series 1 Shares and Series 2 Shares, the Company will be required to generate an average annual return on the Managed Portfolio of approximately 12% if the value of the Managed Portfolio is maintained intact until the Termination Date

Well, DBRS apparently thinks they can do it! Let’s hope so, because there’s not much room for error.