PrefBlog

Now that the situation regarding RY.PR.O has been clarified, let’s take a look at another constituent of the PerpetualPreferred index with a negative YTW.

POW.PR.A hasn’t been mentioned much in this blog, but made the volume charts on October 11, 2006. At the close of business yesterday, October 18, it was quoted at $25.81-87, pays $1.40, and the next ex-date is (somewhere around) December 20.

The embedded options for this issue are:

• Redemption      2004-06-11      2005-06-10  26.000000
• Redemption      2005-06-11      2006-06-10  25.750000
• Redemption      2006-06-11      2007-06-10  25.500000
• Redemption      2007-06-11      2008-06-10  25.250000
• Redemption      2008-06-11   INFINITE DATE  25.000000

So it is currently redeemable at $25.50.

HIMIPref™ calculates the call probabilities as:

• Call  2006-11-17 YTM: -8.50 % [Restricted: -0.70 %] (Prob: 29.45 %)
• Call  2007-01-16 YTM: 0.69 % [Restricted: 0.17 %] (Prob: 5.99 %)
• Call  2007-07-11 YTM: 2.55 % [Restricted: 1.85 %] (Prob: 9.69 %)
• Call  2008-07-11 YTM: 3.70 % [Restricted: 3.70 %] (Prob: 5.09 %)
• Option Certainty  2036-09-12 YTM: 5.42 % [Restricted: 5.42 %] (Prob: 49.77 %)

Note that all these scenarios are combined at their probabilities to derive portfolioYield, but the worst result is used as Yield-To-Worst.

The various yields calculated for this issue are:

The sum of yield components of valuation of -2.6618 is the lowest value in the perpetualPremium index, the average value for the this calculation for this index is just a hair over 4.00.

Some may wonder at the calculations done here – why not just use YTW? As it turns out, in some analytical environments the other measures of yield are more discriminatory, but there is some variation that may be observed even in the current environment. In the graph, the following data points have been removed in order to increase the resolution of the display: AL.PR.E, TOC.PR.B, AL.PR.F. The graph is here, the regression calculation here.

HIMIPref™ will not recommend this issue for purchase to clients, giving the Eligible For Purchase (Code) as ’14’, which a quick look at the glossary defines as ‘pseudoModifiedDuration (Worst) of buy side less than minimum setting’. In other words, there’s a very good chance (YTW!) the issue will be called in the near future. Not only does HIMIPref™ have trouble discriminating between issues with such small pseudoModifiedDurations, but even if it could do this well then there wouldn’t be much money in it (since a small price change for a short-term instrument can result in a very large change of yield.

It may be noted that there is more scatter in the plot of YTW vs. sumYield when the instruments examined are restricted to those which are purchasable: graph, regression.

It should also be understood, as discussed and graphed on the prefShares site, yields have, ultimately, a minor effect on the valuation of shares once they have been qualified for purchase.

Bottom line: POW.PR.A looks overpriced, to the extent it can be analyzed. There are many alternatives available which can be analyzed effectively and quantitatively … so why go to huge extremes to justify holding it? Research is continuing, as ever, to extend the reach of measurement in which the HIMIPref™ analysis can result in superior performance, but this range of accuracy will not be extended at the expense of confidence in what HIMIPref already does well.

The Royal Bank announced today that RY.PR.O will be redeemed at a price of $25.50 on November 24, 2006.

This is an interesting decision on their part. As noted in my previous post on this topic, the issue pays $1.375 and the premium was declining by $0.25 annually – implying a net cost to Royal of $1.125 annually for the $25 capital, which is quite competitive.

I can only assume that they have a desired capital structure that includes some preferreds … and that the issue of RY.PR.B was an opportunistic move with the proceeds earmarked for this redemption.

RY.PR.O was quoted at the close yesterday, 2006-10-18, at $25.96-23, and had a pre-Tax YTW of -6.48% based on a call 2006-11-17 at $25.50 (OK, so the calculation was one week off! It’s still quite bad enough!). Had the issue survived until called  2008-09-23, the pre-tax YTM realized would have been 3.89 % – still pretty skimpy.

So there’s an objective lesson for all readers! It’s all very well to make elegant arguments that something won’t be called based on net cost to issuer, and there may often be a great deal of validity to these arguments. But plain old YTW remains a very powerful tool for avoiding mistakes and decisions made on any single element of valuation will often be in error.