PrefBlog

On a completely unrelated thread, assiduous reader kaspu asked:

While I know that this letter deals only with canadian prefs, I have a question regarding both canadian and us prefs. With all the fooferall in the US regarding sub-prime problems, and perhaps prime problems, it seems that corporate preferred shares, even good investment grade (BBB+), have seen their spreads relative to the Benchmark US 10 year has widened quite a bit. My questions are:

1. Even with the US 10 years going back below 5%, there has been no similar lowering of high credit pref yields. Is this due to a general creditor boycott in regard to preferred shares, which can be illiquid, or is is this a wiespread phenomenom to all non-goverment debt?

2. are the canadian preferreds affected by this US credit fea? or do they trade more closely to how the canadian treasuries fare?

3. There has been quite a bit of talk about the ratings agencies goofing up regarding junk-bonds. Yet it seems to me that this scepticism has also spread to the investment grades. Is this your impression as well? And if so, how are to trust the various rating agencies?

4. Back to the US. There are many different types are highly rated synthetic preferred shares (STRATS, SPARQS etc.) These are usually backed by investment grade bonds, and the prospectus seems fairly clean. Are there any canadian equivalents? As well, can these be classified as CDO-type investments, even though many are rated A and higher.

Thanks in advance,. I know this is quite a bit to ask. But what the heck…..

Well, kaspu, I have to say … I’m not familiar enough with the US Market to address these questions with much confidence, but I’ll give some of the questions the old college try:

1. You should not expect to see the corporate market track Treasuries as closely as all that, especially with the financial sector feeling such stress. In the absence of a good website providing credit spread averages, have a look at the CBOT 10-year swap contract. I’ve discussed swaps on this blog before, in the context of converting perpetuals into synthetic floaters, so if you need to refresh your memory regarding swaps, that’s a good place to start. I note that the 10-year swap contract closed at 102-29 today, which CBOT’s spreadsheet converts to a fixed rate of 5.62% … but there will be settlement date adjustments to make to that figure. You can also get the Federal Reserve’s H15 statistical release which shows 5.64% as of July 24. You should mark prefs off of bonds of comparable quality, not governments.

2. “Canadian Treasuries”? tee-hee … you’re not one of the cool guys! Say “Canadas” … that’s what the cool guys say. Us cool guys also refer to UK government bonds as “Gilts”, just so you know. The Canadian preferred market is dominated by retail. They should trade such that high-quality (read: Bank) discount perpetuals trade at a relatively constant interest-equivalent spread to comparable 30-year paper, but they don’t. Spreads are all over the map and congruence with bond yields can only be detected in very broad terms … for instance, Pfd-3 issues have been trading at an increasing spread to Pfd-2 issues over the past month or so.

3. Rating agencies do not speak with the voice of God and it is a mistake to take them too seriously. It is also a mistake to take them too lightly. Think of credit ratings from major agencies as having the same relevence as market prices … inefficient, yes, and it is entirely rational to disagree with them from time to time … but if you are going to disagree with them, you’d better have a pretty good reason and be prepared to be wrong a lot of the time! They move slowly … perhaps too slowly. A recognized form of bond portfolio management is “Credit Anticipation”, in which you attempt to recognize fundamental changes in companies’ risk profiles before they are highlighted by the rating agencies and subsequently reflected in market price by those who did not anticipate the rating change. One thing that is happening now is that the CDS market is going nuts speculating on which bank holds the most toxic waste … anticipating future changes to rating as the sub-prime situation clarifies.

4. I’m not familiar with these products at all. Sorry! I don’t know of any Canadian preferred products explicitly backed by bonds – that would probably require some fancy footwork with derivatives if the funds were to pay out dividends.

Update: Good spread data is available from Markit Group Limited which administers the CDX Indices