PrefBlog

The fund performed approximately equal to the indices in December, helped by its low weighting in junk FixedResets, which outperformed (as indicated by the performance difference between TXPR (-1.50%) and TXPL (-1.61%)), but hurt by its holdings in insurance DeemedRetractibles.

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I continue to believe that the decline in the preferred share market has been overdone; the following table shows the increase in yields since May 22 of some fixed income sectors:

ZPR, is a relatively new ETF comprised of FixedResets and Floating Rate issues and a very high proportion of junk issues, returned XXX%, XXX% and XXX% over the past one-, three- and twelve-month periods, respectively (according to the fund’s data), versus returns for the TXPL index of -1.61%, -0.76% and -3.06%, respectively. The fund has been able to attract assets of about $909.4-million since inception in November 2012; AUM declined in December, but by about 1% less than the index return, indicating that money is still flowing into the fund. I feel that the flows into and out of this fund are very important in determining the performance of its constituents.

The apparent tracking error for ZPR / TXPL discussed at length last month appears to have been a calculation error on the part of the fund’s web production team – it has now disappeared, without any explanation of the change.

TXPR had returns over one- and three-months of -1.50% and -0.33%, respectively with CPD performance within expectations.

Returns for the HIMIPref™ investment grade sub-indices for October were as follows:

It is clear that the HIMIPref™ indices strongly outperformed the broad indices. Some of this will be due to a normalization of the relationship between closing bids and closing prices, which was discussed with respect to November 29.

Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close December 31, 2013, was 9.8717 after a dividend distribution of 0.123904.

MAPF returns assume reinvestment of dividends, and are shown after expenses but before fees. Past performance is not a guarantee of future performance. You can lose money investing in Malachite Aggressive Preferred Fund or any other fund. For more information, see the fund’s main page. The fund is available either directly from Hymas Investment Management or through a brokerage account at Odlum Brown Limited.

Those investors who receive their distributions as cash will undoubtedly notice that the current distribution of 0.123904 is about 8% below the 0.133256 average of the past three distributions. Some of this is simply the normal ebb and flow of dividend amounts earned by the fund as ex-Date holdings change, but there are two major contributors to the decline this month:

• BNS did not pay a dividend this quarter: the 2013 ex-dates were 3/28, 6/27 and 9/27; the dividend payable in January, 2014, was only earned on 2014-1-3. Had this been earned prior to year-end, the fund’s 13Q4 distribution would have been $0.005826 greater, representing about 62% of the shortfall, and
• As mentioned in the October, 2013 and September, 2013, Portfolio Composition Reviews, the purchase of these issues, and of two CU PerpetualDiscounts, was funded in large part by the sale of HSB.PR.E, which pays a dividend of $1.65 and was sold at prices of about 25.60, implying a Current Yield on the sale of about 6.44%, while BNS.PR.Y was purchased at around 23.50, implying a Current Yield on the purchase of about 4.10% and CU.PR.G was purchased at about 20.65, implying a Current Yield on that purchase of about 5.45%. It is difficult to be precise regarding the distribution reduction that resulted from this effect due to subsequent trading, but the effect is substantial in the context of the distribution reduction.

HSB.PR.E is virtually certain to be called on its first Exchange Date of 2014-6-30, so the fat dividend would be disappearing soon even had the issue not been sold; this is simply another illustration of why Current Yield is a bad metric, even though it is vital when considering short term cash distributions. It will be noted that on the trades mentioned above, Yield-to-Worst increased while Current Yield decreased; implying that the immediate effect on distributions was negative while the effect on Sustainable Yield was positive.

A problem that has bedevilled the market over the past two years has been the OSFI decision not to grandfather Straight Perpetuals as Tier 1 bank capital, and their continued foot-dragging regarding a decision on insurer Straight Perpetuals has segmented the market to the point where trading has become much more difficult. The fund occasionally finds an attractive opportunity to trade between GWO issues, which have a good range of annual coupons (but in which trading is now hampered by the fact that the low-coupon issues are trading near par and are callable at par in the near term), but is “stuck” in the MFC and SLF issues, which have a much narrower range of coupon, while the IAG DeemedRetractibles are quite illiquid. Until the market became so grossly segmented, this was not so much of a problem – but now banks are not available to swap into (because they are so expensive) and non-regulated companies are likewise deprecated (because they are not DeemedRetractibles; they should not participate in the increase in value that will follow the OSFI decision I anticipate and, in addition, are analyzed as perpetuals). The fund’s portfolio is, in effect ‘locked in’ to the MFC & SLF issues due to projected gains from a future OSFI decision, to the detriment of trading gains particularly in May, 2013, when the three lowest-coupon SLF DeemedRetractibles (SLF.PR.C, SLF.PR.D and SLF.PR.E) were the worst performing DeemedRetractibles in the sub-index, and in June, 2013, when the insurance-issued DeemedRetractibles behaved like PerpetualDiscounts in a sharply negative market.

December was another month when insurance DeemedRetractibles significantly underperformed bank DeemedRetractibles:

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… behaving more like Straight Perpetuals:

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A side effect of the downdraft has been the return of measurable Implied Volatility (all Implied Volatility calculations use bids from January 3):

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So we are now seeing a market evaluation of call probabilities such that GWO is now considered to have more of a directional bias than PWF.

In the September, 2013, edition of PrefLetter, I extended the theory of Implied Volatility to FixedResets – relating the option feature of the Issue Reset Spreads to a theoretical non-callable Market Spread.

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These are very interesting results: The BPO issues are trading as if calls are a certainty, while FFH issues are trading as if calls are nonexistent.

Those of you who have been paying attention will remember that in a “normal” market (which we have not seen in well over a year) the slope of this line is related to the implied volatility of yields in Black-Scholes theory, as discussed in the January, 2010, edition of PrefLetter. As has been previously noted, very high levels of Implied Volatility (in the 40% range, at which point the calculation may be considered virtually meaningless) imply a very strong expectation of directionality in future prices – i.e, an expectation that all issues will be redeemed at par.

It is significant that the preferred share market knows no moderation. I suggest that a good baseline estimate for Volatility over a three year period is 15% but the observed figure is generally higher in a rising market and lower in a declining one … with, of course, a period of adjustment in between, which I suspect we are currently experiencing.

Sometimes everything works … sometimes it’s 50-50 … sometimes nothing works. The fund seeks to earn incremental return by selling liquidity (that is, taking the other side of trades that other market participants are strongly motivated to execute), which can also be referred to as ‘trading noise’ – although for quite some time, noise trading has taken a distant second place to the sectoral play on insurance DeemedRetractibles; something that dismays me, particularly given that the market does not yet agree with me regarding the insurance issues! There were a lot of strongly motivated market participants during the Panic of 2007, generating a lot of noise! Unfortunately, the conditions of the Panic may never be repeated in my lifetime … but the fund will simply attempt to make trades when swaps seem profitable, without worrying about the level of monthly turnover.

There’s plenty of room for new money left in the fund. I have shown in PrefLetter that market pricing for FixedResets is very often irrational and I have lots of confidence – backed up by my bond portfolio management experience in the markets for Canadas and Treasuries, and equity trading on the NYSE & TSX – that there is enough demand for liquidity in any market to make the effort of providing it worthwhile (although the definition of “worthwhile” in terms of basis points of outperformance changes considerably from market to market!) I will continue to exert utmost efforts to outperform but it should be borne in mind that there will almost inevitably be periods of underperformance in the future.

The yields available on high quality preferred shares remain elevated, which is reflected in the current estimate of sustainable income.

Significant positions were held in DeemedRetractible, SplitShare and FixedReset issues on July 31; all of these currently have their yields calculated with the presumption that they will be called by the issuers at par prior to 2022-1-31 (banks) or 2025-1-31 (insurers and insurance holding companies). This presents another complication in the calculation of sustainable yield. The fund also holds positions in various SplitShare issues which also have their yields calculated with the expectation of a maturity at par.

I no longer show calculations that assume the conversion of the entire portfolio into PerpetualDiscounts, as the fund has only a very small position in these issues.

I will also note that the sustainable yield calculated above is not directly comparable with any yield calculation currently reported by any other preferred share fund as far as I am aware. The Sustainable Yield depends on:
i) Calculating Yield-to-Worst for each instrument and using this yield for reporting purposes;
ii) Using the contemporary value of Five-Year Canadas (set at 1.94% for the December 31 calculation) to estimate dividends after reset for FixedResets.

Most funds report Current Yield. For instance, ZPR reports a “Portfolio Yield” of 5.04% as of December 27, 2013 and notes:

Portfolio yield is calculated as the most recent income received by the ETF in the form of dividends interest and other income annualized based on the payment frequently divided by the current market value of ETFs investments.

In other words – it’s the Current Yield, a meaningless number. The Current Yield of MAPF is 5.27% as of December 31, but I will neither report that with any degree of prominence nor take any great pleasure in the fact that it’s a little higher than the ZPR number. It’s meaningless; to accord it any prominence in portfolio reporting is misleading.

It should be noted that the concept of this Sustainable Income calculation was developed when the fund’s holdings were overwhelmingly PerpetualDiscounts – see, for instance, the bottom of the market in November 2008. It is easy to understand that for a PerpetualDiscount, the technique of multiplying yield by price will indeed result in the coupon – a PerpetualDiscount paying $1 annually will show a Sustainable Income of $1, regardless of whether the price is $24 or $17.

Things are not quite so neat when maturity dates and maturity prices that are different from the current price are thrown into the mix. If we take a notional Straight Perpetual paying $5 annually, the price is $100 when the yield is 5% (all this ignores option effects). As the yield increases to 6%, the price declines to 83.33; and 83.33 x 6% is the same $5. Good enough.

But a ten year bond, priced at 100 when the yield is equal to its coupon of 5%, will decline in price to 92.56; and 92.56 x 6% is 5.55; thus, the calculated Sustainable Income has increased as the price has declined as shown in the graph:

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The difference is because the bond’s yield calculation includes the amortization of the discount; therefore, so does the Sustainable Income estimate.

Different assumptions lead to different results from the calculation, but the overall positive trend is apparent. I’m very pleased with the long-term results! It will be noted that if there was no trading in the portfolio, one would expect the sustainable yield to be constant (before fees and expenses). The success of the fund’s trading is showing up in

• the very good performance against the index
• the long term increases in sustainable income per unit

As has been noted, the fund has maintained a credit quality equal to or better than the index; outperformance has generally been due to exploitation of trading anomalies.

Again, there are no predictions for the future! The fund will continue to trade between issues in an attempt to exploit market gaps in liquidity, in an effort to outperform the index and keep the sustainable income per unit – however calculated! – growing.

Turnover declined dramatically in December, to about 1%.

There is extreme segmentation in the marketplace, with OSFI’s NVCC rule changes in February 2011 having had the effect of splitting the formerly relatively homogeneous Straight Perpetual class of preferreds into three parts:

• Unaffected Straight Perpetuals
• DeemedRetractibles explicitly subject to the rules (banks)
• DeemedRetractibles considered by me, but not (yet!) by the market, to be likely to be explicitly subject to the rules in the future (insurers and insurance holding companies)

This segmentation, and the extreme valuation differences between the segments, has cut down markedly on the opportunities for trading. Another trend that hasn’t helped was the migration of PerpetualDiscounts into PerpetualPremiums (due to price increases) in early 2013 – many of the PerpetualPremiums had negative Yields-to-Worst and those that don’t aren’t particularly thrilling; speaking very generally, PerpetualPremiums are to be avoided, not traded! This effect has caused the first of the three segments noted above to be untradeable for most practical purposes. The summer’s downdraft reversed the trend and resulted in a large pool of PerpetualDiscounts, but due to their long term they are still, as a class, inferior to DeemedRetractibles.

To make this more clear, it used to be that there were 70-odd Straight Perpetuals and I was more or less indifferent as to which ones I owned (subject, of course, to issuer concentration concerns and other risk management factors). Thus, if any one of these 70 were to go down in price by – say – $0.25, I would quite often have something in inventory that I’d be willing to swap for it. The segmentation means that I am no longer indifferent; in addition to checking the valuation of a potential buy to other Straights, I also have to check its peer group. This cuts down on the potential for trading.

There is no real hope that this situation will be corrected in the near-term. OSFI has indicated that the long-promised “Draft Definition of Capital” for insurers will not be issued “for public consultation in late 2012 or early 2013”, as they fear that it might encourage speculation in the marketplace. It is not clear why OSFI is so afraid of informed speculation, since the constant speculation in the marketplace is currently less informed than it would be with a little bit of regulatory clarity.

As a result of this delay, I have extended the Deemed Maturity date for insurers and insurance holding companies by three years (to 2025-1-31), in the expectation that when OSFI finally does provide clarity, they will allow the same degree of lead-in time for these companies as they did for banks. This has obviously had a major effect on the durations of preferred shares subject to the change but, fortunately, not much on their calculated yields as most of these issues are either trading near par or were trading at sufficient premium that a par call was expected on economic grounds. However, with the declines in the market over the past two months, the expected capital gain on redemption of the insurance-issued DeemedRetractibles has become an important component of the calculated yield.

Due to further footdragging by OSFI, I will be extending the DeemedMaturity date for insurance issues by another two years in the near future.

Sectoral distribution of the MAPF portfolio on December 31 was as follows:

The “total” reflects the un-leveraged total portfolio (i.e., cash is included in the portfolio calculations and is deemed to have a duration and yield of 0.00.). MAPF will often have relatively large cash balances, both credit and debit, to facilitate trading. Figures presented in the table have been rounded to the indicated precision.

Readers will notice that the changes in sectoral composition exceed the stated turnover of about 1%. This is because some trading was done to offset fund cash flows; such trading does not count in the calculation of turnover.

Credit distribution is:

The apparent shift in weight from Pfd-1(low) to Pfd-2(high) is mostly due to the DBRS downgrade of BNS from the former category to the latter.

Liquidity Distribution is:

Changes in liquidity were driven largely by migration of issues between classes; e.g., both GWO.PR.Q and SLF.PR.C moved from the 100-200 group to 200-300, while GWO.PR.R moved from 200-300 to 300+.

MAPF is, of course, Malachite Aggressive Preferred Fund, a “unit trust” managed by Hymas Investment Management Inc. Further information and links to performance, audited financials and subscription information are available the fund’s web page. The fund may be purchased either directly from Hymas Investment Management or through a brokerage account at Odlum Brown Limited. A “unit trust” is like a regular mutual fund, but is sold by offering memorandum rather than prospectus. This is cheaper, but means subscription is restricted to “accredited investors” (as defined by the Ontario Securities Commission) or those who subscribe for $150,000+. Fund past performances are not a guarantee of future performance. You can lose money investing in MAPF or any other fund.

A similar portfolio composition analysis has been performed on the Claymore Preferred Share ETF (symbol CPD) (and other funds) as of August 31, 2012, and published in the October (mainly methodology), November (most funds), and December (ZPR) 2012, PrefLetter. While direct comparisons are difficult due to the introduction of the DeemedRetractible class of preferred share (see above) it is fair to say:

• MAPF credit quality is better
• MAPF liquidity is a lower
• MAPF Yield is higher
• Weightings
  • MAPF is much more exposed to DeemedRetractibles
  • MAPF is much less exposed to Operating Retractibles
  • MAPF is much more exposed to SplitShares
  • MAPF is less exposed to FixFloat / Floater / Ratchet
  • MAPF weighting in FixedResets is much lower