PrefBlog

Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close January 31, 2019, was $8.5108.

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.

The preferred share market has suffered a sharp reverse in the past four months, leaving a lot of room for outsized gains. The Seniority Spread (the interest-equivalent yield on reasonably liquid, investment-grade PerpetualDiscounts less the yield on long term corporate bonds) is extremely elevated (chart end-date 2019-1-11)

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Note that the Seniority Spread was 345bp on January 30. As a good practical example of the spreads between markets, consider that on November 19, CIU issued $385-million of 30-year bonds yielding 3.95%, at a time when issuing Straight Perpetuals would have cost them about 5.75% – a very wide spread even before considering the tax effect.

… and the relationship between five-year Canada yields and yields on investment-grade FixedResets is also well within what I consider ‘decoupled panic’ territory (chart end-date 2018-12-14):

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In addition, I feel that the yield on five-year Canadas is unsustainably low (it should be the inflation rate plus an increment of … 1%? 1.5%? 2.0%?),and a return to sustainable levels is likely over the medium term.

It seems clear that many market players are, wittingly or not, using FixedResets to speculate on future moves in the Canada 5-Year yield. This is excellent news for those who take market action based on fundamentals and the long term characteristics of the market because nobody can consistently time the markets. The speculators will, over the long run, lose money, handing it over to more sober investors.

FixedReset (Discount) performance on the month was -1.12% vs. PerpetualDiscounts of +1.01% in January; the two classes finally decoupled in mid-November after months of moving in lockstep.:

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Floaters took another hit over the month, as they returned -7.21% for January and -21.13% for the past twelve months. But look at the long-term performance:

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Some Assiduous Readers will be interested to observe that the ‘Quantitative Easing’ decline was not as bad as the ‘Credit Crunch’ decline, which took the sector down to the point where the 15-year cumulative total return was negative. I wrote about that at the time and still can’t get over it. Fifteen years!

But, as mentioned earlier with respect to FixedResets, it seems clear that Floaters are used, wittingly or otherwise, as a vehicle for speculation on the policy rate and Canada Prime.

As for the future, of course, it’s one thing to say that ‘spreads are unsustainable and so are government yields’ and it’s quite another to forecast just how and when a more economically sustainable environment will take effect. It could be years. There could be a reversal, particularly if Trump’s international trade policies cause a severe recession or even a depression. And, of course, I could be just plain wrong about the sustainability of the current environment. However, the sharp declines of the past two months clarify the market’s fears, which were unclear on October 29: the market is behaving more as if it fears falling interest rates rather than rising ones – although this does not explain the very high value of the Seniority Spread, discussed above.

Yields on preferred shares of all stripes are extremely high compared to those available from other investments of similar quality. A I told John Heinzl in an eMail interview in late November, the best advice I can offer investors remains Shut up and clip your coupons!

I think that a broad, sustainable rally in FixedResets will require higher five-year Canada yields (or a widespread expectation of them) … and although I’m sure this will happen eventually, it would be foolish to speculate on just when it will happen!

These calculations were performed assuming constant contemporary GOC-5 and 3-Month Bill rates, as follows:

Significant positions were held in NVCC non-compliant regulated FixedReset issues on January 31, 2019; 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 2030-1-31 (insurers and insurance holding companies) or on a different date (SplitShares, when present in the portfolio) This presents another complication in the calculation of sustainable yield, which also assumes that redemption proceeds will be reinvested at the same rate. It will also be noted that my analysis of likely insurance industry regulation as updated is not given much weight by the market.

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 to estimate dividends after reset for FixedResets. The assumption regarding the five-year Canada rate has become more important as the proportion of low-spread FixedResets in the portfolio has increased.
iii) Making the assumption that deeply discounted NVCC non-compliant issues from both banks and insurers, both Straight and FixedResets will be redeemed at par on their DeemedMaturity date as discussed above.

Turnover exploded in January to slightly over 17%. This was due to large sectoral changes, with SplitShares declining from 6.4% to 0.0% of the portfolio, PerpetualDiscounts from 14.1% to 5.8% and DeemedRetractibles from 10.4% to 6.4%, while FixedReset (Discounts) increased from 22.5% to 34.7% and FixedReset Insurance non-NVCC from 35.2% to 41.5%.

Note that the changes by sector add up to more than the reported turnover. The turnover calculation is based on book-value and ignores cash (e.g., the effect on turnover of investing a cash balance is null), while the sectoral composition is based on market value and therefore may change even in the absence of any trading at all.

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.

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.

And, of course, the same segmentation has the same effect on trading opportunities between FixedReset issues.

I have argued for a long time that insurers will become covered by NVCC rules similar to the banks, but regulatory process on the issue is very slow.

As a result of prior delays, I initially 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 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 were either trading near par when the change was made 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 nine months, the expected capital gain on redemption of the insurance-issued DeemedRetractibles has become an important component of the calculated yield.

I recently extended the DeemedMaturity date for insurance issues by another five years, to 2030-1-31.

The new date has been chosen with the idea that a decision will be made by the IAIS (International Association of Insurance Supervisors) in 2019, and (if favourable) will be implemented with an 11-year grace period, similarly to the banks. We shall see just how accurate these suppositions might be!

I must emphasize that these extensions do not give rise to any desire on my part to alter the fundamentals of my analysis. It is simply a reaction to the excessive time the regulators are taking to discuss the issue.

Sectoral distribution of the MAPF portfolio on January 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.

Credit distribution is:

Liquidity Distribution is:

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). 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 July 31, 2017, and published in the August, 2017, PrefLetter. It is fair to say:

• MAPF credit quality is much better
• MAPF liquidity is lower
• MAPF Yield is higher
• Weightings
  • MAPF is less exposed to Straight Perpetuals
  • Neither portfolio is exposed to Operating Retractibles (there aren’t too many of those any more!)
  • MAPF is equally exposed to SplitShares (that is to say, currently no exposure)
  • MAPF is less exposed to FixFloat / Floater / Ratchet
  • MAPF is significantly higher weighted in FixedResets, with a much greater emphasis on lower-spread and insurance issues