PrefBlog

Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close April 30, 2020, was $6.2894.

Attribution analysis, even of the most rudimentary kind, is very difficult this month, due largely to continued awful quotes provided by the Toronto Stock Exchange. For example, the fund holds seven different series of TRP preferreds, with the largest holdings in TRP.PR.D and TRP.PR.G:

And two series of TD:

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 directly from Hymas Investment Management.

This has been the best month for the BMO-CM “50” index since the beginning of my data for this index, December, 1992. The index return of +12.42% is well ahead of that of the second-place March, 2016, which was a “mere” +9.86%. This all seems quite appropriate since March, 2020, was by far the worst month ever – but we have a long way to go before we even break even on a one-year basis!

The preferred share market continues to be underpriced relative to other capital markets, 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 2020-4-9):

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Note that the Seniority Spread was an incredible 435bp near month-end, much narrower than last month’s figure of 515bp. As a good practical example of the spreads between markets, consider that CIU issued a long-term bond in early September yielding 2.963%, about 411bp cheaper than the interest-equivalent figure of 7.07% for CIU.PR.A, which was then yielding about 5.44% as a dividend. Shaw Communications issued 30-year notes at 4.25% interest on December 5, 2019, when their FixedResets, SJR.PR.A, were yielding 6.59% dividends.

As has been noted, the increase in the Seniority Spread over the past one or two years has been due not to an increase in yield (drop in prices) of Straight Preferreds over the year, but largely because the yield of the Straight Preferreds has remained relatively constant while the yield of long-term corporate bonds has dropped dramatically. This month’s change breaks the pattern (as did last month’s mover upwards), as long-term corporate bond yields decreased by 49bp through the measured period, while PerpetualDiscount Interest-Equivalent yields decreased by 125bp.

… and the relationship between five-year Canada yields and yields on investment-grade FixedResets has gone even deeper into what I consider ‘decoupled panic’ territory (chart end-date 2020-3-20):

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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 and in aggregate, lose money, handing it over to more sober investors.

It should be noted that I have been unable to explain the relatively strong performance of Floor issues during the 2018-19 downdraft relative to their non-Floor counterparts. See the discussions on PrefBlog at LINK, LINK and LINK.

I believe the bear-market outperformance by the Floor issues is a behavioural phenomenon with very little basis in fundamentals. When interest rates in general move, FixedReset prices should not change much (to a first approximation, for issues priced near par), since in Fixed Income investing it is spreads that are important, not absolute yields. There should be some effect on Floor issues, which should move up slightly in price as yields go down since the ‘option’ to receive the floor rate will become more valuable. Adjustments due to this effect should be fairly small, however – and over the past year issues with a floor, that started the period being expensive, have simply gotten even more expensive, relative to their non-floored counterparts.

And the tricky thing about behavioural models of investing is that they can lose their explanatory power very quickly when an investment fashion shifts, whereas fundamentals will always be effective – sometimes it just takes a little time! Just to give an example from the preferred share market – until the end of 2014, FixedResets were priced relative to each other according to their initial dividend; when the reset of TRP.PR.A shocked a lot of investors, relative pricing became much more dependent upon the Issue Reset Spread, a much more logical and fundamental property. This paradigm shift was discussed extensively in PrefLetter.

FixedReset (Discount) performance on the month was +13.10% vs. PerpetualDiscounts of +13.13% in April; the two classes finally decoupled in mid-November, 2018, after months of moving in lockstep, but it still appears to me that yields available on FixedResets are keeping the yields of PerpetualDiscounts up, even though a consistent valuation based on an expectation of declining interest rates would greatly increase the attractiveness of PerpetualDiscounts (in other words, PerpetualDiscounts are now priced off FixedResets rather than off Long-term Corporates):

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Floaters recovered somewhat, returning +7.12% for March but the figure for the past twelve months remains awful at -29.43%. 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 initially 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. but it became worse in August, 2019! On August 30, 2019 the HIMI Floater Index (total return) value was calculated as 1906.6; the index first surpassed this value on 2003-8-13. Thus, cumulative total return (that is, including dividends) was negative over a period of slightly-over sixteen years. Worse, on March 31 the index level was 1454.8, a milestone first passed on 1997-7-30; a cumulative negative total return for 22 years and 8 months; at its low on March 18 the index level was 1253.7, first surpassed on 1996-1-4, a span of 24 years and over two months!

It seems clear that Floaters are used, wittingly or otherwise, as a vehicle for speculation on the policy rate and Canada Prime, while FixedResets are being used as a vehicle for speculation on the five-year Canada rate. In support of this idea, I present an Implied Volatility analysis of the TRP series of FixedResets as of April 30, which is comprised of six issues without a Minimum Rate Guarantee and two issues which do have this feature:

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The two issues with floors, TRP.PR.J (+469, minimum 5.50%) and TRP.PR.K (+385, minimum 4.90%) are $4.42 and $3.38 rich, respectively. These figures are a little higher than the 3.45 and 2.64 calculated last month’s figures; however, it should be noted that their floors have become effective since five-year Canadas dipped below 0.81% and 1.05%, respectively. We expect something of an increase in fair value as noted above; but these levels seem elevated!

It will also be noted that the spread of a notional non-callable TRP FixedReset priced at par has increased from 541bp last month to 470bp this month, while GOC-5 has declined from 0.57% to 0.45%.

I also show results for the BAM series of FixedResets, which includes three issues with dividend floors: BAM.PF.H (+417, Minimum 5.00%); BAM.PF.I (+386, Minimum 4.80%); and BAM.PF.J (+310, Minimum 4.75%); these issues are all rich compared to their non-floor siblings, being rich 1.63, 1.25 and 1.07, respectively, much more expensive than last month’s figures of 0.45, 0.46 and 0.05.

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It will also be noted that the spread of a notional non-callable BAM FixedReset priced at par has declined from 557bp last month to 517bp this month, while GOC-5 has declined from 0.57% to 0.45%. This is very similar to the effect seen for TRP. This is mercifully consistent with the TRP results.

Relative performance during the month was uncorrelated with Issue Reset Spreads for either the “Pfd-2 Group” or the “Pfd-3 Group” issues:

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… and results over the quarter for the Pfd-2 Group were better correlated (30%) but uncorrelated for the Pfd-3 Group:

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In the three-month chart, there are four data points in the Pfd-2 Group that are well below the range of the remainder. These are the Husky Energy issues, HSE.PR.A, HSE.PR.C, HSE.PR.E and HSE.PR.G, which have also suffered from the Saudi-Russian oil price war.

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. The same caution applies for an end to the overpricing of issues with a minimum rate guarantee. There could be a reversal, particularly if either Trump’s international trade policies or the economic damage wreaked by the coronavirus approaches the gloomier extreme of current forecasts. And, of course, I could be just plain wrong about the sustainability of the current environment.

On the other hand, I will pass on my observation that international interest in the Canadian preferred share market is increasing, as other Floating Rate indices globally are doing much better. Consider, for example the Solactive Australian Bank Senior Floating Rate Bond Index, which “provides exposure to the largest and most liquid floating rate debt securities issued by selected Australian banks. The index is comprised of investment grade floating rate debt securities denominated in AUD and calculated as a Total Return Index” (LINK although the index constituents currently all have a remaining term of less than five years), and the S&P U.S. Floating Rate Preferred Stock Index.

Yields on preferred shares of all stripes are extremely high compared to those available from other investments of similar quality. As I told John Heinzl in an eMail interview in late November, 2018, 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), since paradigm shifts generally require a trigger (a Wile E. Coyote moment, as they say!) … 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:

I 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 banks (and insurers, until November 2019), both Straight and FixedResets will be redeemed at par on their DeemedMaturity date as discussed above.