John Heinzl was kind enough to quote me in today’s Globe and Mail in his Investor Clinic:
I’m a retired and experienced investor. Some months ago I invested a sizable amount of money in preferred shares of major banks, the rationale being that it would be a safe haven for the cash and produce a steady stream of dividends. They have fallen sharply over the last few weeks. Why?
The facile explanation is that interest rates are rising, so straight preferred shares – which trade much like long-term bonds – are falling. But preferred share expert James Hymas of PrefLetter.com says the tumble in preferreds has more to do with emotion than interest rates.
Short-term rates are indeed rising – the Bank of Canada all but confirmed yesterday that it will hike its benchmark rate on June 1. But long-term corporate bond yields – which are far more important to the preferred share market – are not.
“Long corporate yields have been fairly steady. They have been bouncing around at basically 6 per cent to a little under for the all this year. So whatever concerns there might be about rising interest rates, they’re not being shared by the corporate bond market,” Mr. Hymas says.
So why are preferred shares falling while long corporate bonds are not?
The corporate bond market is large and dominated by institutional investors such as pension funds and insurance companies that take a long-term view. The preferred market, on the other hand, has a bigger retail presence and many issues are comparatively illiquid. This makes preferred prices more volatile, particularly when retail investors start getting nervous – like now.
I’m a bit surprised about the recent drop in preferred prices.
My feeling was that the larger (than historic) corporate bond spread combined with the larger (than historic) preferred pre tax equivalent spread would provide a cushion if inflation started to rise.
Instead, anticipation of the overnight rate increase drives the preferred yield higher? Crazy.
ltr
Nervous retail investors makes a lot sense.
Last night for some strange reason I happened to be watching the CBC and Kevin O’Leary was bleating to Amanda Lang in full scare/nervous mode that “… for every 50bp rate rise you will lose 7% in your long dated debt, paper, whatever bonds…” Later then clarifies by lumping in prefs , “I’m talking mutaul funds, individual debt and prefs”. Again later he says, “…when rate rises start happening, you’ll get slaughtered”.
Today there is a whack of dumping. Probably coincidence, I didn’t think anybody paid any attention to him but what do I know.
First couple of minutes. http://www.cbc.ca/video/#/News/TV_Shows/Lang_&_O%27Leary_Exchange/ID=1474112755
Late yesterday afternoon the whole bid side of the order book for one of the Fixed Resets dissapeared. That is the bid side of the list went to 0. A call to my disount broker was of no help in finding the cause. So I do not think even O’Leary, the market mover, was the start of this!
Kevin O’Leary was bleating to Amanda Lang in full scare/nervous mode
I don’t see much of a track record for the O’Leary Funds.
for every 50bp rate rise you will lose 7% in your long dated debt, paper, whatever bonds
In the first place, that implies a Modified Duration of 14 years. A thirty-year bond with a 6% coupon yielding 6% has a Modified Duration of 13.9, so this is an extreme example.
A PerpetualDiscount with a yield of 6.25% has a ModifiedDuration of 16, but that expresses the ModDur in terms of changes in the dividend yield. The Interest-Equivalent Yield is (1.4x) 8.75%, with an Interest-Equivalent ModDur of 11.4.
Make of that what you will.
I’m not sure what he meant exactly by “rate rise”. If by “rate” he means long yields, well and good. But if he meant “BoC overnight rate”, then his statement assumes 100% transmission to the long end (i.e., a parallel shift), which is not quite so cut-and-dried.
Late yesterday afternoon the whole bid side of the order book for one of the Fixed Resets dissapeared.
Ain’t prefs wonderful? I recently had a long eMail exchange with a potential MAPF investor who wanted to know why I had a ‘disaster-out’ clause in the valuation protocol.
I suspected this would happen, but I did not think to point the finger at retail investors. Makes sense, esp. considering the illiquid nature of these things.
I had bought many bank prefs on the cheap between nov08 to may09. Alas, I did not get any of the new resets on issue. I underestimated the potential for them to trade above par in the short term.
Anyhow, after the first little selloff and recovery in the perps in Feb, I sold most and clocked in cap gains of 30-40%, hoping to buy cheaper later as rate fears surfaced.
This is playing out as expected. People are overreacting and the selling accelerated but seemed to bottom about a week ago.
Now here`s my dilemma. Many of the bank perps are down 10-15% over the last 6 weeks. Your comments suggest this is an overreaction, but I’m trying to figure out how low they could go and when would they bottom going forward.
I will build a position over time in some of the prefs that have sold off. Example CM.pr.j i bought at these levels the other day, 18.20, ytm is already 6.20%. Its yield was much much lower at the peak before the crash in late 07, when rates were in the 2.5-3% range.
So what assumptions can I make. Certainly yields on these will not go to 9% as in march 09 even if boc goes from 0.75-3 over next 2 years?
Or do I just consider that the pref is already priced for a 3% or more boc rate, and just buy along the way, maybe hoping to hit 7% with overreactions (barring any further economic disaster and market shock).
OR are these Perps trading in relation to the new rate reset prefs which are all in the 5-6% range and have not sold off. Personally as a long term hold, I would rather have the potential of the capital gain with the perps on top of the yield, even though I understand that some of the new rate resets have cumulative dividends.
Thanks for your comments
I’m trying to figure out how low they could go and when would they bottom going forward.
Your guess is as good as mine. I suggest that investors should refrain from market timing; instead, make allocations based on long term properties of each asset class and seek to make incremental gains within that asset class.
OR are these Perps trading in relation to the new rate reset prefs which are all in the 5-6% range and have not sold off.
Investment-Grade FixedResets are trading in the 4%-5% range. The higher yielders carry considerably more credit risk – and remember, with a FixedReset, the credit risk is forever.
I understand that some of the new rate resets have cumulative dividends.
Non-financials only – cumulativity can almost, but not quite, be considered a proxy for “non-financial issuer”. Financial issuers cannot economically issue cumulative issues, because such issues will not qualify for Tier 1 Capital status
[…] given that long corporate bond yields are declining and have reached 5.7% – as I recently discussed with John Heinzl of the Globe & […]
– May I ask Mr Hymas when if dividends on the banks perp prefs have ever been suspended? Not easy to find the date.
there were issues with the common divs at risk in late 08. I assume the 80s were problematic, but not sure what the longest prefs have been out there (i seem to remember someone mentioning rbc perp that lasted over 20 years?)
– How does this audience feel in general about buying bank perps at well under par, i.e. 14-18 in view of eventual $25 redemption.
Do you feel this is a sound strategy as far as hedging against prices drops (i.e. price falling 20% not a problem if you hold on to redemption to collect 40% gain).
It has worked for me generally, as opposed to buying the same types of perps as new issues, which have in most cases fallen since I have been tracking them, the last 7 years.
I know retail investors tend to buy new issues since that is how they are sold rather than focusing on total return to maturity
Thanks
May I ask Mr Hymas when if dividends on the banks perp prefs have ever been suspended?
I am not aware of a major bank in Canada having ever suspended its preferred dividends.
Note that the fact I am not aware of it doesn’t mean it’s never happened! There was a canard being repeated during the credit crunch that only National Bank had ever cut its common dividend (in the early ’90’s), but this is simply not true, as discussed in the comments to The ‘Risk’ of Preferreds.
But there’s a very good chance that, if it had ever happened, somebody by now would have told me, probably with a superior smirk on their face.
How does this audience feel in general about buying bank perps at well under par, i.e. 14-18 in view of eventual $25 redemption.
Deeply discounted straight perpetuals are the purest form of preferred share as they are most ‘annuity-like’. The issuer’s call option is virtually worthless once you get to the $14-18 range, as discussed in the January, 2010, edition of PrefLetter.
Note that there is no reason to believe that such shares will ever be redeemed; also note that a redemption is a Bad Thing for investors, not a Good Thing.
Do you feel this is a sound strategy as far as hedging against prices drops
No.
It has worked for me generally, as opposed to buying the same types of perps as new issues, which have in most cases fallen since I have been tracking them, the last 7 years.
Generally new issue straights are issued at even-yield with discounted (even deeply discounted) extant issues from the same issuer; in fact, they should be issued with a higher yield to compensate for the embedded call, as discussed in the January, 2010, PrefLetter.
“The issuer’s call option is virtually worthless once you get to the $14-18 range, as discussed in the January, 2010, edition of PrefLetter.”
– Why? Sorry I cannot subscribe to prefletter due to my status in QC
Note that there is no reason to believe that such shares will ever be redeemed; also note that a redemption is a Bad Thing for investors, not a Good Thing.
– a) Then you are saying there are shares out that have been around for 50 years?
– b) Bad thing?
Do you mean from a yield perspective, i.e. if they call them the risk of having to replace with a potentially a lower yielding instrument?