Research : Perpetual Misperceptions

There are a number of misperceptions held among otherwise sophisticated investors regarding perpetual preferred shares. Now that the October edition of Canadian Moneysaver has been published, I can release this article, which attempts to address two of them, published in their September edition.

Look for the research link!

Update, 2007-10-15: An assiduous commenter asks how much the numbers would have changed without rebalancing … so I’ve done the calculation.

The difference is not as much as my correspondent suspected! Raw data (showing the returns for the period March 30-July 31) has been uploaded for reader inspection for both the PerpetualDiscount and PerpetualPremium indices.

The relatively small difference between the rebalanced and non-rebalanced indices illustrates the point that there is a very sharp point of inflection between “Premium” and “Discount” perpetuals; once that point is crossed, duration changes significantly and the price reaction to yield changes becomes much more like one group than the other, with very little “grey area” between the two camps.

Update, 2007-10-15, later: The immediately preceeding paragraph is nonsense. Sorry!

Update, 2009-1-29: Assiduous Reader PN writes in and says:

I have found your PrefBlog website to be an extremely useful source of information on preferred shares. I have recently delved back into the preferred share market after concentrating on common shares over the last 25 years.

I am continuing to debate the pros and cons of perpetual discounts vs. 5-year fixed resets. In this regard I found your “Perpetual Misconceptions” article in the September 2007 edition of the Canadian Moneysaver to be very useful. I liked Table 1 so much that I reproduced it as a Excel Spreadsheet so I could compute implied future yields for different x and y values (where the resultant return is x% and the current perpetual return is y%). In doing so I discovered a slight discrepancy in the calculation of the discount factors in your Table 1. For a 2% return you have
calculated the discount factor after year 1 as 1.00-.02= .9800 rather than 1/(1.02)=.9804 The small error is continually compounded for years 2 to 20. I was wondering why you choose not to use the generally accepted mathematical formula for discount rates?

I have attached a spreadsheet based on two sets of calculations: the first is based on the generally accepted mathematical formula and the second is based on your computations for Table 1. You can see the results are only very slightly different for the 2% and 5% rates you have chosen and would not affect any of the conclusions you have drawn in your article.

My question is a very minor point and I am sure you must have a good reason for your calculation of the discount factors. I am just wondering what was your reasoning was?

Well, PN, there’s a very simple answer to your question: I am an idiot.

I cannot, at this point, remember anything much about the preparation of this article; what may have happened is that a rough draft of the table made it into the final product without thorough checking; the checking being performed in a cursory fashion because, as you say, the errors are small and the conclusion robust. Let’s just pretend that we’re seeking a total return of 2.04% and that that figure is cited on the table title, shall we?

PN has won a complimentary issue of PrefLetter.