Distressed Preferreds?

After the Globe and Mail published an article on Distressed Preferreds, I received another interesting eMail from another correspondent:

I wondered if you could advise me if you consider any of these “distressed preferreds” worthy of investment?

For the average preferred share investor seeking a source of tax-efficient fixed income, the advice I have regarding a potential investment in distressed preferreds is a BIG FAT NO!

Distressed preferreds – distressed anything – should not be considered as part of a fixed income portfolio. There is sufficient uncertainty regarding the ability of the issuing companies to meet the committments made in the prospectus that they should be regarded as equity substitutes … in other words, once you’ve reviewed the company and decided you wanted to buy the stock, you would then look at these preferreds and decide whether or not you’d be better off with the prefs … the upside on the prefs will be limited, but the dividends would be more assured and there’d be a chance of better recovery if things went wrong.

This is simply another way of stating Carrick’s note in the article:

Arguably, distressed preferreds are a smarter way to play a troubled company than buying its common shares. Common shares will almost certainly offer a better pop when a company rebounds, but preferred shareholders get paid while they wait for the turnaround with high-yielding dividends.

… except that I would replace the word “Arguably” with the phrase “Sometimes, depending on the price and terms of the alternatives to common equity and the investor’s informed view of the prospects for the company,”.

I am willing to consider Pfd-3 issues as “sort-of” fixed income, but only on condition that the total allocation to Pfd-3 is less than 10% of the total preferred portfolio, and the allocation to any single name is less than 5%. This sort of exposure can give a little extra yield without exposing the portfolio as a whole to an undue amount of risk.

I am rather surprised that Brookfield issues were mentioned in the story, but Carrick makes it plain that price is the sole consideration – credit-worthiness is given lip-service, but lip-service only:

Brookfield and Weston are higher quality companies based on their financials and credit ratings. But conditions in the preferred share market today are such that some of their issues are getting squeezed to a point where they’re trading at borderline distressed prices.

Part of the problem is rising interest rates. Pref shares are like bonds in that they fall in price as rates rise, and vice versa. Another factor is the twitchiness in financial markets that was caused by problems in the U.S. subprime mortgage market. Investors have become more risk sensitive and they’re shying away from preferreds that make them nervous.

The typical preferred share has a par value of $25, which is the value of assets each share is worth in the event the issuing company is liquidated. A distressed preferred trades below $20, which implies a 20-per-cent price decline, and it usually has a credit rating of less than pfd-3 (low) from DBRS Inc.

I cannot accept this definition of distress – especially since the rating consideration is cheerfully ignored by two of the issues discussed in the article, BAM.PR.M & WN.PR.E.

Let’s look at a bond: General Electric Capital Corp., 4.125% Sep 19/2035, ISIN XS0229567440, priced right now, at this very moment, at 81.9085-3965 to yield 5.39-35. Admittedly, this does not quite reach the 80%-of-par-value condition … but any definition of “distressed” that comes this close to encompassing GE … is a nonsensical definition. Canada had a perpetual bond with a 3% coupon, issued in 1936; the yield was a little different in 1975:

Further, I would emphasize for the hon. member’s benefit that the yield of these bonds since April 1974 compares favourably in my view with the prevailing market rates.

To illustrate, the interest rate was 8.33 per cent on April 30, 1974. It had decreased to 7.79 per cent in November 1974, it was up again to 8 per cent on February 28, 1975, that is three months ago, and since April 25, 1975 it has been 9 per cent

Hmm… if a perpetual bond with a 3% coupon was trading to yield 9% … therefore priced at maybe one-third of par value …  should it be characterized as “distressed”?

If one wishes to include a market-based element in a definition of “distressed”, it should be with relation to prevailing yields of high quality issuers. Altman’s comprehensive definition is good enough and, as far as I know, widely accepted:

Distressed securities can be defined narrowly as those publicly held and traded debt and equity securities of firms that have defaulted on their debt obligations and/or have filed for protection under Chapter 11 of the U.S. Bankruptcy Code. A more comprehensive definition would include those publicly held debt securities selling at sufficiently discounted prices so as to be yielding, should they not default, a significant premium over comparable duration U.S. Treasury bonds. For this segment, I have chosen a premium of a minimum of 10 percent over comparable U.S.Treasuries. With interest rates falling as much as they have by late-1998, this definition would currently include bonds yielding at least 15.0%.

Anyway … I will accept the inclusion of BBD and NT in lists of distressed preferreds, but not WN & BAM.

I don’t like the trading advice much, either:

The hard part in buying preferred shares is that you often have to pay a premium over market price to get your hands on some. Given that your yield shrinks as your purchase price rises, this is a crucial issue when buying low-yielding traditional preferreds. With distressed shares, you can be a bit more flexible in how much you pay because the yields are so much higher than usual.

Well, by me, overpaying by $0.25 on distressed preferreds is as bad as overpaying by $0.25 on rock-solid investment-grade issues. Worse, in fact, because it will represent a larger fraction of the amount invested.

So … my answer to my correspondent has four minor points:

  • Nortel: No! Not as a fixed income investment, anyway.
  • Bombardier: No! Not as a fixed income investment, anyway.
  • Weston: Maybe just a little bit, if you can get it at a fat spread.
  • Brookfield: I’ve speculated about Brookfield issues before. They have investment-grade credit quality, but often trade as speculatives. Often worthwhile, my fund often holds them.

Unfortunately, the question is too general to be answered with any precision. Before I knew whether to recommend a particular issue, I’d have to know the price of what was being sold and what was being bought. It’s the old story … Google, to name but one, is a good company; fairly well run and profitable. Whether or not I’d pay USD 700 for one of its shares is a different question entirely.

I make specific monthly recommendations for buy-and-hold investors in PrefLetter. Subscriptions are still being accepted!

Update, 2007-10-18: After all this talk about yields, I should really give numeric examples!

Yields for Various Issues
Limit Maturities
Close, 2007-10-17
Issue DBRS
Quote Bid Yield
RY.PR.F Pfd-1 21.00-04 5.39%
BAM.PR.M Pfd-2(low) 20.45-50 5.87%
WN.PR.E Pfd-3(high) 19.51-64 6.15%
IQW.PR.D Pfd-5 13.12-30 8.25%
NTL.PR.G Pfd-5(low) 16.10-17 9.70%*
Nortel’s yield calculated assuming it pays 100% of the prime rate of 6.25% on par value

So – not even Quebecor or Nortel are “distressed” by conventional definitions. Junk, yes. Distressed, no – although Nortel’s 9.70%, when multiplied by an equivalency factor of 1.4, is equivalent to interest yield of 13.6%, which is getting awfully close to long-Canadas-plus-ten-percent! And Weston and Brookfield are merely trading at spreads to top-quality (as represented by RY.PR.F) that investors may decide are good or bad, as they choose.

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