A Bear Checks In

After having given so much attention to the neighborhood bull, it seems only fair to allow some comments from the bears!

Hi James:

Here is the result of a little calculation I did with Royal Bank bond yields and pref yields.  It looks similar (today at least) for other banks, but I don’t have lots of historical bond data.

Comparing RY Bonds and Prefs
  11-May-07 26-Oct-07
Bond Yield (Dur = 5) 4.21% 5.14%
Discount Pref Yield 4.50% 5.49%
Disc Pref Duration 22.1 18.6
Spread 0.29% 0.35%
Yield Ratio 1.069 1.068

Although we seem to be comparing bond apples (duration 5) to pref oranges (duration 18-22), the arithmetic spread, and especially the yield ratio (which I like better for many things and many reasons) is basically the same today as it was 5 months ago.  I happen to have some data from May 11 for two RY bonds, but have no older data.

Perhaps you have access to more historical bond and pref data to investigate this further, but one conclusion I would draw is that pref yields are not currently out of line with bond yields.  Furthermore, a 5.14% bond yield is consistent with (perhaps slightly below) US bond yields.  If the corporate yields hold, then discount prefs will NOT recover, so investors today should only expect the yield component, and give up hoping for capital gains — and could suffer more losses if corporate yields increase.  I wish I knew more about this apparent relationship over the past couple of years of Pref purchasing!

I also note that the bond equivalent yield ratio (at least at this wildly different duration) is 1.07 in the market, rather than 1.40 for taxable investors.  No reason they should be the same because the buyers and sellers of prefs and bonds are quite different. You are welcome to use this with attribution, if you like. ******************************************

[Later] One minor glitch on this, the 1.07 Yield ratio is the inverse of the 1.40 bond equivalent yield, so for direct comparison should be more like 0.93.  Thus there is a 50% (1.40/0.93) after-tax yield advantage to pref shares compared with Duration = 5 bonds.

Well! The first problem I see is with the data. I looked up the issue Royal Bank 4.53% May 7, 2012. This is a deposit note, the most senior bank debt issued (and thus, in terms of credit quality, as far as you can get from a preferred while remaining with the same issuer). It’s basically a liquid institutional GIC and there is $950-million outstanding. According to Bloomberg, the yield on 5/11 was 4.53%.

This is quite the discrepency! If we go to Canadian Bond Indices, we can look at a graph of short-term yields – for both corporates and Canadas. The quoted figure, 4.21%, looks more like a plausible yield for a Canada 5-year, while 4.53% looks like an entirely reasonable value for a 5-year Royal Bank DN.

I suggest it’s better to compare long indices with the PerpetualDiscount index; this reduces the duration mis-match and diversifies away the asystemic risk introduced by using a single corporate for a comparison. Using data from the Bank of Canada we see that the Scotia / PC-Bond / Dex long-term all-corporate index was yielding 5.42% on May 9; going back to Canadian Bond Indices, we can say it’s about 5.8% now; and construct the following table:

Comparing Corporate Bonds and Prefs
  27-Dec-2006 9-May-07 30-Oct-07
Bond Yield 5.18% 5.42% ~5.80%
Bond Duration ~11.7 ~11.6 ~11.3
Discount Pref Yield 4.51% 4.65% 5.64%
Disc Pref Duration 11.73 16.12 14.45
Disc Pref
6.31% 6.51% 7.90%
Yield Ratio
(Prefs : Bonds)
1.22:1 1.20:1  1.36:1
Yield Spread
(Prefs – Bonds)
113bp 109bp 210bp 

So, pending further discussion, it does not appear to me that a bearish argument based on yield spreads in the current year is very convincing!

Update: My correspondent was the commentator prefhound. The delay in attribution was due to my wanting to check how he wanted the attribution made.

7 Responses to “A Bear Checks In”

  1. prefhound says:

    Ahh, how good of you to look up the real data. I’m not really a bear — one who believes things can get worse — but rather am looking to try to understand possible reasons for Pref underperformance.

    My May 11 RY Bond Yield cited in my table was an interpolation between Globe Data for a 2010 bond yielding (4.01%) and a 2017 Bond (4.51%). Obviously, the 2012 bond at 4.53% from Bloomberg indicates the yield curve was NOT linear, as assumed. Too bad private investors don’t have access to decent bond historical data.

    Also, I note your superior data base gives better Pref duration than the simple Excel function — for which I am thankful.

    Your revised table shows an interest equivalent yield spread increase since May of 98 bp, which speaks to the relative investment merit of prefs vs bonds (prefs are obviously better). However, I was looking for a way to project how much discount prefs could increase in price if normal spreads return, and the interest equivalent yield spread is not useful for that.

    I suggest looking at the yield ratio (0.86 or 87 up to May, vs 0.97 Oct 30). Applying a ratio of 0.865 to Oct 30 gives a current “normal” pref yield of about 5.0% — 43 bp more than the older historical cases shown here (43 is a lot less than 98 bp!) Now, if coporate bond yields stay the same and pref yields go down 43bp, we should see a 43 x Pref Duration of 14.5 = 6.25% increase in discount pref prices — not huge compared with recent average price declines more like 15-20%+.

    Also, a Canadian Corporate Bond Yield (I presume investment grade) of 5.8% is quite in line with US, so my “catch up” (semi-bearish) hypothesis is also not valid. I hasten to add that finding a long term 5.8% corporate bond for sale to retail at TD Waterhouse is next to impossible. Provincial strips of 10-20 years are all less than 5.0%.

    I like the idea of being able to say a given pref is over or undervalued by some amount x%, compared with long-term relationships. We see here from this joint effort that discount prefs are undervalued by 6.25%. I wonder if premium prefs are under or overvalued in the same context.

    Finally, in the year 2000, when prefs last made their previous huge dip, US corporate baa yields (I don’t have Canadian data) had increased only 50 bp or so. If we have a similar scenario here, we could get pref and bond yield re-stabilization in 9-12 months (a very bullish scenario).

    On a personal level, I continue to like current pref yields while acknowledging the wide range (risk) of potential year-ahead outcomes.

  2. jiHymas says:

    Yes, the Corporate Bond indices I have used are investment grade.

    The question of historical relationships between long corporates and PerpetualDiscounts is an interesting one; I will be writing about it as soon as the HIMIPref™ Indices have been updated to my satisfaction.

    Defining spreads is a problem. Nesbitt has a review they put out periodically in which they look at After-tax Spread to Canadas given a 35% rate on interest and 0% on Dividends (these reviews target their corporate customers). So, if long Canadas yield “C” and perpetuals (“Straights”, in their parlance; I don’t know how much, if any, distinction they draw between premiums and discounts, or how they calculate yield on premiums) yield “D”, then the spread they highlight is S = D – 0.65C.

    Whether or not the spreads I will eventually be able to graph will make a good market-timing tool is another question! I suspect the answer will be “No!” to the extent that the answer isn’t “Insufficient Data”.

  3. […] There is no really good reason for having chosen 2007-5-9 as a comparitive date: it’s simply that this particular date has been discussed recently. […]

  4. […] Given the current spread of the interest-rate equivalent of discounted perpetual preferreds to long-term corporate bonds (now about 210bp – that is, the average investment-grade PerpetualDiscount issue now yields the equivalent of the long-term investment-grade corporate bond index plus 2.10%, given a tax-equivalency factor of 1.4), I have to say that now looks like a more attractive time than normal. However, there is no reason that the spread couldn’t go to 310bp, which would cause underperformance of such an investment.I talked a bit about spreads in my blog at: http://www.prefblog.com/?p=1394      […]

  5. […] Toppy? It looks more as if the bad dream of the fourth quarter has faded like gossamer … one might be able to make the case that the OpRet Index is toppy, since there’s not much interest-equivalent premium to bonds … but PerpetualDiscounts still have an average pre-tax bid-YTW of 5.49 … interest-equivalent of 7.69% … long corporates are a shade over 5.6%, according to Canadian Bond Indices …. this is within spitting distance of the October 30 spread. […]

  6. […] Be that as it may, it was a strong day, with volume picking up and good strength throughout the entire PerpetualDiscount index. This index now has an interest-equivalent yield of 7.62% (at a conversion factor of 1.4), which is Canadas +350bp, Long Corporates +180bp. This latter (and probably more meaningful) figure has narrowed in about 30bp since last reviewed October 30, but still has a long way to go before reaching last spring’s levels of Long Corporates + ~110bp. […]

  7. […] This may be compared to previous LC/PDIE spreads of 113bp at the end 2006, 109 bp at the beginning of May, 2007, and 210bp at the end of October 2007. So, using these three data points to determine value, in the best of all “Look Mummy I Got A Spreadsheet” tradition, we could say (if we were willing to place our reputation on such a thing) that the LC/PDIE spread is simply moving back to a normal level and we’ve still got about 45bp to go – which is about 6.3% price appreciation. […]

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