Carrick: Why the preferred-shares party might be winding down

Rob Carrick wrote an article with the title Why the preferred-shares party might be winding down, which quoted me extensively:

There are two reasons why bank rate resets will be redeemed at the earliest opportunity, argues James Hymas, president of Hymas Investment Management Inc. and a preferred share specialist. The first is that the dividend these shares must pay on reset is a reflection of a financial marketplace in crisis and not today’s much calmer environment.

“Now, banks wouldn’t have to pay more than 100 basis points over Government of Canada bonds,” Mr. Hymas said. “Even some of the junkier issues [of rate-reset preferred shares] are coming out at a spread of 200 basis points.”

The other reason why banks are expected to redeem their rate-reset preferreds and, in fact, other preferred-share issues as well, is a new set of global banking rules that will be gradually phased in ahead of a 2022 implementation date. The rules will not allow banks to include preferred shares in the key measure of their financial solidity.

Banks are expected to phase out their preferred-share holdings as a result, and this suggests almost all rate resets are going to be redeemed at the first opportunity.

Mr. Hymas said 2014 is when most bank-issued rate resets will hit their first reset/redemption date. Should investors get out now? “Those looking for a long-term investment can do much better elsewhere,” Mr. Hymas said.

He suggests looking at bank and insurance company perpetual preferred shares. Generally, perpetuals have no fixed redemption date and offer no rate-reset potential. Really, they’re a lot like open-ended bonds with no maturity date.

Mr. Hymas argues that most perpetuals issued by banks are a different animal because the 2022 regulatory deadline is almost like a drop-dead date for redemption. In fact, he regards them as being nearly as good as retractable preferred shares, which have a preset date for redemption.

Retractables are considered a desirable kind of preferred share because they offer an escape hatch that perpetuals lack.

The term “deemed retractable” has been coined by Mr. Hymas to describe bank perpetuals that he expects to be redeemed by 2022. An example of this type of share from his recommended list is Royal Bank of Canada Series AD, which have a dividend yield of about 4.6 per cent based on a share price of $24.37. If you hold until redemption at $25, your total return (share price gain plus dividends) is a littler bit higher.

There’s some uncertainty right now about whether insurance companies will be bound by the same rules as banks on preferred shares. Mr. Hymas thinks they will be, and he therefore suggests insurance company perpetuals as another potential landing spot for people selling bank-issued rate resets.

An example from his recommended list is the Great-West Lifeco Inc. Series I, which have a current yield of 5 per cent based on a price of $22.46. In his May newsletter, Mr. Hymas projected the yield based on a $25 redemption in 2022 at 6.25 per cent.

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