Rob Carrick of the Globe and Mail has taken a look at the preferred share market and was kind enough to quote me extensively.
I liked the bit:
You won’t hear Mr. Hymas say so directly because he refuses to make a call on the market. But he does go so far as to offer this bit of wisdom: “Preferred shares are more attractive now than they usually are.”
It’s very frustrating, I know, for a journalist to ask a specialist – “Are these things going up?” and not get a straight answer!
Rob’s piece was actually quite amazing, something the pref market’s needed, well, since last spring. Nice uptick across the board pretty much today.
One question I have right now is this: why would BNS and TD both issue 5.6% prefs in what has pretty much certainly been confirmed as a “declining interest rate environment”?
One more quarter point cut from the BofC, and you’ll be able to walk into a Scotia or TD branch, take out a big loan at the prime rate of 5.5%, invest it in their own prefs, which pay 5.6%, enjoy the interest expense tax claim, and the dividend gross up as well. Seems to me these guys need a new battery in their calculators perhaps?
Have I missed something?
madequota
We are indeed getting close to positive-carry territory, where you could borrow at prime and have net positive cash flow from a preferred share investment.
There are some caveats … the holder of the preferred share has the credit risk. If the bank goes bust, he’s going to lose all his preferred share investment and still owe the money.
There’s rollover risk. He could put the position on at a positive carry and read the next day about how prime’s gone up to 20%.
There’s liquidity risk (which is something holders of Canadian ABCP will be able to tell you all about). You put the position on, the bank calls your loan, you can’t refinance and you’re forced to sell your assets.
And there’s market risk (which is related to liquidity risk). Maybe the market price of the preferred goes to $20, you’ve got negative equity in the position and the bank calls for more collateral … assuming they haven’t already sold out your margined prefs at $18 already!
And, you should always remember, preferreds – at least, the perpetual ones – are priced off long rates. Prime is priced off the overnight rate. The spread between the two can vary considerably.
The banks are paying these fat rates because they need capital, and – at least for now – they feel that paying up for preferred share capital is preferrable to issuing equity. Capital is good. Assuming a credit conversion ratio of 35% for mortgages and a Tier 1 capital ratio of 10%, you can issue $1 worth of preferred shares, issue $29 of deposit notes or GICs, and write $30 worth of mortgages.
It’s a nice business … and the spread on GICs vs. mortgages is much nicer than the spread on Prime vs. Preferreds.