Preferred Shares & Volatility

My name has come up in a Financial Webring discussion of preferreds, with sufficient questions that I’ll address the questions here.

I diligently read Mr. Hymas’s PrefBlog and Pref Info websites. 

Diligently? PrefBlog should be read assiduously!

Creditworthiness, maturity, aside for the moment, would it be wiser to invest in preferreds with a low mean / standard deviation or a high one? Case in point: TD.PR.Q (5.6) has a high of $25.74 and low of $25.00 for a mean of $25.37 and SD of .52. It trades today at $25.64 for yield of 5.46.
TD.PR.O (4.8%) has a high of $26.72, low of $22.01 for a mean of $24.37 and SD of 3.33. It trades at 23.50 for a yield of 5.16. My thoughts, for restful nights, the lower SD would be the way to go but then again, it would stand to reason that the higher SD share would have the greater potential so maybe it would be the way to go, no?

Well, this isn’t a particularly good example, because TD.PR.Q has been trading for less than a month. Having missed the market bottom, it is not surprising that its trading range is significantly less than comparables.

Another thing that makes this not the best example is the big difference in coupons: TD.PR.O pays $1.2125 annually, while TD.PR.Q pays $1.40. This difference makes TD.PR.Q more likely to be called once its call period commences than TD.PR.O (they have similar schedules, by the way; TD.PR.O commences 2010-11-1, TD.PR.Q commences 2013-1-31; both at $26.00 initially, declining by $0.25 annually until they reach $25.00, after that, they’re redeemable forever at the $25.00. price.

The big difference in coupons leads to a major diffence in the manner of calculating yields. It is prudent to suppose (as the initial approximation) that TD.PR.O will never be redeemed – after all, it’s quoted at 23.72-75, if market yields don’t change, why should TD give you a present of $1.25? It is also prudent to suppose that TD.PR.Q – quoted at 25.55-60 – will be redeemed at $25 on the first possible date at this price of 2017-3-2. This will cause a capital loss and represents your worst-case-scenario (short of default, given no change in market yields), which is what one should examine when looking at these things. Always assume that the issuer will do whatever it can to give you the least money it legally can!

In turn, this probability of capital loss should be incorporated into the yield calculation. The quoted yield of 5.46% for TD.PR.Q is the current yield ( = Dividend / Price). But if we account for a redemption, we can use the formula Yield = (Dividend – Return of Capital) / Average Capital Invested. The gross dividend is $1.40; the return of capital is the total expected capital loss ($0.64) divided by the number of years (9) or about 7 cents per year. The average capital invested is 0.5*(25.64 + 25.00) = 25.32. Thus, roughly, Yield to Worst is (1.40 – 0.07) / 25.32 = 5.25%.

The above is only a rough calculation; a precise calculation (by HIMIPref™) that takes into account every cash flow on its precise date indicates that the yield-to-worst is 5.37% (in this case, it’s much higher than the rough calculation, because I’m using the Feb 22 bid of 25.55, and because a full quarter’s dividend will be earned on April 4). To do this calculation, you can always use Shakespeare’s Calculator (broken link redirected 2024-2-1), which I have previously discussed.

Yield-to-Worst is a superior predictor of performance than Current Yield, as I have showed in A Call, too, Harms.

The difference in gross dividends has another effect. When you performed the yield calculation recommended, you are assuming that you will eventually “sell” the TD.PR.Q at a price of $25.00, representing a capital loss. To a certain extent, this gives you protection against market interest rate increases that lower the prices of existing issues – you’ve lost the money already, right? How much do you really care whether you lose it now or lose it on redemption? This concept was discussed in yet another article, Perpetual Hockey Sticks. Note, however, that TD.PR.Q, while above the line that separates PerpetualPremiums from PerpetualDiscounts, is still relatively close to it and, in general, you want to be as far away from that line as possible (unless enticed by large mounds of extra yield). I discuss this in (you guessed it!) an article about Convexity.

One more question: Given the new eligible dividend credit tax scheme, would one be wise/foolish to put all their non-registered funds into quality preferreds? Thinking not only of the tax but principal preservation/safety as well.

I generally recommend that no more than 50% of total fixed income assets be held in preferred shares. The total should include all your interest-rate-sensitive assets, including the bonds and GICs, etc., you have socked away in your RRSP. Why 50%? Well, why not 50%? If you’re looking for pages of math that use some kind of correlation matrix to prove that it should actually be 49.5842%, rounded to 50%, you won’t find it here! 50% is simply a figure that I feel comfortable putting my name on.

Firstly, Prefs are very much a retail product and more sensitive to the vagaries of fashion than bonds, which have a high institutional following. We certainly learned this in 2007 (which … wait for it … has been discussed in an article) a year in which preferred share spreads to bonds rose dramatically and prices got thumped big-time. Anybody who held 100% prefs last year and had to sell something to raise cash is less happy than they would have been had they been 50/50.

Secondly, Prefs are less liquid than bonds. If you need to sell a pref in a hurry, you’re taking your chances – there might not be any bids on the board at that moment in time, and you may not be willing just to sit on the offer side of the market for a week.With bonds, your dealer will (almost!) always make a market for you and charge you a spread against the institutional market that, while appalling, will at least be at least sort-of reasonable.

Thirdly, there’s taxation risk in prefs. If dividends were taxed as income, prices would fall dramatically. I’m as sure as I am of most things that the dividend-tax-credit-and-gross-up is safe … but I don’t feel like eating cat food for the rest of my life if I’m wrong. Remember, the Canadian public has seen fit to elect a grossly incompetent, mindlessly partisan Prime Minister – and if anybody ever mentions to him that the Dividend Tax Credit was introduced in 1971 by Pierre Trudeau … we’re in trouble.

Fourthly, bonds are senior to prefs in the event of bankruptcy. This can have an effect on prices in times of stress and an effect on recovery in times of … er … extreme stress. Pref Holders of Quebecor World will, I’m sure, be happy to explain this at length, with charts and diagrams.

This is not an exhaustive list of risks. There are many investment managers who, to their chagrin, did not include “global financial meltdown” on their list of things to worry about at this time last year. The thing about risk, you see, is that it’s risky. Diversify!

My thoughts were to get ones with a low SD (low volatility) and “hang on”.

Well, I don’t have much reliance on measure of Standard Deviation at the best of times, and this is not the best of times. Preferreds have just emerged (I hope) from their biggest bear market of the 15 years or so I have on record … probably not the worst ever, but there probably weren’t too many fixed-rate perps around in the 70’s. Any measure of SD that is reliant on the recent past is going to grossly overestimate the market risk of prefs going forward.

Also, I suggest an experiment: do the SD calculation on corporates vs. Canadas … or, if you don’t have the data (I don’t either, so don’t feel bad), look at the yields for all governments and all corporates from Canadian Bond Indices. Speaking very generally, the yield action in the past year has happened in governments … corporate yields have increased, to be sure, but rather sedately. It’s the spread that’s gone nuts, not the yield! Just off the top of your head, are you willing to compare the safety of governments vs. corporates based on SD of price or yield?

Take a more pro-active approach: read some of my articles where I talk about the various classes of preferred shares, understand the investment and likely sensitivity to various scenarios, and choose from there. Maybe use SD as a ballpark guide / second opinion, but don’t take it too seriously.

As AltaRed and Shakes point out prefs move with long term interest rates. A 1% increase in long term rates would decrease the value of a bank pref 18%, where the duration is 18 years.

True enough, but I must point out – as hinted at above – that long spreads are just as important as long rates, if not more so. I … all together now, 1, 2, 3! – write about spreads from time to time.

And, having spent more time than I really expected on this post, I will reward myself with an ad: Consider a subscription to PrefLetter to help with individual security selection or, perhaps, consider an investment in Malachite Aggressive Preferred Fund.

8 Responses to “Preferred Shares & Volatility”

  1. lafontaine says:

    Re: …………Preferreds have just emerged (I hope) from their biggest bear market of the 15 years or so I have on record ………..

    Mr Hymas : You are a wise and prudent man , but on the other hand it was a tremendous buying opportunity !!

    Louis H Lafontaine

  2. lystgl says:

    Thanks for the info Mr. Hymas. Answers many questions.
    Certainly agree with your description of our PM.

  3. davejphys says:

    Some of the best yielding preferred shares that I see are from Puerto Rican banks. For example, W Holding (WHI), parent company of Westernbank of Puerto Rico, is a company in which I hold common shares. They also offer preferred shares such WBPRJ, WBPRK, WBPRL, WBPRM, WBPRN, WBPRZ. These are 40% below par and currently yield about 12%.

    The chance of this bank not paying these non-cumulative prefs are extremely low. If they run low on capital, the Fed would make them raise capital and/or reduce assets. They have loads of US agency securities (nearly half of total assets) that they can sell if need be. About half of their deposits are linked to the Fed funds rate and so they will benefit immensely in 2008 from the recent easing.

    The bank is not current as they are restating financials but they do issue FDIC call reports and look to be OK. They do have some problems in Puerto Rico but they have nothing to do with the subprime crisis or any of the other problems facing US mainland banks. These preferred shares are not very liquid but might be appropriate for individual investors.

    Do you have any insight into these? There are a few other PR banks that have preferred shares such as RGFC.PK and DRL.

    Love your blog.

  4. jiHymas says:

    lafontaine – I still laugh when I remember one guy saying … “Any more buying opportunities and I’ll be broke!”

    lystgl – Thanks!

    davejphys – Sorry, I don’t follow US Prefs. Any analysis would be horribly confused by snarl over taxation anyway, as mentioned on January 10.

    I note that the prefs you mention are not rated – it appears that Moody’s rated them once, but the rating has been withdrawn, presumably due to their delay in reporting. As you note, information (to Sep ’07) is available via the FDIC, but this is for the actual bank, not the holding company.

    Your comment If they run low on capital, the Fed would make them raise capital and/or reduce assets. is dangerously close to an assertion that preferred shares will never default. You haven’t crossed that line, I think, but I will point out to other readers that sometimes events can move quickly and that the Fed doesn’t really care about the holding company or its prefs … they care about the actual bank and its depositors.

    Their delay in reporting is very worrisome to me, especially given the change in environment since their last report. But all in all … I’ll say it might be a great investment, it might be a sinkhole … I just don’t know.

  5. madequota says:

    Mr. Lafontaine . . . I often take a ride through your tunnel . . . please fix the potholes, OK?!

    I hope you are right about emerging from this bear, but I remind you that one of the biggest contributing factors to the creation of the pref disaster of ’07 was an unending stream of bank-issued preferreds at wild discounts to the market.

    3 of the big 5 were contributors (some more than once), but CIBC and RY have not issued anything in this period. CIBC could issue at any time due to their general fiscally sorry state, and RY could issue at any time due to their general intellectually sorry state . . . logic would dictate that an issue from either of these 2 today should be in the 5.4 – 5.5% div range, but it would not surprise me in the least to see them continue to litter the table with money, and offer out at 5.7 – 6.2% . . . . this kind of action could kick the market right back in the teeth . . . so keep your seatbelt fastened (especially in the tunnel!)


  6. lafontaine says:

    Mr Hymas –
    Your comment is surprising : ….I still laugh when I remember one guy saying … “Any more buying opportunities and I’ll be broke!” 5.85% – in december 23.5 !!! now at 25.5 5,25% – in december 18.6 !!! now at 23 6% – in december at par !! now at 25.9 at 19.5 and now at 22.25
    and the list goes on and on …..

    Love your Blog ,
    but it was a tremendous buying opportunity ( for me I must say ) and sometime you do have to take risks.


  7. jiHymas says:

    lafontaine – I’m sorry – I meant no offence.

    But you know, I’m sure, my attitude towards market timing and whenever I see or hear the phrase “buying opportunity”, I think of that story.

    Congratulations on your succesful efforts! There’s more than one way to skin a cat.

  8. lafontaine says:

    No problem Mr Hymas , you are the best and I read your column every day …

    I have to say that I really enjoyed the pref market in december : as they say : The best time to buy is when there’s blood in the streets.”….

    and actualy I am selling these days , went up too fast !!!

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