PrefBlog

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.

This entry was posted on Saturday, February 23rd, 2008 at 6:14 pm and is filed under Reader Initiated Comments. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.