DBRS has announced that it:
has today published updated versions of two Canadian structured finance methodologies:
— Stability Ratings for Canadian Structured Income Funds
— Rating Canadian Split Share Companies and TrustsNeither of the methodology updates resulted in any meaningful changes and as such, neither publication has resulted in any rating changes or rating actions.
The new methodology institutes a formal procedure for Reviews:
Rating actions taken on the preferred shares of an issuer are based on the following guidelines:
- • If the downside protection available falls outside the expected range by a signifi cant amount for two consecutive months, the preferred shares may be placed Under Review with Negative Implications to indicate the high likelihood of an impending downgrade.
- • After a rating has been placed Under Review with Negative Implications, it maintains its status until one of the following scenarios occurs:
- – If the downside protection fell outside expected levels for two consecutive months subsequent to the rating being placed Under Review with Negative Implications, then the preferred shares will likely be downgraded. The revised rating level will depend on the path of downside protection levels during the Under Review period, as well as on other factors such as changes in the dividend coverage available and the credit quality of the portfolio.
- – If the downside protection levels are consistent with the then-current rating for two consecutive months subsequent to being placed Under Review with Negative Implications (likely due to an increase in downside protection), the Under Review status will likely be removed with a confi rmation of the rating.
- • If the downside protection indicates that an upgrade is warranted for four consecutive months, then the
transaction will likely be upgraded. The revised rating level will depend on the path of downside protection levels during the previous four months, as well as other factors such as changes in the dividend coverage available and the credit quality of the portfolio.
They’re still using VaR based on one-day drops:
Volatility Rating
- • DBRS analyzes the historical volatility and performance of the portfolio’s underlying securities to estimate the likelihood of large declines in downside protection.
- • Historical performance data for a defi ned period is used (normally ten years).
- • Daily returns are annualized; only negative returns count as potential defaults.
- • A probability of default is calculated that will yield a one year VaR at the appropriate dollar-loss amount equating to the downside protection available.
- • The probability of default is linked to a long-term rating by using the one-year default rates from the DBRS corporate cumulative default probability table.
- • The long-term rating is converted to a preferred share rating using a notching assumption that the preferred shares of a company should be rated two notches below the company’s issuer rating.
A Diversification adjustment has been formalized:
- • Portfolios with greater diversifi cation will generally exhibit less volatility and a lower probability of a large decline over time.
- • As the diversifi cation of a portfolio by industry and by number of securities decreases, the diversification factor applied will increase.
- • See the Downside Protection Adjustments for Portfolio Diversification table in this methodology, which shows the adjustment factor for varying levels of diversification.
The Cash Grind is treated as an adjustment:
- • Higher capital share distributions increase the grind on the net asset value (NAV), which results in the portfolio requiring to earn a certain percentage return from capital appreciation (the percentage grind) to cover the amount that portfolio expenses and distributions exceed dividend income.
- • The percentage grind will have less of a negative effect if there is an asset coverage test preventing capital share distributions once the NAV drops below a certain value.
- – A higher NAV cut-off value will provide greater protection to the preferred shares.
- • A longer transaction term increases the cumulative effect of any
grind on the portfolio.- • The methodology shows the impact of capital share distributions on the maximum preferred share rating.
- – More aggressive distribution policies and asset coverage tests will result in notching below the maximum preferred share rating (see the Impact of Capital Share Distributions on Initial Ratings table in this methodology).
They had this to say about option writing strategies:
DBRS views the strategy of writing covered calls as an additional element of risk for preferred shareholders because of the potential to give up unrealized capital gains that would increase the downside protection available to cover future portfolio losses. Furthermore, an option-writing strategy relies on the ability of the investment manager. The investment manager has a large amount of discretion to implement its desired strategy, and the resulting trading activity is not monitored as easily as the performance of a static portfolio. Relying partially on the ability of the investment manager rather than the strength of a split share structure is a negative rating factor.