FTU.PR.A : How to Analyze?

In the list of March’s good and bad performers, I suggested that FTU.PR.A should, perhaps, be analyzed as an equity substitute … I’ve been thinking a bit more about this, on a very casual basis.

The issue is fully described on the fund’s website. The underlying portfolio is 15 US Financials, the asset coverage is only a little over 1.4:1 and the chance of a formal default is more than some might really be comfortable with – which is, presumably, why DBRS has them under review.

But hear me out! They’re currently quoted at 8.76-97 on the TSX and, given a bid of 8.76, yield 8.62% (dividend/capital gain) to maturity 2012-12-1. They may have been marked down too far, due to the “US Financials” angle and the relatively low asset coverage. If you assume you can take a good-sized position at $9.00 then your asset coverage on the actual amount invested is 1.6:1. If you further assume that:
(a) all dividend payments ($0.04375 monthly = $0.525 annually) are made
(b) the NAV declines by 37.5% to $9, implying a total return on US Financials over the next 4 3/4 years of -20% (after allowance of 17.5% for dividends paid) see update, below
(c) then the entire $9 will be paid to the pref holders
(d) and the return on the investment will be approximately $0.525/$9.00 = 5.8% annually.

Better performance by the US Financials would increase the investment return, to a maximum of the non-defaulting 8.62% rate.

That would be a fixed-incomey way of analyzing them … are there other ways? We have this … thing … worth $14.41 as of March 31. We can say that preferred shareholders have written a deep in the money call on the position, at $10 strike price, exercise 2012-12-1, after buying it at $9 (the assumed invested capital in the prefs). So, perhaps, in option terms, we’ve paid $14.41 for the position in US financials and received $5.41 for writing our call.

I know some Assiduous Readers LOVE options … perhaps some might have comments as to whether we’re happy or sad about the price we’ve received for the call?

Update: Assiduous Reader prefhound points out in the comments that expenses for the fund, plus withholding taxes on US dividends, will reduce the NAV by $1.58 over the remaining life of the fund. Therefore, point (b) of the analysis above should read:

(b) the NAV declines by 37.5% to $9, implying a total return on US Financials over the next 4 3/4 years of -20% -8.7% (after allowance of 17.5% for dividends paid and 11.3% for withholding & expenses and 0.0% for capital share dividends)

Mea culpa! I was too interested in casting the problem as an option exercise to do a proper job on the regular fixed-income style analysis.

11 Responses to “FTU.PR.A : How to Analyze?”

  1. prefhound says:

    Rising to the bait, the word “option” pulled me in, but there is quite a bit to this story.

    Even if the 15 US Financials stay at Mar 31 prices AND the C$/US$ exchange rate doesn’t move AND the underlying US financials pay out the same total dividends as they did in FY 2007 (to Nov 30 for FTU Corp), then by Dec 1 2012 the probable net asset value per unit should be about $12.83, not $14.41 because the units lose 34 cents a year after taxes, expenses and pref share distributions.

    First, an introduction: FTU + FTU.PR.A = a unit with the following features:
    – Units were IPO’d in Feb 2005, with the pref assigned a value of C$10.00 and wind up on Dec 1, 2012
    – The underlying assets are 15 US Financial stocks, whose weights currently vary from 2-11%. (I presume they started similarly weighted but have diverged considerably.)
    – The US$ exposure is currently hedged to the extent of about 50% [Note that a climb in C$/US$ negatively affects the asset coverage, increasing pref share risk and unit volatility, but hurts the capital shares even more!]
    – As US assets, the US dividends suffer a 15% withholding tax. FTU appears to pay no Canadian tax (they lose money!) and is probably not going to get tax credits for capital losses, so FTU.PR.A distributions have so far been designated Canadian eligible dividends for Canadian tax purposes.
    – Some dividends have been cut – Citigroup and Wamu, but I haven’t checked where the total dividends stand for all these firms. Maybe some have been raised, but total dividend income in 2007 was less than in 2006.
    – The recent market caps are small — only 4.875M units outstanding, so pref is about $40M and capital units $20M — so any sort of arbitrage trade could have liquidity issues. I note volume today was a whopping $35,000 in FTU and Zero in the pref.
    – Worst of all, the combined FTU corporation indulges in the fantasy of “covered call option writing” that has caused only heartache over the long run to almost all structured products that use it. If you read the prospectus, pages 18-19, you find that annualized option premiums get magically equated to a % return, which seduces capital share buyers into thinking they are getting “free extra money”. However option premium has nothing to do with the expected returns of a call option writing strategy (basically combining the attributes of a mixture of long shares and cash — less risk and less return than buying and holding the stock). In my very experienced view, the expected excess returns (over stock) of writing covered calls are close to zero after costs, and may well be negative. Even the most optimistic option analysts realize that, in the long run, a writer of options gets to keep only a small fraction of the premiums (or have the stock called away and miss upside — which could be important for anyone contemplating an investment in FTU today). How legal prospectuses can contain such fantasmagorical numbers is beyond me and a testament to atrocious regulation, but I digress. The covered call option writing strategy mostly destroys the wealth of the capital shares as the net effect is to decrease desired leverage without increasing returns. The pref share investors could be indifferent. But maybe they shouldn’t be.

    Second. Let’s just ignore the not-insubstantial covered call option writing and currency issues for a moment and look at the fundamentals reported in the 2007 and 2006 annual reports. The basic idea is that FTU is taking in US dividends, spending money on taxes and expenses and then distributing cash to pref shares first (and for a while, but no longer, to capital shares). Let’s look at the basic economics of this:

    For the Year 2007, ending Nov 30 (sadly, we commenters can’t include tables, so I apologize in advance for how this might format):
    US Dividends Reported $2.365 Million
    +US Tax Withheld $0.417 (we include this to be able to compare with headline US Dividend amounts and yields)
    +Interest Income $0.028
    =Total Pre-Tax Income $2.810 Million

    US Tax Withheld $0.417
    +Long List of Expenses $1.461 (Sponsor Quadravest gets 0.85 bp, but this is all paid by capital units — about 30 cents per capital unit; a MER of 5.54% based on a $5.50 capital unit)
    +Transaction Costs $0.038
    =Total Expenses $1.916 Million (this is 68% of gross pre-tax income – already not very encouraging!)

    Net Income Available $0.894 Million
    -Preferred Dividends Paid $2.518
    =Net Income For Cap’l Shares -$1.62 Million (0.34 per unit)

    And there you have it. Due to expenses borne by capital units and US Tax withholding (and before considering any capital gains or losses on underlying shares, options or currency), the capital units had an annual loss per unit of $0.34 in 2007 (and $0.32 in 2006). Dividends need to increase by 58% before there is any real income to distribute to capital units (which didn’t stop them up until recently).

    Let that continue for another 4.7 years, and it will destroy $1.58 of the remaining $14.41 unit value by Dec 1, 2012, leaving an expected value of $12.83 to support the $10 pref share holders. This is why I hate, detest and vilify structured products – even talented experts like Mr. Hymas have a hard time seeing through the opacity!

    Now, the interesting question is, will DBRS get this in their review? Time to place your bets. These prefs are under long term pressure, but you have chastised me before for “anticipating credit”. Hmmm, wasn’t that what the sub-prime crisis was all about…failure to anticipate credit?

    Third, let’s consider the option characteristics. The buyer of FTU.PR.A is selling a put on the portfolio of US banks, while owning an income security. The value of the put = $10 par – Current Price (ignoring interest rate effects on the price) = $10 – $8.90 = $1.10. The income security is worth 8.90. The buyer of FTU is buying a call on the portfolio with a $10 strike price. The March 31 close of $5.24 for FTU is the call option value. From Put/Call Parity Theory (and ignoring expenses):
    Value of US Portfolio = Value of Long Call – Value of Short Put + Risk-Free 4.7-year bond
    In this case, we shall use 2.65% for a 4.7-Year Treasury yield
    14.41 =? $5.24 -$1.10 + $10/1.0265^4.7 (or $8.84) = 12.98; so this is not perfect, but interestingly is close to the $12.38 I expect for the 2012 value. My experience is that the illiquid market does not value capital units of split shares as call options. One reason here is that call options are being sold on the assets. Another could be arbitrage (I arb’d away a big time premium on ES.UN last year in about a month).

    The question to ask is, for the pref holder, what volatility would justify a $1.10 time premium for a put option? A simple Black-Scholes calculation comes up with 29% annualized volatility, which surprisingly, seems reasonable to me. The 29% has to include currency (hedged 50% at the moment), so should be larger than the US$ portfolio volatility and larger than the volatility of the average bank in the portfolio (15-30%+, depending when you look).

    The interpretation is that the expected value of the pref share at maturity (in risk-free space) will be $10 minus $1.10 or $8.90: the current price. That probably means the pref should be considered in terms of current yield, not YTM, in which case it seems less attractive.

    Anyway, something with nearly zero liquidity and lots of caveats is not worth too much theoretical investigation….

    My conclusion – stay away! Hope this helps.

  2. prefhound says:

    P.S. Too bad I’m not paid by the word!

  3. jiHymas says:

    Wow! Thanks a lot, prefhound, especially for reminding me that I was so interested in thinking how the situation could be modelled using an option-based approach that I ignored the MER drag completely! I’ve fixed up the main post a little.

    prefs are under long term pressure, but you have chastised me before for “anticipating credit”.

    You mean with respect to ES.PR.B? I’m sorry, that wasn’t meant to be a admonishment – it was really just a note on the type of analysis that was done in that instance … basically, a credit analysis should contain various scenarios, but if the base case is different from the steady state, then the analysis should be considered “credit anticipation”.

    In this particular case, a base-case assumption that dividends on the underlying will remain constant would be a “neutral” analysis; an assumption that they will be halved would be “credit anticipation”. While remembering that both scenarios should be in any analysis … it’s a matter of degree.

    Too bad I’m not paid by the word!

    As of today, your salary is doubled!

    I’ll have another look at your comment tomorrow – when, I hope, the effect of the stupid-pills I took this morning will have worn off – and might have more to say then.

  4. prefhound says:

    OK, I’m now so annoyed I have put my investor advocate hat on -getting ready to complain to regulators about several issues with these prospectuses.

    Anyway, for FTU, using information in the prospectus we have:

    The objective of the capital units is to pay out 8% and return initial price (i.e. to make a return of at least 8% on the investment). It is not leverage (in this particular split share) because the sponsors (partly) recognize that writing covered call options can reduce upside capital gains.

    Prospectus claims gross call premiums = % return (top of P18) for example of 17.3% annualized, writing 2% out of the money on a monthly basis with 20% volatility.

    I claim this needs to be multiplied by a factor representing the fraction of premiums that are expected to be kept while maintaining the underlying principal value. This is easily calculated with the Black-Scholes model as 7.1% in this case. Thus the expected annualized return from this strategy before any trading costs = 17.3% gross premiums X 7.1% kept = 1.2%.

    Prospectus claims a Pref Share dividend coverage of 7.8x after costs for 2%/20% assumption (correcting a typo of 2.8x in the middle table on P19).

    If I apply all the same assumptions and use my 7.1% kept factor, I get a pref share coverage of 1.01x — varying by only +/- 0.1 from 0% to 4% out of the money options. Wonder if DBRS knows this!

    Finally, Prospectus claims a 23.7% annualized return per capital unit after costs and dividends for the 2%/20% assumption. I get -0.02% on an ongoing basis or -1.3% annually if also amortizing issue costs over 7 years (all before changes up or down in bank dividends and trading costs). Therefore, the capital units have no basis to support an 8% distribution — it is expected to be all return of capital –eating into the pref share asset coverage.

    From the pref share perspective, the headline asset coverage of $25/$10 = 2.5 becomes 2.37 after issue costs, and is expected to deteriorate by about 30% to 1.7 by maturity if capital units pay out a fixed 8% distribution.

    And, by the way, using prospectus assumptions, the MER works out to 2.5% per capital unit — which, of course, you never see anywhere.

    Love those regulators!

    Details available by request.

  5. jiHymas says:

    Thanks, prefhound … I’ve never been a fan of the capital units and now I have more avenues for attack should I ever need to explain why!

    I suggest you write this up formally and submit it for publication in an appropriate place; or, possibly, reproduce the analytical methodology for the next split-share new issue and publish that.

  6. prefhound says:

    Thank you for your kind comments.
    a) what is an “appropriate place”?
    b) let me know when a new split share appears on the scene…

  7. jiHymas says:

    (a) Well … I like Canadian Moneysaver … while individual security analysis is not really their thing, if it was presented as a template for analysis of other such issues, they might be interested. I must emphasize, however, that I do not speak for them.

    Other retail-oriented investment magazines might also be interested. Typically, such outlets are desperate for copy, particularly copy that isn’t simply an ad for advisory services.

  8. […] this is reminiscent of my musings on the proper analysis of FTU.PR.A; there is some doubt as to whether this will be able to pay all its dividends and 100% of […]

  9. csanniti says:

    For those of us unfortunate souls that are still holding these near-worthless FTU Capital shares – is there any reason to still hold on at this point?
    What was originally promoted as steady income stream vehicles have been causing steady heartburn. The net asset values still seem to be trading at a premium to market values but is that because those values include future distributions? Appreciate your thoughts.

  10. jiHymas says:

    As of November 14, FTU had a NAV of $7.10 with a preferred share liability of $10.

    Therefore, the only value that the capital units have at this point is their option value: think of them as an option to purchase a portfolio currently worth $7.10 with a strike price of $10.00 and an exercise date of December 1, 2012.

    Note that preferred share distributions, fees and expenses will act as a drag on any potential improvement in the NAV.

    I regret to say, however, that I am not an option specialist. You may wish to pose the question at Financial Webring Forum … but remember to check any math and assertions of fact you get on that or any other message board!

  11. csanniti says:

    Good explanation. I guess at this stage one may as well hang on to them given a 4 year time horizon and monitor closely – with possible reinsertion of monthly distributions IF things turn around for underlying assets.

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