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Good intro piece; the one yesterday dealing with bank-related investments from GIC’s to common stock was nicely laid out as well. Thanks for posting them! Here’s the BoC thing summarized:
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Bank of Canada cuts rates by 50 basis points, signals more
22/04/08
OTTAWA (Reuters) – The Bank of Canada cut its benchmark interest rate on Tuesday by a half-percentage point to 3 percent, as expected, and signaled that further easing was required but suggested it might pause before cutting again.
In a statement which projected a steeper U.S. economic downturn that would dampen Canadian growth, the bank said “further monetary stimulus will likely be required,” but dropped a previous reference to the need for more cuts in the “near term.”
“Given the cumulative reduction in the target for the overnight rate of 150 basis points since December, the timing of any further monetary stimulus will depend on the evolution of the global economy and domestic demand, and their impact on inflation in Canada,” the central bank said.
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With this action, widely expected, we certainly didn’t expect any sudden moves in the pref market as a result. From a macro standpoint for a moment, we have to take a look at what is happening with prefs . . . and what is not happening.
Prime is now at a recent-history low of 4.75% with this BoC move. Prefs, on the other hand are trading back at all-time lows with yields in all classes averaging about 5.5%, with a range of about 5.0% on the low side and upwards of 6% on the high side.
Although some may argue that pref value is not directly tied to the bank rate, the reality is that as a purely yielding investment, prefs are really tied to little else but the relative bank rate. After all, why would you put your money in a GIC for example, that due to the bank rate is paying a fully taxable 2 or 3 percent tops, when you can have a tax-protected dividend yield of almost double that with most prefs?
The reality is that the market seems to have abandoned this thinking. Perhaps the “credit crunch” is responsible; maybe the continued flooding of new paper; maybe just a general lack of knowledge about prefs, or a hightened concern about risk. I don’t know for sure . . . but my concern is this:
Relative bank rates have never been more desirable for pref investments. This is when long pref holders should be enjoying market value appreciation. They are not. So what happens when the bank rate policy situation reverses? What happens to these same prefs in a rising rate environment?
Some are speculating that prefs have troughed. I hope so. But what if they’ve actually just . . . peaked?
madequota
I believe the answer to your question is all in spreads. In times of stress, where central bank rates are falling, both corporate bonds and prefs display, on average, slightly rising yields. The spread shoots up as a result. Look up Federal Reserve Data for the 2000-01 recession. Spread is a measure of stress (risk, fear, whatever).
Later, when things calm down, central banks increase rates and corporate bonds and prefs display slightly falling yields. The lowest yields in early 2007 corresponded with rising central bank rates. Spreads fall, stress dissolves gradually.
For prefs to have peaked, I think you would need inflation to rise substantially and be followed by substantial central bank rate increases (like 1974). This may yet happen if the central banks are wrong, but I’m not sure we humans are going to be able to call it in advance.
Finally, the reason people put money in low yielding GICs is the G=Guarantee — principal repayment on a known date; guaranteed interest, etc. I imagine that lots of investors who tried prefs in recent years and saw 10-15% losses will take a long time to come back, if ever.
Indeed, with the pref share rally early in 2008 now evaporated, I would not be surprised if relatively experienced investors are starting to question their judgement. And, if/when we start getting defaults (mostly likely a split share that can’t repay full principal) that may scare the regulars even more. Sorry, I forgot, we already had IQW default.
Big rally or big decline don’t seem as likely to me as a slow muddle through with lots of wobbles.
thanks for the thoughts ph . . . if I understand you then, you’re saying the sinking pref thing is primarily due to stress in the market, and wider spreads. You’re also not equating declining interest rates with an increasing interest in fixed income vehicles, including prefs.
I’m not sure if history backs you up 100% on that, but it is an explanation that successfully explains what’s going on right now.
I’m wondering what macro circumstance could occur that would actually stimulate prefs then. Stress seems to create a safe haven bid for bonds as investors flee equities, but prefs don’t seem to go along for that ride. Evaporation of stress takes money out of bonds, and into equities, but that seems to spank preferreds as well, since they are not seen as an equity vehicle.
Are preferred shares, because of their oddly hybrid nature, and generally spotty trading behaviour, perpetually doomed to being a discounted market vehicle for the non-risk adverse?
madequota
“Stress seems to creat a safe haven bid for bonds…”
This is only true for government bonds. Corporate bonds are not a safe haven. James today notes that long term corporates yield 6.1% in Canada — up at least 50 bp from a year ago. Thus, both corporate bonds and prefs are under stress.
With corporates, the yield goes up under stress and so does the premium for greater term to maturity (slope of spread vs duration increases). Prefs have so far fallen more in percentage terms, or widened their spreads over, corporate bonds. I suspect this is primarily a duration effect — premium prefs which might have been called within a few years have become discount prefs with potentially infinite life.
The macro circumstance that will unwind this is the same macro circumstance that reduces corporate bond yields. If you can find a pref index going back to 2000-02 (we all await James’ HimiPref indices), you will see a very similar decline in pref prices followed by a recovery over 9-12 months. This time the recovery might take longer because of credit concerns and the fact the recession(s) in the US and/or Canada aren’t over yet.
And yes, because of their pecking order (after bonds but before equity), prefs will always be “discounted” (i.e. yield more than corporate bonds in a tax equivalent sense). See James’ recent articles on bank bonds.
Although liquidity is improving a bit in the credit crunch, I haven’t seen a lot of change in corporate bond yields yet (although government bond yields have been rising in the past 3 weeks). IF (and it’s a big if) this positive trend continues, I would imagine prefs have to follow, sooner or later.
New lows in the pref indices are discouraging, but hopefully won’t knock long term pref investors off their game plan.
we all await James’ HimiPref indices
Especially me! There are some problems with the draft that need to be addressed…
“Stress seems to creat a safe haven bid for bonds…”
See Where’s the Risk? for a long term graph of Moody’s Seasoned Baa vs. Treasury. Note that this isn’t an entirely satisfying graph, as there’s a term spread as well as a credit spread in the data … but you get the idea.
In good times, rates rise but spreads narrow … in bad times, rates fall but spreads increase. Basically. Maybe I’ll write something about it.
This (and a similar query on FWF; and Kaitas21’s question) have given me the idea for a good article about credit stratification in the pref market. Whoopee!