Critchley Credits Desjardins for Fixed-Reset Issues

Barry Critchley of the Financial Post today wrote (hat tip: Financial Webring Forum) a column titled Rate Reset Preferreds Catch On, in which he claims:

Given that there are only about four moving parts on any product, Desjardins worked on the yield and came up with a product that saw the yield set at a spread above the yield on five-year Canada bonds. And that spread would remain throughout the life of the issue. At the end of five years, investors were given a choice: another fixed-rate pref or a floating-rate pref. That repricing meant the prefs would be brought back to trading at par, given that investors were being offered a new “market” rate.

This is not correct. Have a look at Chart #1 in my recent article Analysis of Perpetual Resets for a ten year graph of the market spread of PerpetualDiscount issues vs. the five year Canada. It not only varies significantly, but the Credit Crunch has, not surprisingly, brought these spreads to a peak.

It is my belief that the current enormous spreads are being used to sell these issues to retail … “Look at this! 5-Year GOC +XXX bp! Widest in years and there’s a FIXED RESET!”.

However, one must remember that the issuer has options and that one of these options is to call the issue. If, in five years, the rate on a given issue is reset to a specific yield, the issuer will compare this specific yield to the yield at which new preferreds (from that issuer!) could be issued.

  • If the reset yield is greater than the market yield (for that issuer!), investors should assume the issue will be called (which could, I suppose, be construed as “trading around par”, but the investor won’t [or shouldn’t] be too happy about it).
  • If the reset yield is approximately equal to the market yield (for that issuer!), then the investor is happy and the issue will – probably – remain outstanding and trade around par
  • If the reset yield is significantly less than the market yield (for that issuer!) then the issue will – probably – remain outstanding and trade below par.

There is some mitigation of interest rate risk with this structure, but the issues are perpetual. Investors are taking on perpetual credit risk while hoping for – at best – 5-year-money rewards.

Because the rate will not be good enough in bad times, investors must demand a rate that is more than good enough in good times.

One very good example of how attempts to keep perpetual money trading at par can blow up is the Nortel Ratchet Rate issues (NTL.PR.F & NTL.PR.G). The “ratcheting” mechanism was supposed to keep the issue priced around par. It hasn’t done that very well. Same thing for all the BCE issues.

Mr. Critchley goes on to point out that Desjardins takes credit for the structure – I scooped him on that ages ago.

Mr. Critchley is writing a lot about this structure lately – his prior column quoted an unimpressed ex-capital-markets guy.

And … just to make sure nobody missed it … there was yet another new issue with this structure today (number five in a continuing series): National Bank 5.375%+205.

2 Responses to “Critchley Credits Desjardins for Fixed-Reset Issues”

  1. […] literature references the “Desjardins Preferred Share Universe Index”; Desjardins is heavily promoting its involvement in fixed resets and (this wins all arguments in the bond world) Innovative Tier 1 Capital was put in the Scotia […]

  2. […] Critchley Credits Desjardins for Fixed-Reset Issues […]

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