On an old thread regarding RY.PR.K, Assiduous Reader Kaitas21 asked:

Hi Hymas,

I wonder if you could shed some light on the RY.PR.K or even the recent Brookfield Asset Management 5.00% Cumulative, Convertible Class A Preference Shares, Series 21. Both issues have the conversion privilege to convert the prefs into their underlying common shares at the discretion of the issuer AND the holder. But if the holder exercises his/her conversion rights, the issuer can decide not to give the shares and redeem them into cash. So it seems that this type of prefs are linked to the common shares. How does this affect the price of the pref ? RY.PR.K is trading above par and it’s IPO coupon is 4.72%.

thanks again!

Note that this is a question of great pith and moment because the mechanism of retraction is common among retractibles; it should be noted that RY.PR.K has been called for redemption.

On the PrefInfo Help Page, I note:

A Retraction is an option available to the shareholder, whereby the shareholder may force the issuer to purchase (or to find an alternate third-party to purchase) his shares at the indicated price. It should be noted that Hymas Investment Management is not aware of any retraction privileges which do not have accompanying Redemption options that are exercisable prior to the eligibility period for the Retraction at a price lower than that specified or implied by the Retraction – so it is most conservative to assume that such a Redemption Option will be exercised immediately prior to the first Retraction date.

It should also be noted that many Retraction options specify that the shareholder will not receive cash, but will receive common shares at a price of 95% that of market, to a total value equal to the par value of the preferred shares retracted. Allowing 1% of this total value for commissions and differences between the calculated market value and the price that the shareholder might actually recieve when selling these shares results in, for instance, a $26.04 = ($25.00 / 0.96) presumed retraction price on a share with a par value of $25 on which common is received at 95% of market and presumed to be sold immediately.

The stipulation that in the case of conversion into shares the shares are priced at 95% of the then current market price means that the prefs are not, in fact, linked all that closely with the common. In the case of a $25 preferred share being converted to shares, if the computation of 95% of the market price is $25, the holder will receive one common for each preferred. If the computation results in a figure of $100, the holder will receive one common for every four preferreds. In any event, assuming a steady market, the holder is receiving common at a rate of:

Market Value of Common Received = (Par Value of Preferred) / 0.95

or, for a $25 preferred, $26.32.

When entering figures into the HIMIPref™ database, I actually use a divisor of 0.96, resulting in a figure of $26.04, to account for commissions and differences between the computed market price and the price that the holder might actually sell it at. Note that this is an approximation! It is entirely possible that the market value of the common could plunge in the period between the computation and the first chance the holder has to sell the stock. The process is not a risk-free conversion.

One other nuance to be noted is that the minimum conversion price is usually set to $2, implying that the maximum number of common shares receivable for each preferred is 12.5. This protects the common equity holders from extreme dilution in the event that, for instance, the price of the common goes to $0.01 which, in the absence of a minimum, would result in preferred shareholders would get 2,500 common shares per preferred.

If there is no minimum price, the conversion feature is referred to as a death spiral conversion provision:

Company completed a convertible debt financing containing terms that are commonly referred to in the investment community as “death spiral” conversion provisions. In financings such as these, any drop in the Company’s stock price has the potential to create a negative feedback loop of massive dilution, occurring when a company uses its shares (valued at a 10% discount to market) to pay principal and interest on the debt, which dilution in turn could drive further steep drops in the Company’s stock price, which market decline could in turn lead to even greater dilution upon the next payment of principal and interest using company stock, and so on.

The chances of, say, Royal Bank’s common price going below $2 and thus resulting in a potentially massive short-changing of the preferred shareholders are very slim. However, this provision has been very important in the conversion of IQW.PR.C in which the $2 stated minimum price is used, rather than the market price of somewhere around $0.20. It may not happen often, but it does happen … and IQW.PR.C holders are getting about 13 shares (since the conversion amount includes about $1 in unpaid dividends), worth about $2.60, for their $25.00 retractibles. That’s one of the risks!

All in all … if the company is healthy and has a double-digit share price, you can assume for analytical purposes that the company will elect to pay out $25.00 cash rather than $26.00 in shares. There are risks, but they’re relatively minor.

If the company is not healthy and does not have a double-digit share price … well, then, the retractible preferred are a speculation with their equity characteristics overwhelming the fixed-income characteristics.

One Response to “Retractions”

  1. […] conversion shows the value (to the company, and to the existing common shareholders) of the use of a minimum price to avoid ‘death spiral’ conversion. The last price of IQW.PR.C is $1.65; the last price of the IQW is $0.185 … but the face […]

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