Preferreds or Common?

There was an interesting comment on FWF today:

I would always expect variation in daily value for a bond or a bond fund. What strikes me as not “fixed income” about preferreds is that they have noticeably deviated from any bond indice comparison. And corporate bonds have held up; so this is a preferred-specific issue. The market seems to be saying the risk factor in preferreds is much higher than comparable corporate bonds.

This was in the context of a discussion about the investment merits of bank preferreds vs. bank common, given that many Canadian banks’ common are trading with unheard of dividend yields in the current depressed market.

This is simply another example of trader-mentality vs. investor-mentality. I have nothing against traders. Trading is a useful skill and can be a lucrative skill … if I had a trader’s mentality, I’d still be counting my winnings from the Tech boom. Unfortunately (in this particular case, anyway) I have an investor mentality and simply would not be able to sleep at night, knowing that I held a piece of garbage for the sole reason that the price was rising.

For investors, it is important to look through trading behavior into the actual investment characteristics of a particular vehicle. I will certainly not deny that bank prefs are behaving a lot more like bank common nowadays than like bank bonds, but this observation does not constitute a solid ground for an investment strategy.

What do I always say? The investment world is chaotic, and things that were not even slightly important a year ago can become a driving force in the blink of an eye. It is not enough to look at price behaviour alone. At this time last year, non-bank ABCP with a General Market Disruption liquidity guarantee was just the same as bank ABCP with a Global liquidity guarantee. And, what’s more, the two classes had been trading in lockstep for years. Until, one day, they didn’t.

Preferred shares may, in times of stress, over-react to bad news about the common. There are many among us who have very fond memories of what happened to TRP.PR.X and TRP.PR.Y at the time that TRP common halved its dividend. Call me polyanna, but the fund loaded up on TRP Preferreds … because although the common dividend had halved, the preferred dividend looked … well … perhaps to say “as solid as ever” would be overstating the case, but “almost as solid as ever” seems to understate it! Assiduous Readers will know what I mean, anyway.

So by all means, prefs will often trade more like common than they trade like stock. An investor must look through that and realize that prefs are not common. Prefs are also not bonds. They’re preferreds. I feel it is appropriate to benchmark them (at least, the high quality ones) against long corporates because that is what their risk most resembles; but I recognize that sometimes markets will go blahooey, if for no other reason than their investor universe is different. Times when things are going blahooey is when I earn my pay – largely by doing nothing. Nice work, if you can get it.

I will note that the fact that things can go blahooey is a major reason behind my exhortations to limit preferred exposure to 50% maximum of a fixed income portfolio. The spreads are juicy, and sometimes they’re very juicy indeed … but when you need to raise cash for non-investment reasons, you really don’t want to be a forced seller.

PerpetualDiscounts finished the day with an average yield of 6.40%, equivalent to 8.96% at the standard conversion factor of 1.4x. Long corporates – which have been basically ignoring all this kerfuffle about financials, having priced it in months ago – continue to yield about 6.1%; the PerpetualDiscount / Long Corporate PTIE spread is therefore about 286bp. This is wild!

One Response to “Preferreds or Common?”

  1. […] Things went blahooey today all right! Yet another ghastly day, with some extremely sloppy trading (great market making there, guys! Keep up the good work!), not terribly exciting volume and … none of the volume leaders had any block trades at all. Retail’s panicking, Institutional’s at the cottage … I get a little trading done now and then. Not much, but enough to be worthwhile. […]

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