Well, I promised in a previous post that I’d write a few words about this issue: and the time has come!

According to the prospectus dated May 13, 1997, available on Bombardier’s website (good for them!), these issues are convertable into each other on August 1, 2007 and on the first of August every five years thereafter. In certain circumstances, conversion may be forced and there will be only one series outstanding.

BBD.PR.B is the “Series 2” and currently pays 100% of the Canadian Prime Rate, according to Bombardier’s website – there’s no direct link, so you have to poke around a little … what you want is Bombardier > Investor Relations > Share Information > Dividend Information > BBD.PR.B. Since the Canadian Prime Rate is now 6%, this translates to $1.50 on the face value of $25.00.

BBD.PR.D is the Series 3, and pays $1.369 p.a., which was set in 2002 and will be reset in 2007 to take effect August 1.

THEREFORE, according to Mr. Calculator, the Bs will pay about 13.1 cents p.a. more than the Ds, provided prime stays put, until the next reset date which is now less than 10 months away. Being more precise and taking account of ex-Dates, we find that the Bs have their next dividend ex-date on or about Nov 28, and at the end of each month until the end of next July, which is a total of 9 more payments of $0.125, total $1.125. The Ds will pay in January, March and July, $0.34225 a time, total $1.02675.

All the above assumes no default and no change in prime, of course! But we can basically say that from now until conversion, the Bs will pay about $0.10 more than the Ds, so, in full accordance with the Holy Efficient Market Hypowhatsit, should be priced about maybe approximately $0.10 higher, as adjusted for liquidity and discounting effects, not to mention the phase of the moon.

So let’s take a look at the quotes: BBD.PR.B was quoted at the close of business November 13 at $18.21-35. BBD.PR.D was quoted at the close of business November 13 at $16.80-84.

This is an absurd price spread. Clearly, a strategy that will work very well on paper, at the very least, is to short the BBD.PR.B and long the BBD.PR.D for a gross take-out of about maybe $1.40. What’s the profit?

Strategy: Short BBD.PR.B, Long BBD.PR.D
Item Effect Notes
Initiate Position +$1.40 Will depend on trading prices, obviously
Net Dividend -0.10 Assumes Prime Constant – decline in prime will reduce loss
Cost of Margining -$0.855 Need to put up 150% on the short = $27.40, can borrow 50% on the long = $8.40, have to put up $19.00, don’t get any interest on this because you’re retail scum and don’t get institutional rates, and call your opportunity cost @ 6% for 9 months = $0.855. NOTE: Different brokers perform their short-margin requirements in different ways and I am not familiar with all of the methodologies! If they insist that you have to have the full $27.40 cash in the account not earning interest; or if they charge you interest on your margin-reducing long side, this calculation will not be applicable and the cost of margining will change accordingly! ENSURE YOU KNOW HOW YOUR BROKER WILL CHARGE YOU BEFORE PUTTING ON THE POSITION!
Commission -$0.10 A nickel a side each way to put the position on – the custodian will do the conversion for free. At least, we hope so
Total Net Profit $0.345 Not bad. See any problems with the calculation?

OK, so it looks like there’s a $0.345 / share profit out there, just waiting to be grabbed, for anyone who wants to take it. The only constraint is how much you can get done without moving the price too much – a constraint I won’t attempt to play down! However, so far today, November 14, the Bs have traded 4,610 shares in a range of $18.31-35, while the Ds have traded 8,350 shares in a range of $16.75-81. So it would seem that there’s enough money available to be worth a ‘phone call.

 This strategy is credit neutral – if Bombardier goes bust in the next 9 months, then both your long and short are worthless, which is fine. And you don’t have to rely on the market to recognize the equality either – you can just convert one to the other next summer and your position will flatten out. All in all, it seems like a pretty good play for those who can short. Especially if you have a facility where you get paid interest on your cash collateral for the borrow!

 The major risk is of a short squeeze on the Bs, where you could be forced to buy back the short, perhaps at a greater spread to the Ds than that at which you entered the position. This is the risk of any short strategy – make up your own mind as to the likelihood of that. And never bet the house on ANYTHING. There’s lots of good ideas out there … do enough of them and the one’s that turn out well will pay for the ones that turn out badly, hopefully with a little bit extra tacked on.

I’m not doing this for clients at the moment: shorting is not currently something I “do”. Which, of course, is why I’m publishing the idea! Have a look, maybe it makes sense for your.

I’ve attached two graphs:

Have fun!

Update re short squeezes: According to the prospectus, conversion is effected by surrender of an actual certificate in the period 14-45 days prior to the actual conversion date. This could give rise to a short squeeze – IF a sufficient number of shareholders choose to convert from the higher priced issue shorted into the lower priced issue held … which doesn’t seem too likely, but worth mentioning.

Erk! Update re taxation: It was noted on Financial Webring Forum Financial Wisdom Forum [edited 2015-3-31] that there are tax effects on shorting dividend paying stocks in Canada … according to Blakes

Payments made to compensate a securities lender for dividends on a borrowed share of a Canadian issuer will generally not be deductible unless the securities borrower is a registered securities dealer in which case two thirds of the payment will generally be deductible;

Therefore, tax will be owing on the dividends received, but nothing may be deducted with respect to the dividends paid … at a marginal tax rate of 21% on the $1.12 received on the Bs, the tax loss due to dividends will be $0.235, which nearly wipes out the pre-tax profit all by itself.

The only hope for this strategy, then (in the absence of very fancy trading arrangements to skip over the dividends … and I will NOT opine on the admissability of such a strategy for tax purposes!) is to get paid on the cash collateral for the short, or to simply hope that the spread decreases faster than the nine-month maximum.

*Sigh* Tripped up by tax effects! That’s what happens when I step outside my specialty … but really, these things are Pfd-4 by DBRS so I wouldn’t want to go long … still, anybody who for any reason owns the Bs should give serious consideration to swapping into Ds … assuming they really want to own the name.

Further update re Tax: The relevent section of the Income Tax Act is 260(6)(a):

(6) In computing a taxpayer’s income under Part I from a business or property

(a) where the taxpayer is not a registered securities dealer, no deduction shall be made in respect of an amount that, if paid, would be deemed by subsection 260(5) to have been received by another person as a taxable dividend; and

(b) where the taxpayer is a registered securities dealer, no deduction shall be made in respect of more than 2/3 of that amount.

And please note that I am not a tax specialist! Consult your own tax advisor before making or not making any decision based on the above!

3 Responses to “BBD.PR.B / BBD.PR.D”

  1. […] This pair is very similar to the BBD.PR.B / BBD.PR.D pair that has been discussed previously. They are convertable into each other on December 1, 2007, just over ten months off, but are trading at prices that are very different. […]

  2. jiHymas says:

    A reader sent me the following comments:

    1. I look on it as a long investment in the amount of the Pref D purchased. Therefore, I put up (e.g. on 1000 shares) about $18K of my capital. By thinking about it this way, I avoid your calculation of margin interest cost — which appears as one of your costs, but then makes the invested capital = 0, so investment return would be infinite.

    2. The way shorting accounts work at TD Waterhouse and E*Trade is that a separate shorting account holds the cash from shorting plus the short position (net = 0). The cash is adjusted daily or weekly as Pref B fluctuates, coming from or going to the C$ margin account. This way, the only amount that does not earn interest is the current cash balance in the short account (100% of short proceeds +/- changes). If this goes up because Pref B goes up, I have to post more (so my capital actually increases above the $18K originallly envisaged), but of course, the opposite could also occur if Pref B goes down from day to day, so I stick with my estimate of capital employed as the cost of the Pref D. Of course, the Pref D value in the margin account also provides the “other” 50% to make 150% overall margin on the short — but that 50% is at least earning a return!

    3. The bid ask spreads (for decent numbers of shares) on these puppies are wide — 50 or more cents is not unusual, so one can’t do the trade on a large scale (I’ve done 1000, 1500 and 500 share orders in the past). It has taken me several hours to get fills at prices that work (which has its own risks).

    4. Pre-Tax Profit = Divs In – Divs Out + B/D Spread – Costs at both ends (time valued, and with all the caveats about being forced out). = about 8-9% (with $1.50 B/D realized spread) in 7 months (max). By expressing it as a percentage of invested capital one can decide if it is worth the trouble. I think it worthwhile as a fixed income strategy.

    5. Today, we know when these Pref B and D prices must converge (July or sooner, when they are interconvertible). My guess is that they will converge as soon as (if not before) the announcement is made (60 days in advance?). My previous attempt at this a few years back was several years from interconvertibility; the B variable dividend was smaller than the D fixed dividend (and one had to forecast short term rates to be comfortable). At that time I got a $2.00 spread and mentally allowed two years for it to unwind. In the event, it took about 3 months, so I made 11% after (then higher) costs, which made for an excellent return.

  3. […] It’s been three months (to the day!) since I looked at this pair, so I thought I’d update the calculations. […]

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