PrefBlog

Harry Koza titled his G&M column of today Back to the 70s: We haven’t seen spreads this wide since Carter, in which he states (emphasis added):

tapping the market right after their third-quarter earnings in late August with five-year rate reset preferred share issues (TD, Scotiabank, BMO and CIBC).

Those are interesting. You get a nice dividend for the first five years, ranging from 5 per cent for TD and Scotiabank, to BMO at 5.2 per cent and CIBC at 5.35 per cent. At the end of five years, the dividend resets at a juicy spread over whatever a five-year Government of Canada bond yields at that time – the CIBC one resets at 218 basis points over Canadas. Of course, they are redeemable on every five-year anniversary date as well, so if the current historically wide yield spreads have reverted to precredit crunch levels by then (which, to my jaundiced view of the current credit conflagration, is no better than an even money bet) and the bank can refinance cheaper, they will call them away from you, and you’ll have to reinvest elsewhere, possibly at lower yields.

Still, they are worth a look for taxable income investors. Good credits, decent yield, five-year term. Gee, I almost want to buy some myself.

Five-year term? I’m sure that is how they’re being sold, but I will continue to refer to them as having a “pretend-5-year-term”. If they turn out to be awful investments, they will turn out to be very-long-term instruments.

In a a discussion on FWR the point was made:

Won’t the fact that the issuer may call if there is inflation be a good thing? as unlike a perpetual, all things being equal it keeps the price closer to issue price.

Well, first I’ll make the point that these fixed-reset issues are perpetual. They simply have a dividend that resets. The credit risk is perpetual.

But what will happen if there is inflation? We can expect the Government of Canada 5-year bond yield and 90-day T-bill yield to increase to provide some kind of real yield; and then there will be a credit spread (of varying size) to be added to that. So, yes, one must agree: fixed-reset perpetuals offer a degree of protection against inflation-risk that is not present with “straight” (fixed dividend) perpetuals.

We’re investors, however. The question, as always, is not “Is there risk?” but rather “How much risk, of what particular kinds, is there and how much am I getting paid to take it?”. Given that straight perpetuals now yield about a point – maybe a bit more – over the initial fixed-reset rate, we can say we’re being paid 100 basis points (annually!) to take on that inflation risk.

Some investors may think that’s not enough. Some investors may think it’s very generous. I feel that central banks, globally, learned their lessons very well in the 1970s and that at the present time the Bank of Canada can be trusted to take their inflation mandate seriously (and that politicians can be trusted not to change the mandate).

Is this a guarantee? Am I therefore recommending a 100% holding in straight perpetuals? Of course not. There are no guarantees in either life or investing … inflation risk is forever with us (to some degree or another) and the question is: how do we set up a total portfolio that will allow us to achieve our goals in the face of a wide spectrum of risks – including, but not limited to, inflation.

While I will not condemn the Fixed-Reset Asset class completely – I will not condemn any asset class completely, everything has a price – I will suggest that perpetual preferreds are not the most logical choice of inflation hedge, even if they reset.

Fixed-Resets have attracted a wide variety of views, which I have endeavored to present on PrefBlog:

• Critchley Credits Desjardins for Fixed-Reset Issues
• Critchley of Financial Post: Fixed-Resets Good!
• Fixed-Resets : Critchley Likes, Ruggins Doesn’t
• and my own: Research: Analysis of Perpetual Resets

Make your own minds up and don’t – ever – make any bets you can’t afford to lose.

Update: As stated above, inflation is a risk. But so is deflation:

Other economists anticipate a calamitous deflation. Albert Edwards, economist strategist at Société Générale, the Paris-based investment bank, says an apocalyptic deflation will hit the global economy next year, cutting through equity assets “like Freddy Krueger.”

Michael Mandel, a PhD economist who writes for BusinessWeek magazine, predicts the rapid withering of inflation. “A year from now, will we be talking about galloping inflation or a plunge into deflation?” he asks. “I think the odds favour deflation or, at least, lower inflation. Producer price inflation in the traditional service industries is now only 0.6 per cent on a year-over-year basis – and the majority of the [U.S.] economy is services, not manufacturing. [This measure] is the best gauge of inflation that we have.”

There’s always more than one risk! Deflation will, of course, boost straight perpetuals – at least by the amount of their discount, at least until the first call date.

This entry was posted on Friday, September 5th, 2008 at 5:02 pm and is filed under Miscellaneous News. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.