PrefBlog

I was challenged on Financial Wisdom Forum to opine on preferred share market inefficiency:

I do wonder if this market is as inefficient as you suggest. It seems to me when inefficiencies exist (that is to say easy money to be made) in capital markets such inefficiencies don’t last long as smart money rushes in to scoop up the cash and thus eliminating the inefficiency . Perhaps Mr Hymas would care to offer an expert opinion on the preferred share market with respect to its inefficiencies or lack there of.

Fortunately enough, there’s an example of inefficient pricing noted just above:

Take AIM.PR.A (which is one of my holdings and is definitely not investment grade). It was yielding 7.3% (current) when I started buying in February. I knew it was resetting end of March at around 4.5% of the redemption price (for a current yield of 5.1% at my ACB), but thought: ‘It must be safe to buy because the market must have priced in whatever.s going to happen’. Well, in early March they announced the details of the reset and then it sunk like a stone! So a week or so after the announcement, I thought: ‘Now the market must really have priced in everything, so now I can buy some more at a bargain’. Which I did. But it kept sinking and sinking and still is sinking!

Let’s look at the yield of AIM.PR.A using the new and improved yield calculator for FixedResets. Assumptions are always necessary when making yield calculations so assume

• The bid in thirty years will be the same as the close on Friday, 19.31
• Constant 5-year Canada yield of Friday’s close of 0.79%

and combine that with what we know about the issue

• Resets 2020-3-31
• Reset yield is GOC-5 +375bp
• Paydates are quarterly from June 30

We calculate the yield as 5.85%.

Now look at AIM.PR.C, which closed on Friday at 24.91, currently pays $1.5625 p.a. and resets at five year intervals commencing 2019-3-31 at GOC-5 + 420bp. Make the same assumption of a constant price. The yield is 5.33%.

This relative valuation makes no sense. AIM.PR.C should yield more than AIM.PR.A, since it has greater call risk.

Some people may tell you that the differential makes sense, because when AIM.PR.C resets in four years it is GUARANTEED!!! to reset at a higher level since GOC-5 will DEFINITELY!!! be higher at that time … to which we may retort that in that case, AIM.PR.A will also reset higher since it will reset again one year later.

In order for AIM.PR.C to achieve the 5.85% yield offered by AIM.PR.A, we must assume a constant GOC-5 yield of 1.49%. If we assume that GOC-5 will reach 1.49% and stay there forever, then AIM.PR.A will then yield 6.45% (n.b. a greater increase since the lower price of AIM.PR.A means it is more levered to the GOC-5 rate). So for the realized yields to be equal, we must assume that GOC-5 will increase to 1.49% by the time AIM.PR.C resets in four years, but return to 0.79% when AIM.PR.A resets a year later (there will be infinite equivalent paths for equality of yield, but they will all look more or less like that) and that this zig-zag will continue forever. This seems like a rather complex path to be betting on.

And the above ignores call risk, i.e., assumes that the Volatility of the Market Reset Spread for AIM is zero and that neither issue will be called with 100% certainty. This is another rather aggressive assumption.

If we turn the question around a little, we can determine that, in order for the yield on AIM.PR.A to be equal to the yield on AIM.PR.C (again, with zero allowance made for call risk), then we may say that the constant price of AIM.PR.A should be $21.20, given a constant GOC-5 yield of 0.79 (for both issues!). Thus, we may conclude to a first approximation that AIM.PR.A is about 9% undervalued relative to AIM.PR.C at current prices.

It is not at all unusual to conclude that cheaper issues are unduly cheap relative to their more expensive siblings. I believe that this is due to some feeling among preferred share investors as a group that:

• Anything priced at around par will always be priced near par, because, dammit, they’re PREFERRED SHARES
• Anything priced significantly below par is a speculative piece of shit

Regrettably, this hypothesis would be very difficult to prove. And, as the regrettable timing of MAPF’s move into low-spread FixedResets demonstrates, just because something is probably mostly true most of the time doesn’t mean it’s always true all of the time. But … if the odds are with you on all your decisions and you take care that an unlucky streak won’t wipe you out … you’ll do fine.

This entry was posted on Saturday, March 28th, 2015 at 7:08 pm and is filed under Issue Comments, Reader Initiated Comments. 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.