Fairfax Financial Holdings Limited has announced:

that it has determined the fixed dividend rate on its Cumulative 5-Year Rate Reset Preferred Shares, Series K (“Series K Shares”) (TSX:FFH.PR.K) for the five years commencing April 1, 2017 and ending March 31, 2022. The fixed quarterly dividends on the Series K Shares during that period, if and when declared, will be paid at an annual rate of 4.671% (Cdn. $0.291938 per share per quarter).

Holders of Series K Shares have the right, at their option, exercisable not later than 5:00pm (Toronto time) on March 16, 2017, to convert all or part of their Series K Shares, on a one-for-one basis, into Cumulative Floating Rate Preferred Shares, Series L (the “Series L Shares”), effective March 31, 2017. The quarterly floating rate dividends on the Series L Shares will be paid at an annual rate, calculated for each quarter, of 3.51% over the annual yield on three month Government of Canada treasury bills. The actual quarterly dividend rate in respect of the April 1, 2017 to June 29, 2017 dividend period for the Series L Shares will be 0.98384% (3.99% on an annualized basis) and the dividend for such dividend period, if and when declared, will be Cdn. $0.24596 per share, payable on June 29, 2017.

Holders of Series K Shares are not required to elect to convert all or any part of their Series K Shares into Series L Shares.

As provided in the share conditions of the Series K Shares, (i) if Fairfax determines that there would be fewer than 1,000,000 Series K Shares outstanding after March 31, 2017, all remaining Series K Shares will be automatically converted into Series L Shares on a one-for-one basis effective March 31, 2017; and (ii) if Fairfax determines that there would be fewer than 1,000,000 Series L Shares outstanding after March 31, 2017, no Series K Shares will be permitted to be converted into Series L Shares. There are currently 9,500,000 Series K Shares outstanding.

The Toronto Stock Exchange (“TSX”) has conditionally approved the listing of the Series L Shares effective upon conversion. Listing of the Series L Shares is subject to Fairfax fulfilling all the listing requirements of the TSX and, upon approval, the Series L Shares will be listed on the TSX under the trading symbol “FFH.PR.L”.

FFH.PR.K is a FixedReset, 5.00%+351, that commenced trading 2012-3-21 after being announced 2012-3-12.

The most logical way to analyze the question of whether or not to convert is through the theory of Preferred Pairs, for which a calculator is available. Briefly, a Strong Pair is defined as a pair of securities that can be interconverted in the future (e.g., FFH.PR.K and the FloatingReset FFH.PR.L that will exist if enough holders convert). Since they will be interconvertible on this future date, it may be assumed that they will be priced identically on this date (if they aren’t then holders will simply convert en masse to the higher-priced issue). And since they will be priced identically on a given date in the future, any current difference in price must be offset by expectations of an equal and opposite value of dividends to be received in the interim. And since the dividend rate on one element of the pair is both fixed and known, the implied average rate of the other, floating rate, instrument can be determined. Finally, we say, we may compare these average rates and take a view regarding the actual future course of that rate relative to the implied rate, which will provide us with guidance on which element of the pair is likely to outperform the other until the next interconversion date, at which time the process will be repeated.

We can show the break-even rates for each FixedReset / FloatingReset Strong Pair graphically by plotting the implied average 3-month bill rate against the next Exchange Date (which is the date to which the average will be calculated).

The market appears to have a distaste at the moment for floating rate product; most of the implied rates until the next interconversion are lower than the current 3-month bill rate and the averages for investment-grade and junk issues are both well below current market rates, at -0.13% and -0.59%, respectively! Whatever might be the result of the next few Bank of Canada overnight rate decisions, I suggest that it is unlikely that the average rate over the next five years will be lower than current – but if you disagree, of course, you may interpret the data any way you like.

Since credit quality of each element of the pair is equal to the other element, it should not make any difference whether the pair examined is investment-grade or junk, although we might expect greater variation of implied rates between junk issues on grounds of lower liquidity, and this is just what we see.

If we plug in the current bid price of the FFH.PR.K FixedReset, we may construct the following table showing consistent prices for its soon-to-be-issued FloatingReset counterpart given a variety of Implied Breakeven yields consistent with issues currently trading:

Estimate of FloatingReset FFH.PR.L (received in exchange for FFH.PR.K) Trading Price In Current Conditions |
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Assumed FloatingReset Price if Implied Bill is equal to |
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FixedReset | Bid Price | Spread | 0.00% | -0.50% | -1.00% |

FFH.PR.K | 22.28 | 351bp | 21.12 | 20.61 | 20.11 |

Based on current market conditions, I suggest that the FloatingResets that will result from conversion are likely to be cheap and trading below the price of their FixedReset counterparts. Therefore, it seems likely that I will recommend that holders of FFH.PR.K continue to hold the issue and not to convert, but I will wait until it’s closer to the March 6 notification deadline before making a final pronouncement. I will note that, given the apparent cheapness of the FloatingResets, it may be a good trade to swap the FixedReset for the FloatingReset in the market once both elements of each pair are trading and you can – presumably, according to this analysis – do it with a reasonably good take-out in price, rather than doing it through the company on a 1:1 basis. But that, of course, will depend on the prices at that time and your forecast for the path of policy rates over the next five years. There are no guarantees – my recommendation is based on the assumption that current market conditions with respect to the pairs will continue until the FloatingResets commence trading and that the relative pricing of the two new pairs will reflect these conditions.

Insofar as the relative valuation of FFH.PR.K is concerned, Implied Volatility analysis indicates it’s fairly priced relative to other FFH issues:

[…] 5.00%+351, that commenced trading 2012-3-21 after being announced 2012-3-12. In 2017 the issue reset to 4.671%; I recommended against conversion; and there was no […]