Assiduous Reader prefhound recently commented:
With recent strength in the Pref market, some Fixed Resets are priced north of $27 with YTW of 2-4%. What is your take on how sustainable that is and how far up they could go – north of $28?? Negative YTW??.
Two Examples are:
BPO.PR.C $27.35 YTW (first call) of 3.73% when the other BPO fixed resets average 4.86% (including BPO.PR.E, which is also likely to be called).
MFC.PR.O $27.61 YTW (first call) of 2.4% when the other MFC fixed resets average 3.99% (including MFC.PR.R, which is also likely to be called).
I had been thinking of highlighting this, but it took the comment to rouse me from my lethargy.
The interesting thing about FixedResets with very large premia is that there will be some investors who should definitely not hold them in taxable accounts due to differential tax rates. For most taxable investors a normal yield calculation will be just fine, since tax payments on larger-than-normal dividends will be offset by a recovery of taxes on the capital loss on the (presumed) call date – but this approximation is not exact and at worst can be completely wrong.
Some investors might be sitting on massive capital losses; an additional capital loss expected in the future might not be claimable immediately or, in the worst case scenario, at all. These problems were discussed in the post Tax Impact on FixedResetPremium Yields; and John Heinzl was kind enough to quote me in the Globe in his article Beware the tax trap of these tempting preferreds.
A long time ago I published a spreadsheet automating the calculation of tax effects on these issues; I’m pretty sure I noted the link in PrefLetter, but I don’t believe I ever posted about it on PrefBlog.
The calculator is an Excel Spreadsheet and is linked in the right-hand navigation panel under the heading “Calculators”.
So let’s look at four issues – the two highlighted by Prefhound and the two highest priced FixedResets:
| Attribute | ||||
| Attribute | BPO.PR.C | MFC.PR.O | RY.PR.R | CWB.PR.C |
| Bid Price | 27.30 | 27.26 | 27.50 | 27.45 |
| Call Price | 25.00 | |||
| Settle Date | 2017-4-11 | |||
| End Date | 2021-6-30 | 2021-6-19 | 2021-8-24 | 2021-7-31 |
| Quarterly Dividend |
0.375 | 0.35 | 0.34375 | 0.390625 |
| Cycle | 3 | 3 | 2 | 1 |
| Pay Date | 30 | 19 | 24 | 30 |
| Include first div? | Yes | Yes | Yes | Yes |
| Reset Date | 2021-6-30 | 2021-6-19 | 2021-8-24 | 2021-07-31 |
| Q’ly Div after reset | 0.39125 | 0.378125 | 0.3675 | 0.409375 |
| Marginal Div Tax | 29.52% | |||
| Marginal Cap Gain Tax | 23.20% | |||
| Results | ||||
| Non-Taxable | 3.68% | 3.36% | 3.21% | 4.07% |
| TaxableClaimLoss | 2.44% | 2.22% | 2.10% | 2.70% |
| TaxableNoClaim | 1.98% | 1.76% | 1.62% | 2.22% |
Tax Data is from Ernst & Young’s calculator, Ontario, 2017, taxable income of $150,000. “Dividend Rate after reset” has been input according to a constant GOC-5 yield of 1.08%, but is irrelevant to the calculation.
So to get back to Prefhound‘s questions: is this sustainable? Well not in the medium- to long-term, obviously, because one must assume that these high-spread, high-price issues are going to be called at the first opportunity. And one must also anticipate the price dropping towards 25.00 with every dividend paid. But the yields are probably sustainable – there are some investors who view issues of this type as substitutes for GICs, given the high call probability, and they’re just fine with 2%+ yields. Could these issues go over $28? Well, I won’t say anything’s impossible, but I consider it unlikely. A lot of people really don’t like paying such a high premium.
Better answer than I deserve….
Unclaimed capital losses can be claimed at death to the extent to which the departed investor had taxable income from other sources in the year of death or the prior year. I discount far off tax recoveries at the after tax return on a taxable portfolio – say 2.5% in this example. So if you get the tax refund on the capital loss in 25 years, it is worth 23.2% / (1.025)^25 = 12.5%, which improves things slightly. Even better, the sad sack investor with big capital losses might learn something before 25 years and eliminate the loss carryforward before he dies.
Anyway, if these are GIC substitutes, those investors could be in for a rude shock and their advisers should be shot. The extra 1% return from similar over par prefs would be more sensible if one wants premium prefs for any reason.
[…] effects should be understood; there has been a brief discussion of tax effects on PrefBlog and a calculator is available; but this essay is a more detailed […]