Assessing the value of the minimum reset yield

Barry Critchley was kind enough to mention me in his piece Assessing the value of the minimum reset yield:

The minimum rate reset feature has some value for the investor and could become real value in five years if the five-year Canada bond rate is below the current five-year rate. The question is whether investors are being rewarded now.

James Hymas, portfolio manager of the Malachite Aggressive Preferred Fund and publisher of the PrefBlog thinks they’re not. “I think it’s overly reflective in the price, but given the current yield on five-year Canada bonds (around 1.70 per cent) the current value is minimal.”

Hymas said the minimum reset has value if in five years, the five-year Canada rate is below 1.70 per cent, a level that’s “significantly below the target inflation rate,” of two per cent set by the Bank of Canada, and not far from the record low five-year rate.

In Hymas’s view, a coupon that starts with a five is required. In the meantime, he says that better value lies in the secondary market.

4 Responses to “Assessing the value of the minimum reset yield”

  1. jiHymas says:

    Assiduous Reader JW attempted to post the following, but experienced difficulties … so here it is! I have taken the liberty of inserting paragraph breaks from this version; I originally posted it elsewhere. Note that the comments section had a spirited discussion of this issue last February – JH

    James I just don’t understand how you can ascribe “zero value” to the minimum rate guarantee.

    This would presume that the bond market has even the slightest idea where bond yields will be in five years. Sure, if 5y yields are 3 percent then sure the guarantee will be of no value – but what if yields are 0.50? I can assure you that the bond market has no clue what the future holds.

    The min rate guar is there precisely to protect investors from the disaster of all those prefs that have been smoked for the past three years. Prefs will min rate guar have all held up very well. Has the 5y spread been generous lately? no, but that’s not the point.

    If 5y yields are substantially higher in four years, then next to one will care about narrowness of the ENB 3.17 spread, especially if the 3m/5y spread is even more narrow by then!

    also, I don’t think that you can rightly compare the BPO and ENB issues on credit quality and equate them. If it was BAM vs ENB then yes, but not BPO.

    Anyway, my main point is simply that the min rate guar is there to protect investors from a repeat of 2014-2016 and no one saw that coming (including the “know-nothing” bond market) so this is insurance and no insurance isn’t free but it’s a trade off between a higher base coupon and spread vs a lower coupon and spread with the guarantee. I will take the latter.

    You just can’t ascribe zero value to it. If – for whatever reason – someone had started to issue those types of prefs in 2013 and you had then that the min rate guar was worth nothing, then within one year you would have had to eat those words.

  2. jiHymas says:

    Let’s look at the following model:

    i) You are a rational investor.

    ii) You are in a very restricted investment universe with only two asset classes available, which are fairly priced relative to each other.
    a) Government bonds
    b) Preferred shares

    iii) All tenors of government bond are available, but the yield curve is always flat and changes are always parallel

    iv) There are two preferred shares available, with almost identical terms. One has a floor (reflective of the current government bond yield), the other doesn’t. Prices are par for both.

    v) You invest in some mixture of five year goverments and preferred shares without a floor.

    Now suppose that government yields decline substantially. Do you sell your preferred shares to buy governments?
    a) If so, why?
    b) If not, how does the model need to change before you do?

  3. Prefhound says:

    I don’t recall the detailed arguments from February that James refers to, but, if the 5-year GOC yield is 0.5% when a minimum yield pref issued at GOC 1.7% resets, then the pref will be called and a new, lower rate, one issued. Ergo, I have to think the minimum yield guarantee has very limited significance in a callable scenario and I value the minimum yield feature at Zero (same as the convertibility feature into floating rate….).

  4. jiHymas says:

    Ergo, I have to think the minimum yield guarantee has very limited significance in a callable scenario

    The holder of such an issue will have outperformed his non-floored counterparts IF the price of the non-floored preferreds declines. I think that’s the crux of the matter, but my question is: why should we forecast such a decline?

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