There was no announcement from Brookfield Renewable Partners L.P., but BEP.PR.M closed today.
BEP.PR.M is a FixedReset 5.00%+300M500 ROC announced 2018-01-09. The issue will be tracked by HIMIPref™ but relegated to the Scraps subindex on credit concerns.
The issue traded 437,036 shares today in a range of 24.75-00 before closing at 24.99-00. Vital statistics are:
| BEP.PR.M | FixedReset | YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2048-01-16 Maturity Price : 23.14 Evaluated at bid price : 24.99 Bid-YTW : 4.92 % |
This issue looks quite expensive to me, but quantifying the degree of richness is difficult. According to Implied Volatility Analysis:
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Well, it’s starting to get monotonous, but we see in this chart many of the same features we saw when reviewing the recent BIP new issue as well as last week’s BEP issue, the CM issue and NA issue:
- The curve is very steep, with Implied Volatility equal to 40% (a ridiculously large figure), and
- The extant issues are trading relatively near to, or well above par
The ludicrously high figure of Implied Volatility is something I take to mean that the underlying assumption of the Black-Scholes model, that of no directionality of prices, is not accepted by the market; in turn, I suggest that this reflects a rather touching faith that the existence of a minimum rate guarantee on reset also indicates that the issues will never, ever trade below par. There will be a lot of long faces when this test gets failed in the future! All it will take is a spread-widening, whether market-wide or company-specific.
However, for the long term, I suggest that any change in the slope of the curve will be a flattening, with a very high degree of confidence. This will imply that the higher-spread issues will outperform the lower-spread issues.
Complicating the above analysis is a high probability that the three extant issues will each be called at the first opportunity. I will certainly agree that this is likely to happen, but I balk at ascribing a 100% probability to this outcome. There may still be a few old geezers amongst the Assiduous Readers of this blog who can still (faintly) remember the Great Bear Market of 2014-16, in which quite a few similar assumptions made earlier turned out to be slightly inaccurate.
All told, though, I have no hesitation in slapping a ‘Very Expensive’ label on this issue. According to the analysis illustrated by the above chart, the fair price is 23.36.
Update: Demonstration – to prepare the following chart I have constrained Implied Volatility to 10% (a much more reasonable figure, I think) and done a very, very, rough approximation to the error-minimizing Market Spread.
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In this calculation, the calculated fair values for the issues BEP.PR.G / I / K / M, with the difference from the actual market price in brackets, are 27.11 (+1.56), 28.23 (+2.48), 25.29 (+0.20) and 22.53 (-2.46). The values for N(d2) are 72%, 88%, 41% and 7%, respectively.
See the comments for the discussion.
Update #2, 2018-1-23: From January’s PrefLetter, here are charts FR-16, FR-31 and FR-37 … the numbering is consistent with the Fixed Reset Review of October 2016 that is referred to in the comments:
Chart FR-16, 2018-1-12
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Chart FR-31, 2018-1-12
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Chart FR-37, 2018-1-12
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See the comments for discussion.
To try to stay current, I will comment here on BEP new issue, when my calculations were about BIP (but probably apply to all these “overpriced” issues lately).
If you look at BIP A,B,C,D prefs that are outstanding, all have reset spreads much higher than the new issue (let’s call the new one BIP.PR.E). If I were to assume that BIP.PR.E is the “market level” with a reset yield of 3% + GOC-5, then all of BIP A,B,C,D should be evaluated as called on their reset date (assuming the market yields stay the same). When I do that calculation, all of the BIP YTWs are pretty close to 5%, so Pr.E might not be an outlier after all.
Is this a scenario you already consider when concluding Pr.E is expensive?
assume that BIP.PR.E is the “market level” with a reset yield of 3% + GOC-5, then all of BIP A,B,C,D should be evaluated as called on their reset date (assuming the market yields stay the same)
Yes, I think that is what the market is doing, or very nearly.
However, as I state in the post “I will certainly agree that this is likely to happen, but I balk at ascribing a 100% probability to this outcome.” The point of Implied Volatility analysis is to vary the Market Spread according to a normal distribution and see what happens.
The BEP FixedResets, G, I, K and M have Issue Reset Spreads of 447bp, 501bp, 382bp and 300bp respectively. According to the analysis, they have values of N(d2) which is the risk-adjusted probability of option exercise (see FixedReset Notes, October 2016, page 35 of the PDF) of 86%, 89%, 81% and 72%, respectively, when evaluated with the parameters specified on the chart.
The assumption of directionality in Market Spreads (i.e., that all issues with Issue Spreads of greater than X will be called, full stop) is what breaks the model and leads to the unrealistic calculation of a 40% Implied Volatility.
I claim that the actual Volatility of the Market Spread should much less than 40%, that the values of N(d2) are all too high; hence the plotted curve should have a shallower slope, hence the fair price of the higher-spread issues is being underestimated by the market; since in the event of a dramatic widening of the Market Spread, the lower spread issues will be trading at an arbitrarily large discount to par, while the higher spread issues will be trading at a much lower discount in the event they are not called.
I’ve updated the main post with a demonstration calculation that constrains Implied Volatility to 10%.
OK, thanks for the detailed explanation.
Now, if the market spread is 300 bp instead of 350 in the 2nd chart, won’t the probabilities of call increase even further?
My point is that the market doesn’t have to guess at the “directionality of market spreads” or interest rates to have a high apparent “volatility” parameter, all the market has to do is assume spreads & rates remain static. So the “directionality” assumed = 0 (and the volatility assumed by the market is also zero). No directionality is not an aggressive assumption, although, as you point out in the Fixed Reset PDF, no volatility is not appropriate for potentially perpetual issues.
However, the market assumption (inappropriate or not) is also likely to be the pricing assumption at the time of reset, not the “market spread” from the volatility calculation.
In addition, the use of “expected future current yield” as the y-axis doesn’t seem to address the high probability that, in this case, nobody can realize that yield because the issue will have been called. Use of the term “expected” implies that call probability has been factored in, but it is more like “future current yield if not called”. YTW would be around 5%. If not called until the 2nd next reset, it would be somewhat higher and a probability weighted future yield would be more like 5.3% for the large reset yields.
I also see in figure FR-16 of the PDF that it is not unusual for YTW to be flat with reset spread, so that is the environment new issues seem to be priced in and it remains an open question whether they would migrate to the values suggested by the volatility/market spread model.
Now, if the market spread is 300 bp instead of 350 in the 2nd chart, won’t the probabilities of call increase even further?
That will depend on the volatility of that spread. Remember that the spread quoted is for a theoretical non-callable perpetual annuity income stream (see the definition “Pure Price” on page two of the 2016 version of Implied Volatility FixedResets essay). For this issue, given a Market Spread of 145bp and an actual Issue Reset Spread of 300bp (and a minimum reset!) for this issue, we may say that the issuer is paying 155bp p.a. for the embedded options. And I say that ain’t enough.
My point is that the market doesn’t have to guess at the “directionality of market spreads” or interest rates to have a high apparent “volatility” parameter, all the market has to do is assume spreads & rates remain static.
I would consider that a form of directionality, since you’re assuming a fixed end-point on the Call Date. But it’s just a matter of definition.
However, the market assumption (inappropriate or not) is also likely to be the pricing assumption at the time of reset, not the “market spread” from the volatility calculation.
At the time of reset the issuer knows whether his option is in the money or not. There is no need for any assumption.
In addition, the use of “expected future current yield” as the y-axis doesn’t seem to address the high probability that, in this case, nobody can realize that yield because the issue will have been called.
Well, yeah, but “Expected Future Current Yield” is already a pretty big mouthful and I didn’t want to make the label any longer!
I also see in figure FR-16 of the PDF that …
Sorry, figure FR-16 of which PDF?
Sorry, been away a few days.
Fixed Reset Notes Oct 2016 is referenced in your first reply (2nd comment here) and is the PDF I was referring to.
Keep up the good work!
I also see in figure FR-16 of the PDF that it is not unusual for YTW to be flat with reset spread,
As Prefhound noted, he is referring to Chart FR-16 of the FixedReset Notes for October 2016, originally published in PrefLetter.
Chart FR-16 is a little misleading and requires more explanation. The problem is the special nature of bank issues and their fortuitous Issue Reset Spreads, which lead to the appearance of YTW being flat against increasing Issue Reset Spread.
Chart FR-37 disaggregates the data, displaying only Pfd-2 issues for which the Yield-to-Worst Scenario is existence to perpetuity, while presenting the banks and non-banks as separate series. It may be seen that both series have an increasing slope, indicating the influence of options.
Chart FR-31 shows data for all Pfd-2 (re-aggregated) and Pfd-3 issues which meet the ‘YTW = Perpetuity’ condition. It is clear that the re-aggregated Pfd-2 group has no correlation (as hinted for the ‘high-quality’ subset pictured in Chart FR-16), while there is a reasonable correlation for the Pfd-3 group.
A possible objection to this is that in the latter two charts I am restricting the data to (essentially) issues trading at a discount to par, but I don’t think that matters.
Why does one buy a premium issue? Barring gross mispricing, it’s because you want the thing to be called. You are expecting it to be called. What you want is the interim coupons and the par value on the call date and you’re happy.
So consider two issues, one with an Issue Reset Spread of 400bp and the other with an IRS of 500bp. Clearly – all else being equal – you have greater confidence that the latter issue will be called. There is more certainty regarding the outcome of the investment, therefore, you must be willing to accept a lower YTW. However – barring very strange circumstances at the two issue dates or prior resets – the coupon of the latter issue will be much higher than the former issue’s. Therefore, we normally expect the latter issue to trade with a lower YTW and a higher Current Yield.
It’s important to keep the distinction between the two metrics firmly in mind.
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