It will be recalled that BMO.PR.S will reset At 3.852% effective May 25, 2019.
BMO.PR.S is a FixedReset, 4.00%+233, NVCC-compliant issue that commenced trading 2014-4-23 after being announced 2014-4-14. It is tracked by HIMIPref™ and is assigned to the FixedReset-Discount Sub-Index.
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., BMO.PR.S and the FloatingReset 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).
Click for Big
The market appears to have lost its fleeting interest in floating rate product; the implied rates until the next interconversion are above the current 3-month bill rate as the averages for investment-grade and junk issues are at +0.63% and +1.33%, 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 BMO.PR.S FixedReset, we may construct the following table showing consistent prices for its soon-may-be-issued FloatingReset counterpart given a variety of Implied Breakeven yields consistent with issues currently trading:
| Estimate of FloatingReset (received in exchange for BMO.PR.S) Trading Price In Current Conditions | |||||
| Assumed FloatingReset Price if Implied Bill is equal to |
|||||
| FixedReset | Bid Price | Spread | 1.50% | 1.00% | 0.50% |
| BMO.PR.S | 18.65 | 233bp | 18.63 | 18.13 | 17.62 |
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, BMO.PR.S. Therefore I recommend that holders of BMO.PR.S continue to hold the issue and not to convert. I will note that once the FloatingResets commence trading (if, in fact, they do) 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.
Those who wish to convert anyway are advised that the deadline for notifying the company of such a desire is 5:00 p.m. (EDT) on May 10, 2019. Brokers and other intermediaries generally set their internal deadlines a day or two in advance of this date, so if you wish to convert there’s no time to waste! Note that brokers will, in general, try to execute the instruction on a ‘best efforts’ basis if received between the two deadlines, provided that the procrastinating shareholder grovels entertainingly enough.
I asked this question once before and I’m trying again now.
Why do companies want to have a floating rate preferred stock?
Especially, 5 years after the initial offering?
Is it just another nice to have choice which is beneficial to them?
If they really want this, why not offer this early on, say at the time of offering itself?
Thanks so much for your educational responses!
I believe it’s just a gimmick.
I think James’ answer is the short one.
To understand their existence you need to go back about 10 years ago when fixed and floated resets were created. Back then, everyone was concerned with low rates due to the financial crisis and thought that we would have a high inflation because of dubious assets being bought at inflated prices by central banks. As a response to these concerns, financial institutions have created fixed reset and floated reset preferred shares. Because everyone likes predictability and the companies that issue preferred shares want to have all the aces in their hands the floated shares were offered only at the renewal time when a company has the possibility to recall them if it does not like the new rate. Think about what could have happened for a company if floated shares were issued from the beginning and there was a rampant inflation.
A few years later in 2015-16 when people were concerned the fixed reset preferred shares would renew at a lower rate than the initial one, the financial industry came out with a new product: fixed reset preferred shares with a minimum reset rate. There is no problem for a company. If it does not like the new reset rate the preferred share will be recalled and the new one at the minimum rate would be issued. In this game the (issuing) companies have all aces in the their hands, the buyers assume all risks, and even the pros, like James, have a hard time.
I have had a couple of floating preferred shares and have been quite happy with the results, but I bought them when no one wanted them. I am not sure what I will do at the renewal time. A floated preferred share will have a hard time during a crisis and we have not had one in the last ten years. Anyway I think that a floated preferred share could be quite useful at the right time. The problem is we live in an unseen times.
“I have had a couple of floating preferred shares and have been quite happy with the results, but I bought them when no one wanted them.”
This is a variant of another simple answer – i.e. that they exist to create opportunities for arbitrage by finance professionals and saavy investors. Yet one more way for the financial industry to extract a tax from wealth owners.
Thanks for the wonderful answers.
Think about what could have happened for a company if floated shares were issued from the beginning and there was a rampant inflation.
This is so very true…All the flexibility for the issuer and the preferred stock owner as the ultimate bagholder. But the risk to the company would still exist if runaway inflation becomes a problem after the conversion. I could be mistaken, but the conversion options exist only every 5 years. But then, the company would merely pay the ‘market rate’ for a few years and then redeem it. At least in Canada, the redemption mechanism and pricing is clearly detailed in term sheets, unlike say UK where there was a huge ruckus related to Aviva preference shares.
This is a variant of another simple answer – i.e. that they exist to create opportunities for arbitrage by finance professionals and saavy investors. Yet one more way for the financial industry to extract a tax from wealth owners.
This is a simple but very accurate observation.
Think about what could have happened for a company if floated shares were issued from the beginning and there was a rampant inflation.
Most of them would have been called at the always applicable FloatingReset redemption price of 25.50!
If it does not like the new reset rate the preferred share will be recalled and the new one at the minimum rate would be issued.
Yes. This highlights the major problem with the structure: the call lock-out period is only five years (or, sometimes, six and a half at issue time).
And the aggravating thing is that people love this! They are very happy with the concept that the issuer has a call after only five years, pleased that it’s a shorter lockout than the 9-years for a par call on the standard Straight Perpetual structure. It means their money isn’t tied up for so long!
And this extends to so-called professionals, as well. I had one guy tell me – and this guy runs a hell of a lot more money than I do – that he preferred to buy shares priced in the $21-23 range, precisely because of the higher call probability relative to that horrible sub-$20 crap.
When I expostulated (as diplomatically as I could, because I was wearing my salesman’s hat at the time), he said it didn’t matter to him, because he – being so much superior to me – didn’t restrict his practice to preferred shares and could reinvest the money in other asset classes.
And such is the calibre of Canadian retail investment management … and quite a bit of the institutional side, for that matter.
they exist to create opportunities for arbitrage by finance professionals and saavy investors.
There are certainly times when a knowledge of the theory of ‘Strong Pairs’ can come in useful, certainly. But I will point out that issuers can take whatever type and degree of risk they want at little cost, regardless of investor conversion choices, through the use of Interest Rate Swaps.