MAPF Portfolio Composition : June, 2019

Turnover ticked up a little to a still anemic 1% in June, as the fund is now ‘all-in’ on FixedResets, particularly those with a low Issue Reset Spread. There were a few trades beginning to look interesting on the strong day June 28; if the buying pressure exhibited at the close remains in effect in the coming week, there may well be more trading to report next month!

There is extreme segmentation in the marketplace, with OSFI’s NVCC rule changes in February 2011 having had the effect of splitting the formerly relatively homogeneous Straight Perpetual class of preferreds into three parts:

  • Unaffected Straight Perpetuals
  • DeemedRetractibles explicitly subject to the rules (banks)
  • DeemedRetractibles considered by me, but not (yet!) by the market, to be likely to be explicitly subject to the rules in the future (insurers and insurance holding companies)

This segmentation, and the extreme valuation differences between the segments, has cut down markedly on the opportunities for trading.

To make this more clear, it used to be that there were 70-odd Straight Perpetuals and I was more or less indifferent as to which ones I owned (subject, of course, to issuer concentration concerns and other risk management factors). Thus, if any one of these 70 were to go down in price by – say – $0.25, I would quite often have something in inventory that I’d be willing to swap for it. The segmentation means that I am no longer indifferent; in addition to checking the valuation of a potential buy to other Straights, I also have to check its peer group. This cuts down on the potential for trading.

And, of course, the same segmentation has the same effect on trading opportunities between FixedReset issues.

I have argued for a long time that insurers will become covered by NVCC rules similar to the banks, but regulatory process on the issue is very slow.

As a result of prior delays, I initially extended the Deemed Maturity date for insurers and insurance holding companies by three years (to 2025-1-31), in the expectation that when OSFI finally does provide clarity, they will allow the same degree of lead-in time for these companies as they did for banks. This had a major effect on the durations of preferred shares subject to the change but, fortunately, not much on their calculated yields as most of these issues were either trading near par when the change was made or were trading at sufficient premium that a par call was expected on economic grounds. However, with the declines in the market over the past nine months, the expected capital gain on redemption of the insurance-issued DeemedRetractibles has become an important component of the calculated yield.

In December, 2018, I extended the DeemedMaturity date for insurance issues by another five years, to 2030-1-31.

The new date has been chosen with the idea that a decision will be made by the IAIS (International Association of Insurance Supervisors) in 2019, and (if favourable) will be implemented with an 11-year grace period, similarly to the banks. We shall see just how accurate these suppositions might be!

I must emphasize that these extensions do not give rise to any desire on my part to alter the fundamentals of my analysis. It is simply a reaction to the excessive time the regulators are taking to discuss the issue.

Sectoral distribution of the MAPF portfolio on June 28 was as follows:

MAPF Sectoral Analysis 2019-6-28
HIMI Indices Sector Weighting YTW ModDur
Ratchet 0% N/A N/A
FixFloat 0% N/A N/A
Floater 0% N/A N/A
OpRet 0% N/A N/A
SplitShare 0% N/A N/A
Interest Rearing 0% N/A N/A
PerpetualPremium 0% N/A N/A
PerpetualDiscount 0% N/A N/A
Fixed-Reset Discount 46.3% 5.71% 14.50
Deemed-Retractible 0% N/A N/A
FloatingReset 0% N/A N/A
FixedReset Premium 0% N/A N/A
FixedReset Bank non-NVCC 0% N/A N/A
FixedReset Insurance non-NVCC 40.8% 9.27% 8.42
Scraps – Ratchet 1.4% 7.17% 13.87
Scraps – FixedFloater 0% N/A N/A
Scraps – Floater 0% N/A N/A
Scraps – OpRet 0% N/A N/A
Scraps – SplitShare 0% N/A N/A
Scraps – PerpPrem 0% N/A N/A
Scraps – PerpDisc 0% N/A N/A
Scraps – FR Discount 10.3% 7.16% 12.51
Scraps – DeemedRet 0% N/A N/A
Scraps – FloatingReset 0.7% 8.17% 11.22
Scraps – FR Premium 0% N/A N/A
Scraps – Bank non-NVCC 0% N/A N/A
Scraps – Ins non-NVCC 0% N/A N/A
Cash +0.4% 0.00% 0.00
Total 100% 7.33% 11.72
Totals and changes will not add precisely due to rounding. Cash is included in totals with duration and yield both equal to zero.
The various “Scraps” indices include issues with a DBRS rating of Pfd-3(high) or lower and issues with an Average Trading Value (calculated with HIMIPref™ methodology, which is relatively complex) of less than $25,000. The issues considered “Scraps” are subdivided into indices which reflect those of the main indices.
DeemedRetractibles are comprised of all Straight Perpetuals (both PerpetualDiscount and PerpetualPremium) issued by BMO, BNS, CM, ELF, GWO, HSB, IAG, MFC, NA, RY, SLF and TD, which are not exchangable into common at the option of the company or the regulator. These issues are analyzed as if their prospectuses included a requirement to redeem at par on or prior to 2022-1-31 (banks) or 2030-1-31 (insurers and insurance holding companies), in addition to the call schedule explicitly defined. See the Deemed Retractible Review: September 2016 for the rationale behind this analysis.

Note that the estimate for the time this will become effective for insurers and insurance holding companies was extended by three years in April 2013, due to the delays in OSFI’s providing clarity on the issue and by a further five years in December, 2018.

Calculations of resettable instruments are performed assuming a constant GOC-5 rate of 1.34% and a constant 3-Month Bill rate of 1.66%

The “total” reflects the un-leveraged total portfolio (i.e., cash is included in the portfolio calculations and is deemed to have a duration and yield of 0.00.). MAPF will often have relatively large cash balances, both credit and debit, to facilitate trading. Figures presented in the table have been rounded to the indicated precision.

Credit distribution is:

MAPF Credit Analysis 2019-6-28
DBRS Rating Weighting
Pfd-1 0
Pfd-1(low) 0
Pfd-2(high) 23.3%
Pfd-2 33.7%
Pfd-2(low) 30.0%
Pfd-3(high) 3.7%
Pfd-3 4.8%
Pfd-3(low) 3.3%
Pfd-4(high) 0%
Pfd-4 0%
Pfd-4(low) 0%
Pfd-5(high) 0.7%
Pfd-5 0.0%
Cash +0.4%
Totals will not add precisely due to rounding.
The fund holds a position in AZP.PR.C, which is rated P-5(high) by S&P and is unrated by DBRS; it is included in the Pfd-5(high) total.
A position held in INE.PR.A is not rated by DBRS, but has been included as “Pfd-3” in the above table on the basis of its S&P rating of P-3.

Liquidity Distribution is:

MAPF Liquidity Analysis 2019-6-28
Average Daily Trading Weighting
<$50,000 3.4%
$50,000 – $100,000 82.2%
$100,000 – $200,000 8.9%
$200,000 – $300,000 5.1%
>$300,000 0%
Cash +0.4%
Totals will not add precisely due to rounding.

The distribution of Issue Reset Spreads is:

Range MAPF Weight
<100bp 0%
100-149bp 25.7%
150-199bp 26.9%
200-249bp 28.7%
250-299bp 10.4%
300-349bp 0.9%
350-399bp 1.2%
400-449bp 1.8%
450-499bp 1.2%
500-549bp 1.3%
550-599bp 0%
>= 600bp 0%
Undefined 1.9%

Distribution of Floating Rate Start Dates is shown in the table below. This is the date of the next adjustment to the dividend rate, if the issue is currently paying a fixed rate for a limited time; which in practice is successive terms of 5 years. Issues that adjust quarterly are considered “Currently Floating”.

Range MAPF Weight
Currently Floating 3.4%
0-1 Year 11.0%
1-2 Years 46.9%
2-3 Years 25.5%
3-4 Years 12.2%
4-5 Years 0.7%
5-6 Years 0%
>6 Years 0%
Not Floating Rate 0.4%

MAPF is, of course, Malachite Aggressive Preferred Fund, a “unit trust” managed by Hymas Investment Management Inc. Further information and links to performance, audited financials and subscription information are available the fund’s web page. The fund may be purchased either directly from Hymas Investment Management or through a brokerage account at Odlum Brown Limited. A “unit trust” is like a regular mutual fund, but are not sold with a prospectus. This is cheaper, but means subscription is restricted to “accredited investors” (as defined by the Ontario Securities Commission). Fund past performances are not a guarantee of future performance. You can lose money investing in MAPF or any other fund.

A similar portfolio composition analysis has been performed on the Claymore Preferred Share ETF (symbol CPD) (and other funds) as of July 31, 2017, and published in the August, 2017, PrefLetter. It is fair to say:

  • MAPF credit quality is much better
  • MAPF liquidity is lower
  • MAPF Yield is higher
  • Weightings
    • MAPF is much less exposed to Straight Perpetuals
    • Neither portfolio is exposed to Operating Retractibles (there aren’t too many of those any more!)
    • MAPF is equally exposed to SplitShares (that is to say, currently no exposure)
    • MAPF is less exposed to FixFloat / Floater / Ratchet
    • MAPF is significantly higher weighted in FixedResets, with a much greater emphasis on lower-spread and insurance issues

5 Responses to “MAPF Portfolio Composition : June, 2019”

  1. misha says:

    Hello, James.

    Would it be possible for you to walk your readers through the reasoning for low issue reset spread logic? Or point to a prior article where you discussed it?

    Is it because most of those issues are trading at the same current yield, which means that the LRS issues are now at a lower price, which means that if rates reset higher then the incremental coupon increase is being applied over a lower unit price, which means the current yield will rise more than the rise for HRS issues? Which in turn will lead to capital appreciation once current yields equalize?

    Thanks in advance.

  2. skeptical says:

    While you wait for James’ response, here are my two cents.
    IMHO, there’s a very solid rationale for holding rate reset preferreds with lower spreads.

    Right now the resets with low spreads(less than 180 bps) are trading at roughly half the par price. As and when the GOC 5 year yield rises, these issues will become immensely attractive as companies begin to recall higher spread issues as well as higher coupon perpetuals. As the interest rates rise, these issues will get towards their par price.

    The primary risk- when would interest rates normalize? If the rates don’t normalize for several more years, expect this under-performance to continue. But if the interest rates move towards normalcy, say 3 to 4 per cent or higher for GOC 5 year, you will see a rapidly rising preferred market.
    But such a move could cause problems in both bond markets and stock markets (see the late 2018 market moves for rising rates and Fed tightening).

  3. misha says:

    @skeptical, if high spread issues being called soonish is the motivation, why wouldn’t I want to buy those instead for the high capital gain IRR?

    I read James’ volatility missive again ( gaining only slightly more understanding upon each read. I still don’t get the volatility bit but at least I’m on board with the pure price (P)

    I get that P = 25 * (G+I)/(G+M), where I is issue spread and M is market spread. Oh, wait, I think I vaguely figured it out, at least for pure price. Today, say for TRP.PR.B, market spread is 3.3% (CY=4.7%, GOC=1.4%). I is 1.28%. Theoretical PP is $14.37. If GOC5 rises to let’s say 3%, pure price will rise to $17.09, if market spreads stay the same. That’s an 18.9% gain.

    In contrast, TRP.PR.D, with its higher market spread and issue spread would rise only by 12.7%.

    This of course ignores volatility, which means I’m probably drawing the wrong conclusions.

    It also ignores the nearly 5 years of additional dividends for TRP.PR. (aka Excess Payments) in James’ essay, because I’m not sure how to treat those cashflows (other than just reducing the current price as if those excess payments arrived today).

    But GOC5 stays fixed, then I’d rather buy TRP.PR.D with its higher IRS. Why? On 4/30/2024, rate will reset to 1.4%+2.38%, dividend will be $0.95. But I would have collected $4.75 of dividends in the meantime. Neglecting PV, that would drop my cost basis to $16.40-$4.75 = $11.65, and I’ll be collecting $0.95 on it in perpetuity, for a yield of 8.1%. Repeating that calculation for TRP.PR.B, I end up with $0.67 div on cost basis of $11.00, for yield of 6.1%. I’ll take the former, thank you.

    I understand that this may be an artifact of the pricing for those two particular issues, but still even if GOC5 increases, TRP.PR.D will still maintain a future yield advantage.

  4. misha says:

    OK, my calculation was just dead wrong. I wasn’t counting TRP.PR.B’s extra dividends between its reset and TRP.PR.D’s resets. When that’s factored in, the two trade at a nearly identical “future yield” (7.9% vs 8.1%).

  5. jiHymas says:

    Would it be possible for you to walk your readers through the reasoning for low issue reset spread logic? Or point to a prior article where you discussed it?

    There are many elements to valuation as explained here.

    Right now the resets with low spreads(less than 180 bps) are trading at roughly half the par price. As and when the GOC 5 year yield rises, these issues will become immensely attractive as companies begin to recall higher spread issues as well as higher coupon perpetuals.

    I will note that the lower-spread issues, being lower-priced, are more highly leveraged to GOC-5 rate increases, since the GOC-5 rate is paid on par.

    Similarly, the leverage to a narrowing of market spreads is also higher in the lower-spread lower-priced issues.

    Of course, the leverage also works in reverse, which hasn’t been fun for the last nine months!

    HIMIPref™ does not explicitly ‘take a view’ on either the GOC-5 rate or market spreads; but, as noted in the link above, there is a component of reversion in the valuation algorithm.

    @skeptical, if high spread issues being called soonish is the motivation, why wouldn’t I want to buy those instead for the high capital gain IRR?

    Because a lot of the market improvement implicit in the concept of issues that are currently below par being called is soaked up by the value of the call option, which becomes increasingly negative as the price of the issue increases.

    Assuming that the improvement hits all issues equally, resulting in, say, a 5% price increase for a $23 issue, then you can say with a great deal of confidence that a $15 issue will have delivered much more than +5%.

    This is an example of negative convexity.

    But GOC5 stays fixed, then I’d rather buy TRP.PR.D with its higher IRS.

    Yes. Generally speaking, lower-spread, lower-price issues yield less. The reason for this is they have more upside because the embedded call on the issue is further away for them than the embedded call on a higher-spread, higher-price issue.

    If the market improves, the lower-spread, lower-price issue will increase in price more, as discussed above. However, if we assume the market is efficient (not always a wise assumption in the preferred share market!) then assuming equal risk (however that might be defined) there must be compensation for the higher-spread, higher-price issue. This compensation is realized in the ‘market unchanged’ scenario, where the higher yield of the higher-priced issue results in a higher total return.

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