PrefBlog

Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close June 28, 2019, was $8.0896 after a dividend distribution of 0.097735.

It should be noted that June 28 was a very strong day, with a lot of closing prices – but not closing bids! – being boosted by a large number of market-on-close orders.

Since MAPF uses the closing bid for valuation purposes, its reported value did not receive the full value of the boost experienced by the indices and of all prospectus-based funds of which I am aware; for instance, the fund has a large position in HSE.PR.A, which the fund values at its closing bid of 12.48, not at the closing price of 13.30. The cumulative effect of these discrepancies represents well over 1% of fund value.

I rarely mention this pricing discrepancy between the fund and the indices – it’s all just noise and it all evens out over time – but this month the difference was egregious! Still, regardless of whether the June 28 rally is sustained throughout July, the prospects for outperformance vs. the indices in the coming month looks bright!

MAPF returns assume reinvestment of dividends, and are shown after expenses but before fees. Past performance is not a guarantee of future performance. You can lose money investing in Malachite Aggressive Preferred Fund or any other fund. For more information, see the fund’s main page. The fund is available either directly from Hymas Investment Management or through a brokerage account at Odlum Brown Limited.

The preferred share market has suffered a sharp reverse in the past five months, leaving a lot of room for outsized gains. The Seniority Spread (the interest-equivalent yield on reasonably liquid, investment-grade PerpetualDiscounts less the yield on long term corporate bonds) is extremely elevated (chart end-date 2019-6-14)

Note that the Seniority Spread was 385bp on June 26, an astonishing 40bp wider than reported at the end of May. As a good practical example of the spreads between markets, consider that on March 20 the redemption of IGM.PR.B was announced; the redemption of this 5.90% Straight Perpetual was explicitly financed by the issue of 4.206% debentures, implying a Seniority Spread for this issuer of about 350bp at that time.

… and the relationship between five-year Canada yields and yields on investment-grade FixedResets is also well within what I consider ‘decoupled panic’ territory (chart end-date 2019-6-14):

In addition, I feel that the yield on five-year Canadas is unsustainably low (it should be the inflation rate plus an increment of … 1%? 1.5%? 2.0%?),and a return to sustainable levels is likely over the medium term.

It seems clear that many market players are, wittingly or not, using FixedResets to speculate on future moves in the Canada 5-Year yield. This is excellent news for those who take market action based on fundamentals and the long term characteristics of the market because nobody can consistently time the markets. The speculators will, over the long run, lose money, handing it over to more sober investors.

FixedReset (Discount) performance on the month was +1.37% vs. PerpetualDiscounts of +0.40% in June; the two classes finally decoupled in mid-November after months of moving in lockstep, but it still appears to me that yields available on FixedResets are keeping the yields of PerpetualDiscounts up, even though a consistent valuation based on an expectation of declining interest rates would greatly increase the attractiveness of PerpetualDiscounts:

Floaters got hammered again, returning -2.46% for June and -35.51% for the past twelve months. Look at the long-term performance:

Some Assiduous Readers will be interested to observe that the ‘Quantitative Easing’ decline was not as bad as the ‘Credit Crunch’ decline, which took the sector down to the point where the 15-year cumulative total return was negative. I wrote about that at the time and still can’t get over it. Fifteen years! Not only that, but the total return on this index since 2003-11-28 has been zero! Just over fifteen and a half years!

It seems clear that Floaters are used, wittingly or otherwise, as a vehicle for speculation on the policy rate and Canada Prime, while FixedResets are being used as a vehicle for speculation on the five-year Canada rate. In support of this idea, I present an Implied Volatility analysis of the TRP series of FixedResets (as of June 27, because I believe these quotes to be more reliable than those of June 28, as discussed above), which is comprised of six issues without a Minimum Rate Guarantee and two issues which do have this feature:

The two issues with floors, TRP.PR.J (+469, minimum 5.50%) and TRP.PR.K (+385, minimum 4.90%) are $2.58 and an incredible $4.00 rich, respectively and marked increases from last month, despite the fact that their floor will not become effective unless five-year Canadas dip below 0.81% and 1.05%, respectively. For all the gloom, we’re still a long way from those levels!

As for the future, of course, it’s one thing to say that ‘spreads are unsustainable and so are government yields’ and it’s quite another to forecast just how and when a more economically sustainable environment will take effect. It could be years. There could be a reversal, particularly if Trump’s international trade policies cause a severe recession or even a depression. And, of course, I could be just plain wrong about the sustainability of the current environment.

Yields on preferred shares of all stripes are extremely high compared to those available from other investments of similar quality. A I told John Heinzl in an eMail interview in late November, the best advice I can offer investors remains Shut up and clip your coupons!

I think that a broad, sustainable rally in FixedResets will require higher five-year Canada yields (or a widespread expectation of them) … and although I’m sure this will happen eventually, it would be foolish to speculate on just when it will happen!

These calculations were performed assuming constant contemporary GOC-5 and 3-Month Bill rates, as follows:

Significant positions were held in NVCC non-compliant regulated FixedReset issues on June 28, 2019; all of these currently have their yields calculated with the presumption that they will be called by the issuers at par prior to 2022-1-31 (banks) or 2030-1-31 (insurers and insurance holding companies) or on a different date (SplitShares, when present in the portfolio) This presents another complication in the calculation of sustainable yield, which also assumes that redemption proceeds will be reinvested at the same rate. It will also be noted that my analysis of likely insurance industry regulation as updated is not given much weight by the market.

I will also note that the sustainable yield calculated above is not directly comparable with any yield calculation currently reported by any other preferred share fund as far as I am aware. The Sustainable Yield depends on:
i) Calculating Yield-to-Worst for each instrument and using this yield for reporting purposes;
ii) Using the contemporary value of Five-Year Canadas to estimate dividends after reset for FixedResets. The assumption regarding the five-year Canada rate has become more important as the proportion of low-spread FixedResets in the portfolio has increased.
iii) Making the assumption that deeply discounted NVCC non-compliant issues from both banks and insurers, both Straight and FixedResets will be redeemed at par on their DeemedMaturity date as discussed above.

This entry was posted on Monday, July 1st, 2019 at 4:56 pm and is filed under MAPF. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.