Research: Break-Even Rate Shock (PrefLetter Version)

Investors will often purchase FixedResets in preference to PerpetualDiscounts because “there is better inflation protection”. In this essay, published as an appendix to the June, 2009, PrefLetter, I attempt to quantify and discuss this effect.

The related Break-Even Rate Shock Calculator has been published previously, as has the Moneyletter version of this discussion.

Look for the research link!

15 Responses to “Research: Break-Even Rate Shock (PrefLetter Version)”

  1. stusclues says:

    The relationship between Fixed Reset yields and Perpetual Discount yields is currently broken, with PDs yielding much lower than they should (eg. BAM, FTS). This seems more evidence that FRs are way too cheap. What do you make of it James?

  2. jiHymas says:

    This seems more evidence that FRs are way too cheap. What do you make of it James?

    I’m leaning towards the view that the relationship between the two classes is largely influenced by interest rate anticipation: when bond yields are expected to increase, this will be reflected in market prices, but not in the calculations I make regarding yield (which assumes constant bond yields). And now, I suspect, there is widespread expectation of a decline in bond yields, so my presumed reset rates, and therefore yields on FixedResets, are higher than what the market is using.

    In other words, I suspect that the market is attempting to maintain a fixed relationship between FixedReset and PerpetualDiscount yields, where is is using a forecast rate for GOC-5 to calculate FR yields that may be significantly different from the market rate.

    It’s a difficult hypothesis to test!

  3. skeptical says:

    IMHO, there is an inversion in the yield curve of preferreds.
    Perpetuals are getting priced off of the long bond while the fixed resets are getting priced off of 5 years. That’s why the curves are inverted with Fixed Resets yielding more than the perpetuals. That’s what the yield curve for pretty much all bonds indicate at this moment and it has made its way to the preferreds.
    OTOH, a case could be made that because of the macro factors and the energy policies of various governments, we are unlikely to see the extreme low rates we saw in the past. Should that happen, the fixed resets will get fundamentally repriced and jump much higher than where they are. When will that happen? Hard to say. But it’s a solid possibility and is much more in tune with the economic fundamentals.
    If the higher rates remain sticky, e.g. a year or two, we will see this scenario unfold.

  4. stusclues says:

    “It’s a difficult hypothesis to test!”

    Is it ever!

    The market narrative that suggests CBs will go too far with their increases, cause a serious (rather than mild) recession and then have to reduce rates, perhaps significantly, may happen, maybe it won’t. There are lots of other possibilities, not improbably one where CBs are mostly successful and rates can stop increasing but don’t have to be reduced much.

    If the preferred share market actors want to price off of their yield curve expectations, I’ll bet against that all day long.

  5. jiHymas says:

    If the preferred share market actors want to price off of their yield curve expectations, I’ll bet against that all day long.

    You ‘n’ me both, brother, you ‘n’ me both.

  6. hrseymour says:

    I agree with James about there being a disconnect.

    FR prices appreciated in lock step with the GOC-5 yield in 2021 as the “ice age” threat (of permanently near zero interest rates) subsided. There was a bizarre Minsky Moment at the beginning of 2022 when FR prices suddenly started to decline as the GOC-5 yield continued to increase!

    It can be partially explained by the FR rates being temporarily locked into “ice age” values (until they reset). But, IMHO, the real explanation is the fear that surging interest rates will crush the (Canadian) economy resulting in a new “ice age” starting in maybe 2024. As evidence, look at how comparatively highly FRs with guaranteed minimums are priced, even though these minimums now seem nearly worthless.

    Note that this phenomena seems to limited to Canada. Rate resets are beginning to appear in the US, and they do not appear to be subject to this (irrational?) fear. See KEY-L, for example.

  7. skeptical says:

    Rate resets are beginning to appear in the US, and they do not appear to be subject to this (irrational?) fear. See KEY-L, for example.
    They are perhaps new in the game. Either they’ll prove to be prescient or learn their lessons when rates get cut again. we’ll find out in due course.

    Go back to circa 2010, the early days of rate resets in Canada, when spreads of about 1.5 for investment grades were sold at $25 and favorably received by the markets.

    This post by James is particularly insightful recap of the situation back in 2010 and contrasts with the perpetuals.

    https://prefblog.com/?p=10968

    Some of the minimum rate resets are trading close to par, especially the (ENB, BEP, BIP and PPL issues) because of their somewhat earlier call dates, happening within 6 months. Based on the latest PPL redemption, the market is speculating that these will be redeemed, hence the rise in prices.

    If the shift in the rates is secular, then the rate resets are a deep bargain.

  8. Nestor says:

    “If the shift in the rates is secular, then the rate resets are a deep bargain.”

    my view is we are now in a secular bear market for bonds (and by extension stocks). rates won’t go back down that low again. recession or no recession. this will last at least a decade. maybe longer. just my opinion.
    doesn’t change how i will invest in prefs. have an allocation. buy the recommendations suggested in your monthly Prefletter and life goes on.

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