In October, 2010, it became apparent that the market was ascribing increased importance to Implied Volatility Theory as it applied to Straigh Perpetuals. In this essay, I review the evidence supporting this statement and consider the investment implications of this increased sophistication.
Look for the research link!
A lot of perpetuals are about to pierce through pandemic lows.
Some REITs are also rapidly approaching those levels.
IMHO, we are likely to test those lows for almost every asset class in the coming weeks and months.
We had a number of REITs that lost more than a year’s worth of dividends today. A number of prefs had similar per share losses as well. It might appear that we’re at, or maybe near the bulk of the “capitulation” trade…however, we still have 1 or 2 75bp hikes in Canada, and probably at least one more in the USA. It’s hard to imagine the REIT space getting into the 10%+ div category…but it was hard to see prefs get to 7 as well. Idk…there’s a lot of tempting stuff out there now; question is how long we need to sidestep the bear traps 🪤!
The only thing is the point at which things will fall apart completely so that the inflation concern is overridden by the asset deflation concerns. We are marching in that direction quite rapidly. Once unemployment reaches a higher number, say 6% and new jobs disappear, most people’s spending habits will change. Plans for new cars, housing, vacation, travel, appliances, renovations etc. will be shelved. And combine that with higher rates for mortgages, lines of credit and collapsing asset prices, the overall mood will turn quite sombre.
That’s what the central banks want to do. The only question is where would they stop. S&P 3300?2800?Pandemic lows? Trump inauguration? Who knows where they feel enough pressure or political pain.
In such a setup, yields on preferreds will keep on increasing and we might end up with 6.5/7 or even higher rates.
Would it be permanent?
Would it be followed by massive rate cuts.
Rest of the year will be interesting.
I’ve been buying more trp.pr.a and other preferreds. They’ve been losing trades so far. ratchetrick’s comments above are correct, we should wait for a bottom. Unfortunately, it’s easier said then done.
I’ve been buying more trp.pr.a and other preferreds. They’ve been losing trades so far. ratchetrick’s comments above are correct, we should wait for a bottom. Unfortunately, it’s easier said then done.
we should wait for a bottom. Unfortunately, it’s easier said then done.
Attempting to find a market bottom is a fool’s game. When executing a trade will help you to meet, or even exceed, your portfolio objectives, execute it. Don’t go chasing a will o’ the wisp, because you’ll just get lost in a swamp.
Your ‘bird in the hand’ approach is very prudent.
i have been easing into the perpetual prefs lately. some of the insurance prefs are near 6% (7.8% interest equivalent). with 10 and 20 year canada bonds at 3.5%, that’s a spread of 4.3% after tax.
might they go lower? sure. maybe the market figures out we’re going into recession and rates have peaked? sure.
i don’t know. i don’t care. i’ll happily buy more if yields back up.
i patiently wait for James’ monthly newsletter to figure out what to do.
“When executing a trade will help you to meet, or even exceed, your portfolio objectives, execute it.”.
I do like this approach… not always easy to stick with it though.
Similarly to what Nestor said earlier, even though it appears the MAPF doesn’t usually hold a high % of perpetuals, I have added quite a few of them of late since I do like the opportunity to own some of the investment grade names (Brookfield AM, Brookfield Renewable Partners to a lesser extent, Power Financial, Great-West Lifeco and a few others) at 6+%. We have even reached about 6.25% over the last few days.
The idea of getting this yield forever (as long as the companies remain solvent obviously) does fit my investment strategy and even greatly exceeds what I was targeting before the preferred shares market got pummeled.
I see this as a good opportunity for a mostly buy&hold investor. Maybe the last few years were an aberration with central banks keeping rates that low and the future will be very different but many preferred shares are trading at or close to their lowest ever (outside of black swan events like the subprime, dot.com and COVID crises) and I do not believe households or governments can withstand yields like we had in the 80s/90s.
Plus, developped economies are more mature and growth likely to remain muted.
Sure, yields can be even higher in the future but I am likely to gradually add to these positions and wait because this kind of yields + a real potentiel of price appreciation over the coming years is a solid investment in my opinion.
Granted, I am not saying anything original or enlightening but I just wanted to take part in this conversation 🙂
Although I fully respect the opinions of everyone who offers their thoughts here, I must say, after reading most of these posts … it seems most of you are trying to convince yourselves that losing massive amounts of account value by entering positions too early is “ok”. All I would respectfully offer is this: it’s not ok.
We have at least a few more large central bank hikes coming, and barring a sudden reversal in the price of oil (which imo, is the main contributor to the so-called “inflation” issue) … bonds, and perpetual prefs have not come anywhere near the bottom of this cycle.
6%+ is great, even tempting… but I think a little patience, and maybe some “market timing” (sorry, James) … is a better plan at this time. 7%+ is better than 6, and to get there , most prefs need to, and probably will lose another $2+ per share. Sorry to poo poo the long term investor thinking…but purposely losing principle is just not a good strategy imo.
Your point is valid, as always.
However, with Canada 1 year government bond yield at about 3.1%, I think the market has already priced in the fact that the BoC is likely to raise its key interest rate in the 2.75/3.0% range.
I believe what the market needs is a feeling that inflation has peaked or at least that the central banks can have some sort of handle on the situation and that things do not spiral out of control.
Although it fizzled very quickly, preferred shares had a nice run-up of +7/10% a few weeks ago so things can turn quickly.
You are right, maybe we can get 7% some time in the future but at this stage, maybe someone else would say that 8% is better than 7%, etc.
I am not saying that I will gladly accept a loss of $2/share (obviously not!) but I do not know where the bottom is and I believe that starting to get my feet wet at 6%+ is not a bad strategy.
You are right, oil is one of the drivers of the inflation issue and we are unlikely to see the war in Ukraine to be over anytime soon but I would say that if China can reopen some key parts of its economy in the near future and better deal with COVID, it will also help a lot.
This market is not driven by any fear of inflation in the strictest sense. If it were, we’d have the low resets trading at near par.
If this market were afraid of rising rates, the floaters would be way up in price. If BoC hikes next month by 75pbs, prime linked floaters would be yielding nearly 6%. If they hike even more, the party would keep on getting bigger. At 6% prime, these floaters would yield around 8%, based on today’s prices.
In this market, both the rate reset and perpetuals of CU that yield close to 6% get sold off on no real news.
This is a very strange market in which everything is getting sold. People are getting afraid, and when we talk of cowards, there are no bigger cowards than the preferred holders of Canada!
A while ago I spent time going through the posts on this blog from 2008. And this fall is eerily similar to that- every month leading to higher yields and lower prices. One difference- a complete lack of new issues. Perhaps because of the LRCNs on the financial side and the bond market holding on so well overall.
Should the bond market revolt, we are going to get some ugly sell offs in preferred market. We are off only about 10 to 12% from the peak.
No position has been safe this year other than cash or parts of energy. A typical 60/40 is down by around 23%. So are REITs. Crytpo/tech…you surely be joking Mr. Feynman.
For perpetuals, if one believes that inflation will be ultimately brought down and the companies remain solvent, it’s a decent play if one can’t or doesn’t want to be in cash.
For those timing the market, like ratchetrick , what’s your allocation plan? At what yields do you plan to deploy how much capital?
Indeed, I thought holding for example prime linked floaters would hedge against the weakness of perpetuals only to see all of them fall in tandem…
I’ve read a few articles stating that banks should avoid increasing their prime rate at the same pace as rate hikes from the BoC to avoid putting too much pressure on indebted companies/households.
I do not know if that is realistic or if it has happened in the past but it would hit prime prefs a lot but it does not make much sense in this fight against inflation.
To explain this “very strange market” as you label it, maybe we can say that holders of perpetuals sell because they are afraid of rising rates and those who hold rate reset fear a recession and lower rates in the future.
Also possible that some investors believe a crash in the stock market is coming and that if it were to happen, preferred shares would slump also.
Skeptical & Yomgui … you both raise very valid points, and present very valid concerns about the challenges in foreseeing where all this is heading. My allocation plan? Good question….here’s my approach as of this particular point in the saga:
As you guys have already pointed out, cash is the safest asset. Seems like it always has been, but we all understand that stagnant cash has no earning power on its own … right now, unfortunately, that’s a price I think prudent investors need to pay. The assorted geo political issues, combined with the rate hike mantra of the moment, all but ensure that market fear will not subside any time soon. And fear is far more powerful than greed. You’ve probably noticed how markets always take the elevator down, and the stairs up. For that reason alone, it’s unlikely anyone will miss the buying opportunities of the “bottom”, whenever that comes.
Skeptical, to answer your question more directly; I think I will no longer be able to resist the buying urge if, and when we see pref yields on resets , or perpetuals flirt with 7%. Right now , around 6%? Don’t think so … oil needs to come back down to earth to make inflationary downside a manageable risk imo. $109/bbl? Not what’s needed … maybe Biden’s possible tax thing on gasoline will trigger a turning point there…idk…we’ll see soon enough.
My bottom line is this: If the train’s entering the station…it’s best to get off the tracks. I’m totally uncomfortable right now with how Jerome, Tiff, Vladimir and all the other people influencing this situation are behaving. For all of those reasons….I’m out (for now)!
i’m less worried …
New York Fed model now projects NEGATIVE GDP growth for 2022 AND 2023
-0.6% 2022
-0.5% 2023
https://libertystreeteconomics.newyorkfed.org/2022/06/the-new-york-fed-dsge-model-forecast-june-2022/
“Conversely, the chances of a hard landing—defined to include at least one quarter in the next ten in which four-quarter GDP growth dips below -1 percent, as occurred during the 1990 recession—are about 80 percent.”
of course, just a few months before, they were predicting higher GDP.
so in their view, the economy is deteriorating very quickly. Good. bring on the recession.
Nestor . . . this little economic scurmish will usher some of the fluff home buyers, and the over-leveraged real estate investors out of the market. It’ll probably bring a $1m house in Toronto down to somewhere near $800K. But, if you’re hoping for a drop much below that, . . . you’re dreaming in technicolour.
Fact is . . . if you couldn’t afford the house of your dreams before all this “eco-noise”, you still won’t be able to after the dust settles. Recessions can present buying opportunities, . . . but they will not produce the magic solution to someone’s financial under-performance.
ratchetrick,
not sure why you are bringing up house prices since i didn’t mention them. it would really depend on how bad the recession got and how high unemployment reached. i’m fairly certain central banks don’t care about house prices. i’ve got two. no debt. so, don’t care. but irrelevant.
i would be happy to see a recession as it would take a lot of the fluff out of markets. stocks would become more fairly valued, and we can have a nice bull run after .. but one rarely gets what they want in markets and trading.
i certainly don’t think i’m settling on 6% dividends or trying to justify to myself why i’m holding perpetuals. a 10% drop in their value doesn’t mean anything to me. 20% wouldn’t bother me either. (especially if i’m getting 6% back) if i’ve decided i want the asset, and i’m going to commit “X” dollars to it, they i start off slow. buy some now. see how it goes. watch how the asset behaves. you’re never going to pick the low.
lastly, i’ve mentioned this before, nobody should put all their eggs into one asset. most reasonable people will allocate between asset classes and periodically adjust.
if prefs are half of your income portfolio (max), in total, that might be 10-20%. maybe perpetuals become half of that for me. that’s between 5-10% if that drops by 20% that’s a loss of 1-2% of my net worth. really, is it a big deal? especially if i’m managing my other portions correctly. by either being in short duration bonds, or being out of stocks completely during a bear market. or have commodity exposure in another part of the portfolio to offset risk elsewhere.
you make it sound as if some of us here are putting all our money in perpetuals or other prefs. that certainly wouldn’t be the smartest thing to do. hey. maybe if pref yields get back to 7%, i’ll decide to increase my 60% of my income portfolio. again. not sure what the big deal is about trying to pick the low.
btw ratchetrick, what makes you think pref yields are going to 7% ? (would imply a ~$3 drop from here). is it you think the markets are going to collapse? is there something that makes you think that?
Well, I don’t necessarily think we’ll see 7% divs on many prefs, but that’s the yield level (and corresponding discounted share price) I need to accept the risk associated with this asset class. You seem comfortable with the volatility these shares often demonstrate. I’m not… but that’s just a question of personal preference.
I would actually agree with most of what you put forward in your post as well…with the possible exception of accepting losses in the proportions you describe. The point you make about being diversified not only within an asset class such as preferred shares, but in all asset classes, even outside of the financial markets is a quality piece of advice, that I’d certainly echo to everyone!