DBRS has published its new Methodology: Rating Canadian Split Share Companies and Trusts, August 2009:
DBRS applies a combination of quantitative and qualitative analysis in its Preferred Share rating process. The quantitative analysis includes using an historical value-at-risk (VaR) framework to assess the likelihood of large portfolio losses based on historical data. DBRS uses VaR results together with qualitative analysis relating to general macroeconomic factors and to certain industries or companies to which the Portfolio will be exposed.
| DRBS Preferred Share Rating Minimum Downside Protection Required* (Net of Agents’ Fees and Offering Expenses) | ||
| Rating | Downside Protection (per DBRS) |
Asset Coverage (per HIMI Calculation) |
| Pfd-2 (high) | 57% | 2.3+:1 |
| Pfd-2 | 50% | 2.0:1 |
| Pfd-2 (low) | 44% | 1.8-:1 |
| Pfd-3 (high) | 38% | 1.6+:1 |
| Pfd-3 | 33% | 1.5:1 |
| Pfd-3 (low) | 29% | 1.4+:1 |
Due to the unique risk of structured Preferred Shares (i.e., exposure to equity market fluctuations), DBRS will generally not assign a rating in the Pfd-1 range to Preferred Shares unless a de-leveraging mechanism is in place to provide greater protection on the repayment of Preferred Share principal. If a de-leveraging mechanism is in place, a portion of the Portfolio equal to the principal amount of Preferred Shares outstanding will be liquidated and invested in cash or cash equivalents if the Portfolio NAV declines by a predetermined percentage. In addition to the de-leveraging mechanism, there are other structural features to mitigate declines in downside protection that are addressed in this methodology, including the suspension of Capital Share distributions if the NAV drops below a predetermined level.
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When rating split share transactions, DBRS will assign higher ratings to Issuers with a Preferred Share dividend coverage ratio suffi ciently greater than 100%.
| Level of Diversification | Adjustment to Minimum Downside Protection Required (Multiple) |
| Strong by industry and by number of securities | 1.0x (i.e., no change) |
| Adequate by industry and by number of securities | 1.0x to 1.2x |
| Adequate by number of securities, one industry | 1.2x to 1.3x |
| Single entity | 1.3x to 1.5x |
In general, DBRS views the strategy of writing covered calls as an additional element of risk for Portfolios because of the potential for the Portfolio to give up unrealized gains when the option gets called and, at the same time, as part of the Portfolio’s mandate, the security may need to be repurchased in the market at the higher price. Furthermore, an option-writing strategy relies on the ability of the investment manager. The investment manager has a large amount of discretion to implement its desired strategy, and the resulting trading activity is not monitored as easily as the performance of a static Portfolio. Relying partially on the ability of the investment manager rather than the strength of a split share structure is a negative rating factor.
DBRS uses a variation of the historical VaR method to assess the likelihood of large declines in downside protection. VaR is the amount of loss that is expected to be exceeded with a given level of probability over a specifi ed time period. For example, if a Portfolio has a one-day VaR of $1 million with a probability of 5%, there is a 5% probability that the Portfolio will lose at least $1 million in a one-day period.
Alternatively, there is a 95% probability that the Portfolio will lose no more than $1 million in a one-day period. Using the historical method, daily returns are calculated for a given Portfolio using price data for a historical period of time specifi ed by DBRS. Daily returns are then sorted from lowest to highest. If there are 100 daily returns and a probability of 5% is desired, the 5% VaR would be approximately equal to the fifth worst return.
Why daily?
The key consideration in gathering historical data is the time period used. There is a balance between collecting enough returns and avoiding irrelevant data due to a major shift in the Portfolio’s environment that may decrease the value of using data observed prior to the shift. DBRS will generally aim to use ten years of historical data to calculate the probability of a large decline in downside protection. Shorter periods will be used if ten years of data is not available for a particular Portfolio; however, the comparison of split share Portfolios will always be completed using identical time periods.
The VaR methodology used here doesn’t make a whole lot of sense to me. Why daily data? Why ten year periods? It seems to me that it would make more sense, for instance, to use all available data over time periods that at the very least approximate the time period of the prediction … that is to say, if a bank-based split share has asset coverage of 2.0:1 and 5-years to maturity, what is the probability of a 5-year loss of 50% for the index? What’s the probability of a such a loss if there is only 1 year to maturity?
What they’re doing is:
(4) Using the initial amount of downside protection available to the Preferred Shares, determine the dollar loss required for the Preferred Shares to be in a loss position (i.e., asset coverage ratio is less than 1.0)
(5) Solve for the probability that will yield a one-year VaR at the appropriate dollar-loss amount for the
transaction.
Contrary to the methodology used, I will assert that the probability of a one-year loss of 50% in a diversified bank portfolios is GREATER THAN the probability of a five-year loss of 50%.
And as for:
(6) Determine the implied long-term bond rating by comparing the probability of default with the DBRS corporate cumulative default probability table.
(7) Link the implied bond rating to the appropriate Preferred Share rating using an assumption that the
preferred shares of a company should be rated two notches lower than the company’s issuer rating.
I’m gonna keep thinking! I’m gonna keep an open mind! But off the top of my head I can’t figure out why this makes sense.
[…] This continues their revision of SplitShare rating methodology. […]