How Low Can They Go?

It’s been quite the day of eMails for me! In addition to the relatively technical questions about PrefLetter, I received one that asked:

Can you tell me if there is a rule of thumb in determining rates companies offer for new preferred offerings as it relates to the BOC key rate?

In a word: No.

When a company thinks it might wish to offer preferreds, they contact their Corporate Finance guys at the dealers and ask them where they think they might sell a deal. After looking at comparables, thinking about the tone of the market, talking to the people on the front lines who will actually be selling the deal, all that kind of thing, Corporate Finance comes up with a guess and then the company decides if it makes sense for them.

That being said, there is usually some consistency – look at all the recent Pfd-1 perpetuals done lately with a 4.5% coupon, for example.

At some point, I’m going to get out my records and write an article about the historical trend of perpetual issuance, comparing the grossed-up interest rate equivalent with long Canadas – which is as close to the standard as exists.

In 2005, the new issue spread (according to some third party information I have) varied in a range of Canadas +140bp to Canadas +200bp.

In 2006, it was more like Canadas +200 to Canadas +250.

In 2007 … well, let’s see. High quality perps have been going at 4.50% … use 1.4x to gross that up, that’s 6.30% interest-equivalent. Long Canadas spent the first quarter in the 4.10%-4.30% range, mostly, so that’s a spread of Canadas +200 to Canadas +220, roughly in line with 2006.

Long Canadas are – taking today’s sell-off into account – trading in the 4.45% area, so we’ll say that perpetual prefs should be in the 6.55% interest-equivalent area, which is the 4.68% dividend area, which is more or less where they actually are, as of last night.

The major weaknesses of this back-of-the-envelope calculation are:

  • Spreads could change due to perceived corporate weakness, particularly in the banking sector. They certainly changed in 2005/06!
  • Ranges of the spreads are very large: 50bp!
  • Those are new issue spreads I’m talking about. Logically, spreads on (deep) discount perpetuals should be smaller, as there is the opportunity to make a significant capital gain before your have to worry about the potential of a call.
  • Preferreds are dominated by retail, which is prone to panic.

But, all that being said … let’s make a deal: You guess where long Canadas are going to be, and I’ll guess where perpetuals are going to be!

2 Responses to “How Low Can They Go?”

  1. tobyone says:

    Thanks for the informative explanation for a parttime retail investor new to the pref market such as myself. Today an RBC economist is predicting 75 basis point interest rate hike by yearend in Canada. In a simple interpretation does this mean the 10 year GOC @4.5 could go to 5.25?
    How much of this sentiment is already factored into the market, if any, or can this be quantified in advance? Perhaps noteworthy that the 2-30 year spread indicates an inverted yield curve in Canada but not so in USA.

  2. jiHymas says:

    No, you can’t simply apply the (predicted) 75bp increase in the overnight rate as a parallel shift all the way across the curve. Yield curves do funny things.

    The short end reflects monetary policy; the long end reflects inflation expectations (all to a first approximation, of course!). Hence, if the market decides that the bank is being so tough with monetary policy that inflation will go to zero, it is entirely plausible that the long end could decline when short rates are increased.

    This happened in the ’90’s in the UK Gilt market. Lovely, textbook changes! Short-end-up, long-end-down, rates just pivoted around a point in the 10-year area and the curve changed from upward sloping to downward.

    On the other hand, if inflation does pick up and the market perceives that the bank is just keeping up with inflation and that the short-end real-rate is unchanged, we could indeed see a parallel shift across the curve.

    This is, of course, a complicated way of saying “I don’t know”. I have seen some commentary claiming that 2.5 hikes of 25bp each have been priced into the BOND market, but this was from a sell-side analyst. Sell-side analysis … well, there are three things you can get from the sell side:

    (i) Data. They’re great with data!

    (ii) Ideas. They chatter so much that every now and then they say something worth thinking about. Not bad!

    (iii) Actual, actionable investment advice. Forget it.

    I don’t know where the market is going to go. I have made the asset allocation decision for myself that, over a long period of time, prefs are a pretty good index in which to be invested – for me, with my tax situation and my investment needs. So, if I can outperform that index then, over that same long period of time, it will be even better! That’s all I worry about.

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