PrefBlog

Rob Carrick was kind enough to quote me in his Portfolio Strategy column of February 20:

A different take on the appeal of perpetual and fixed reset preferreds is offered by James Hymas, president of Hymas Investment Management. He doesn’t believe perpetuals will fall in price as much as some people expect and, regardless, he still sees some benefits in them for investors who want income.

His argument begins with the point that there are two issues to consider when choosing income-producing investments – the safety level of the investment itself and the reliability of the income it produces.

Fixed resets do a good job of protecting investors when inflation’s on the rise and pushing up interest rates, Mr. Hymas [pontificated]. But they fall behind perpetuals when it comes to preserving a reliable flow of income. Let’s say you bought some fixed reset preferreds back in early 2009, when they were being issued with yields of 6 per cent or more. Those shares could be very well be redeemed in a few years, leaving you in the tough position of trying to replace a 6-per-cent yield.

With perpetuals, your income flow lasts indefinitely, if not in perpetuity, and it’s comparatively safe.

“If you’ve got something from one of the big banks paying $1 a year, you can be as sure as you can be of anything in the investing world that you’re going to get that $1 a year until the shares are called,” Mr. Hymas said.

Mr. Carrick had to deal with the journalist’s constant bugbear: how to address a complex question for a wide swath of the investing public in 1,000 words or less. One question I must always ask when responding to queries on “interest rates” is: “Which interest rates?”. Short term rates are different from long term rates; government rates are different from corporate rates. And that’s just where we start!

The article has eight comments so far – a good one that addresses the issue is:

The premise of the article is that inflation is rising. Without that assumption all of it become irrelevant.

But there is no argument presented to support that premise. Just because very-short-term-government-set rates are rising does NOT mean that inflation is rising.

And just because the current month’s CPI was closing on 2% does not mean the rate is rising either. That rise is just a reversal of last year’s deflation – both short term events.

And, of course, even if we grant that FixedResets are good at protecting principal (which is only true up to a point – they are subject to exactly the same long-term credit risk as Straights) there is the eternal Fixed Income tug-of-war to consider between Protection of Principal and Protection of Income. You can’t have both; money market instruments emphasize protection of principal; straight perpetuals emphasize protection of income. FixedResets are in between – but not so close to the Money Market side of the struggle as many people like to think.

Update: A few more comments: the first, a retail view of the case for FixedResets (subsequent editing note applied to quote)

Rate-reset preferreds eliminate the risk of rising interest rates while perpeptuals expose you to full risk. If you bought bank reset perpetuals preferreds, when first issued in 2009, you now have a 10% capital gain (on paper )but most importantly a guaranteed 6% dividend over the next five years. If economic growth is slow then rates will not rise much over that time and the dividend is gold. The rate reset will then kick in to protect you going forward.

If rates do rise substantially, the banks will redeem the shares and you can re-invest in a high interest savings account until another investment opportunity presents itself. In this way your capital is preserved.

On the other hand, if you bought perpetuals and rates rise substantially, the shares will be deeply discounted and you will have a substantial capital loss. If you choose not to sell you will be locked in and have inferior returns going forward.

On a risk-return basis the rate-reset perpetuals preferreds are the winners IMHO.

The commenter got it right first time: rate-reset (or FixedReset, in my nomenclature) are indeed perpetuals, a thing that is very often forgetten in good times. The credit risk is forever. While the FixedReset structure does indeed provide protection against inflation (to the extent that this is reflected in 5-Year Government bonds, which is a pretty large extent!), but provides no protection whatsoever against credit risk. If a particular issuer gets into trouble between now and the next reset and is not able to refinance at a lower rate, it will probably not call the issue – and the price of the issue will, almost (but not quite) by definition be lower than par.

Additionally, one should always remember that in this wicked world, nice things cost money. Inflation protection is nice. And it costs money, as I have discussed in my essays on break-even rate shock. Naturally, having calculated the cost, one can quite legitimately take the view that it’s cheap at the price – but I suspect many purchasers do not attempt to quantify the cost in any way whatsoever. Especially when the same protection is available for free with Government real return bonds (RRBs)! I’m willing to bet that there are a few investors out there who have nominal Canadas and FixedReset preferreds, when it be more logical to own RRBs and Straight Perpetuals.

But the crux of the argument is If rates do rise substantially, the banks will redeem the shares and you can re-invest in a high interest savings account until another investment opportunity presents itself. In this way your capital is preserved..

Well, in the first place the banks’ decision whether or not to redeem the shares will have little, if anythng, to do with the rate on 5-Year Canadas. If those rates are high, then to a first approximation we may assume that all other rates will be high as well; and (also to a first approximation) the decision will be made dependent upon the cost of refinancing options. It is the Reset Spread that is critical to the refinancing decision, not the five year rate.

And in the second place, even a high interest savings account (paying what? 1%?) will not replace the lost income on call. You may have your principal but – as is too often the case with investors being far more concerned than they should be with Preservation of Capital at the expense of the other objective of Preservation of Income – income will suffer.

I rather liked one of the other comments:

James Hymas Rocks!

… even with the “thumbs down” comment rating!

This entry was posted on Saturday, February 20th, 2010 at 3:09 pm and is filed under Press Clippings. 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.