In the first part of this analysis, we got as far as estimating the two fundamental credit quality ratios as:
- Asset Coverage Ratio : 2.3:1
- Income Coverage Ratio: 0.5:1
As noted, the Income Coverage Ratio is a little scary (as the company will, in the absence of other income, have to dip into capital to make the preferred dividend payments), but on the other hand consider that there is a lot of capital to dip into! The shortfall is approximately $0.25 annually; the term of the investment is seven years (since the prospectus notes that the preferred shares will be redeemed at $10.00 on April 30, 2014); and therefore that the shortfall amounts to about $1.75 over the term of the investment.
If we deduct this amount from the capital available (which we previously calculated as approximately $23.55), we are left with $21.80 to cover our $10.00 investment. So, even after setting aside some capital to meet the income requirements, we still have a fair amount of danger space.
We can also take comfort from one of the committments in the prospectus:
No distributions will be paid on the Class A Shares if (i) the distributions payable on the Preferred Shares are in arrears, or (ii) in respect of a cash distribution, after payment of the distribution by the Company, the NAV per Unit would be less than $15.00. In addition, it is intended that the Company will not pay special distributions, meaning distributions in excess of the targeted $0.075 per month in distributions, on the Class A Shares if after payment of the distribution the NAV per Unit would be less than $25.00 unless the Company would need to make such distributions so as to fully recover refundable taxes.
So, if the Asset Coverage Ratio falls below 1.5:1, then at least distributions to the capital unitholders will not be a drain on corporate resources, which is a comfort. The “intention” regarding special distributions is appreciated, but as hard-nosed fixed income investor, we don’t really care a lot about their precious “intentions”. It’s their committments that matter.
In sum, I have no problems with the rating of this issue as Pfd-2(low) by DBRS.
OK, so the issue looks like it’s investment grade. It’s only just investment grade; carnage in their underlying portfolio of life insurance companies could add to our worries; but it’s a reasonable investment and worth looking at further.
The issue is currently quoted on the TSX at $10.55-65. What’s the yield if purchased at $10.65?
Using Keith Betty’s Yield Calculator (remember, we can’t use a generic bond calculator, since bonds trade with accrued interest and preferreds don’t), we plug in the following values:
| Parameterization of Yield Calculation |
| Current Price |
10.65 |
| Call Price |
10.00 |
| Settlement Date |
2007-04-25 |
| Call Date |
2014-04-30 |
| Quarterly Dividend |
0.13125 |
| Cycle |
2 |
| Pay Date |
10 |
| Include First Dividend |
1 |
| First Dividend Value If Different |
0.01917 |
Some of the above values require explanation … this is a simple generic calculator, not one designed for six decimal places of precision.
I have told the calculator that it will receive payments on the 10th day of February, May, August & November, as promised in the prospectus. This is indeed the date of receipt but the date of accrual is actually the last business day of January, April, July, October. Thus, the final payment has been marked down a bit; the calculator pro-rates the final dividend to what it thinks it will have accrued and not paid to April 30, which underestimates the final payment by ten-day’s-worth of accrual.
In the “Include First Dividend” field, I have indicated to the calculator that I expect to receive a payment on May 10. I won’t, but it’s the best way to indicate to the calculator that the first payment, in August, will be larger than usual ($0.15042, rather than $0.13125).
I have double checked the calculated cash-flows (in the blue highlighted area, cells G2:H31), to ensure that it reflects reality – or, at least, the best approximation of reality achievable with a generic spreadsheet. They look OK to me.
And finally, after looking at the answer (4.2%), I have performed an independent sanity check: it’s a seven year investment. Since I’m buying at 10.65 and being called at 10.00, that’s a total loss of $0.65, or $0.093 annually. I’m getting paid $0.525 annually, so after deducting my projected capital loss, I have a net income of $0.432 from an investment of $10.65 that will decline to an investment of $10.00 over time, which is an average investment of 10.33. Therefore, I can make a very (very!) rough approximation of the total yield as $0.432/$10.33 = 4.18%. OK. I’m happy that the calculator is working properly, especially after looking at the two-digit calculation in cell U105, which is simply copied to the one-digit answer in cell B21.
I can compare this value with bonds by multiplying by my Interest Equivalency Factor of 1.4 … to get the same after-tax income from interest payments, I’d need a yield of about 5.9%. And I can compare this with other comparable preferred shares, such as, for instance, whatever has been recently recommended in PrefLetter.
However, I have to remember the issue size. This issue might be liquid enough now that I can invest everything I want at a price of $10.65. And I might have every intention of simply holding the issue until it’s redeemed. But there’s many a slip twixt the crouch and the leap … if I have a lot of shares, and need to sell them in 2010, will I be able to do it? If I only have a few shares, will the lack of liquidity mean that potential buyers will discount what they would otherwise pay to account for their liquidity problems? These worries must be accounted for at all times, and particularly when the issue capitalization is only $30-million.
All in all, this isn’t a bad issue at the current price. You could do worse.
Update: And never forget credit quality! This is on the very edge of investment grade; while it’s good enough for a conservative investment portfolio, it’s not good enough to be a huge chunk of an investment portfolio.
And, of course, this does not constitute specific investment advice, one way or the other. I am a financial advisor – but I am not necessarily YOUR financial advisor.
Update: On April 30, the issuer announced:
that it has completed the issuance of an additional 150,000 preferred shares at $10 per share and 150,000 Class A shares at $15 per share representing total gross proceeds of $3,750,000. This issuance was pursuant to the exercise of the over-allotment option granted to the agents in connection with the Company’s recently completed initial public offering. With the exercise of the over-allotment option, the total amount raised by the Company was $76,750,000.
