PrefBlog

We had a look at POW.PR.A yesterday, as an example of an issue in the PerpetualPremium index with a negative YTW; now let’s look at RY.PR.K (previously commented upon on August 22). This is particularly interesting in light of the RY.PR.O redemption recently announced. RY.PR.O was also at an intermediate stage of its call schedule and also had a call price declining by $0.25 p.a. The important differences between these issues are:

• the “K” is retractable and is therefore included as debt on the balance sheet. RY.PR.O is perpetual and therefore may be included in Tier 1 Capital.
• the “K” has an annual dividend of $1.175; the “O” pays $1.375.

This issue was quoted at the close of business, 2006-10-19, at $25.66-62 and has the embedded option schedule:

• Redemption      2003-08-24      2004-08-23  26.000000
• Redemption      2004-08-24      2005-08-23  25.750000
• Redemption      2005-08-24      2006-08-23  25.500000
• Redemption      2006-08-24      2007-08-23  25.250000
• Redemption      2007-08-24   INFINITE DATE  25.000000
• Retraction      2008-08-24   INFINITE DATE  25.000000

So it is currently redeemable at $25.25 and, while one can never be absolutely certain of anything in this world, the idea that it will be redeemed prior to becoming retractible in 2008 is a safer bet than most.

These options, run through the HIMIPref™ software, give rise to the following optionCalculationList:

• Call  2006-11-18 YTM: -6.24 % [Restricted: -0.51 %] (Prob: 31.99 %)
• Call  2007-09-23 YTM: 2.61 % [Restricted: 2.42 %] (Prob: 1.14 %)
• Soft Maturity  2008-08-23 YTM: 3.64 % [Restricted: 3.64 %] (Prob: 66.87 %)

So HIMIPref™ is accounting for the possibility of an immediate call (one maturityNoticePeriod hence) at $25.25, which will result in a realized yield of -6.24%. This is a very odd issue, quite frankly! I noticed it when I was working on my article about Yield-to-Worst as a predictor of future returns (A Call, too, Harms) … at one of the year-ends studied it was among the issues with the lowest YTW but was not called, making my point a little less emphatic, but returning poorly over the ensuing year anyway. I drew attention at that point to the issue:

The other retractable in the low yield-to-worst lists for 2000-2002 that was not called was RY.PR.K. Although it managed to avoid the worst case scenario (a call nine months subsequent to its appearance in the list), it underperformed the index by a cumulative total of about 6% in the following three years. Clearly, dodging the redemption bullet was not, in and of itself, a great cause for celebration!

The continuing oddness can be illustrated over the past year by looking at a graph of the bid price over the past year. The high prices for this issue lead to YTWs that have been negative more often than not.

I don’t understand! Fortunately, however, I don’t need to understand. Knowing where to find the “Sell” button is good enough for me!

Now that the situation regarding RY.PR.O has been clarified, let’s take a look at another constituent of the PerpetualPreferred index with a negative YTW.

POW.PR.A hasn’t been mentioned much in this blog, but made the volume charts on October 11, 2006. At the close of business yesterday, October 18, it was quoted at $25.81-87, pays $1.40, and the next ex-date is (somewhere around) December 20.

The embedded options for this issue are:

• Redemption      2004-06-11      2005-06-10  26.000000
• Redemption      2005-06-11      2006-06-10  25.750000
• Redemption      2006-06-11      2007-06-10  25.500000
• Redemption      2007-06-11      2008-06-10  25.250000
• Redemption      2008-06-11   INFINITE DATE  25.000000

So it is currently redeemable at $25.50.

HIMIPref™ calculates the call probabilities as:

• Call  2006-11-17 YTM: -8.50 % [Restricted: -0.70 %] (Prob: 29.45 %)
• Call  2007-01-16 YTM: 0.69 % [Restricted: 0.17 %] (Prob: 5.99 %)
• Call  2007-07-11 YTM: 2.55 % [Restricted: 1.85 %] (Prob: 9.69 %)
• Call  2008-07-11 YTM: 3.70 % [Restricted: 3.70 %] (Prob: 5.09 %)
• Option Certainty  2036-09-12 YTM: 5.42 % [Restricted: 5.42 %] (Prob: 49.77 %)

Note that all these scenarios are combined at their probabilities to derive portfolioYield, but the worst result is used as Yield-To-Worst.

The various yields calculated for this issue are:

The sum of yield components of valuation of -2.6618 is the lowest value in the perpetualPremium index, the average value for the this calculation for this index is just a hair over 4.00.

Some may wonder at the calculations done here – why not just use YTW? As it turns out, in some analytical environments the other measures of yield are more discriminatory, but there is some variation that may be observed even in the current environment. In the graph, the following data points have been removed in order to increase the resolution of the display: AL.PR.E, TOC.PR.B, AL.PR.F. The graph is here, the regression calculation here.

HIMIPref™ will not recommend this issue for purchase to clients, giving the Eligible For Purchase (Code) as ’14’, which a quick look at the glossary defines as ‘pseudoModifiedDuration (Worst) of buy side less than minimum setting’. In other words, there’s a very good chance (YTW!) the issue will be called in the near future. Not only does HIMIPref™ have trouble discriminating between issues with such small pseudoModifiedDurations, but even if it could do this well then there wouldn’t be much money in it (since a small price change for a short-term instrument can result in a very large change of yield.

It may be noted that there is more scatter in the plot of YTW vs. sumYield when the instruments examined are restricted to those which are purchasable: graph, regression.

It should also be understood, as discussed and graphed on the prefShares site, yields have, ultimately, a minor effect on the valuation of shares once they have been qualified for purchase.

Bottom line: POW.PR.A looks overpriced, to the extent it can be analyzed. There are many alternatives available which can be analyzed effectively and quantitatively … so why go to huge extremes to justify holding it? Research is continuing, as ever, to extend the reach of measurement in which the HIMIPref™ analysis can result in superior performance, but this range of accuracy will not be extended at the expense of confidence in what HIMIPref already does well.

The Royal Bank announced today that RY.PR.O will be redeemed at a price of $25.50 on November 24, 2006.

This is an interesting decision on their part. As noted in my previous post on this topic, the issue pays $1.375 and the premium was declining by $0.25 annually – implying a net cost to Royal of $1.125 annually for the $25 capital, which is quite competitive.

I can only assume that they have a desired capital structure that includes some preferreds … and that the issue of RY.PR.B was an opportunistic move with the proceeds earmarked for this redemption.

RY.PR.O was quoted at the close yesterday, 2006-10-18, at $25.96-23, and had a pre-Tax YTW of -6.48% based on a call 2006-11-17 at $25.50 (OK, so the calculation was one week off! It’s still quite bad enough!). Had the issue survived until called  2008-09-23, the pre-tax YTM realized would have been 3.89 % – still pretty skimpy.

So there’s an objective lesson for all readers! It’s all very well to make elegant arguments that something won’t be called based on net cost to issuer, and there may often be a great deal of validity to these arguments. But plain old YTW remains a very powerful tool for avoiding mistakes and decisions made on any single element of valuation will often be in error.