PrefBlog

BAM.PF.J will reset at 6.229% effective 2023-1-1. BAM.PF.J was issued as a FixedReset, 4.75%+310M475, that commenced trading 2017-9-13 after being announced 2017-09-06.

BAM.PR.Z will reset at 6.089% effective 2023-1-1. BAM.PR.Z was issued as a FixedReset, 4.80%+296, that commenced trading 2011-11-2 after being announced 2011-10-24. BAM.PR.Z reset to 4.685% effective 2018-1-1; I recommended against conversion; and there was no conversion.

BPO.PR.I will reset at 6.359% effective 2023-1-1. BPO.PR.I was issued as a FixedReset, 4.85%+323M485, that commenced trading 2017-12-7 after being announced 2017-11-29.

IFC.PR.A will reset at 4.841% effective 2022-12-31. IFC.PR.A was issued as a FixedReset, 4.20%+172, that commenced trading 2011-7-12 after being announced 2011-6-22. IFC.PR.A reset at 3.396% effective December 31, 2017, and I recommended against conversion. There was no conversion.

The most logical way to analyze the question of whether or not to convert is through the theory of Preferred Pairs, for which a calculator is available. Briefly, a Strong Pair is defined as a pair of securities that can be interconverted in the future (e.g. IFC.PR.A and the FloatingReset that will arise if enough holders convert). Since they will be interconvertible on this future date, it may be assumed that they will be priced identically on this date (if they aren’t then holders will simply convert en masse to the higher-priced issue). And since they will be priced identically on a given date in the future, any current difference in price must be offset by expectations of an equal and opposite value of dividends to be received in the interim. And since the dividend rate on one element of the pair is both fixed and known, the implied average rate of the other, floating rate, instrument can be determined. Finally, we say, we may compare these average rates and take a view regarding the actual future course of that rate relative to the implied rate, which will provide us with guidance on which element of the pair is likely to outperform the other until the next interconversion date, at which time the process will be repeated.

We can show the break-even rates for each FixedReset / FloatingReset Strong Pair graphically by plotting the implied average 3-month bill rate against the next Exchange Date (which is the date to which the average will be calculated).

Click for Big

It is somewhat surprising to note that the market is pricing in a lengthy policy tightening cycle by the BoC: the implied rates until the next interconversion are not much different from the current 3-month bill rate of 4.26%, with the averages for investment-grade and junk issues at +4.08% and +4.25%, respectively. Some may conclude that investors are making no attempt to forecast the duration of this tightening cycle!

Since credit quality of each element of the pair is equal to the other element, it should not make any difference whether the pair examined is investment-grade or junk, although we might expect greater variation of implied rates between junk issues on grounds of lower liquidity, and this is just what we see.

It should be noted that the data is not of particularly good quality, since of the InvestmentGrade pairs, only SLF.PR.G / SLF.PR.J and TRP.PR.A / TRP.PR.F have FloatingResets of any appreciable liquidity. These two pairs are plotted with the coordinates (2.89 years, 3.62%) and (2.39 years, 4.22%) respectively. So there’s a certain amount of danger that plots could change appreciably if the upcoming conversion options result in FloatingResets that are highly liquid. Be warned!

If we plug in the current bid price of the IFC.PR.A FixedReset, we may construct the following table showing consistent prices for its soon-may-be-issued FloatingReset counterpart given a variety of Implied Breakeven yields consistent with issues currently trading:

Similarly, for BAM.PF.J:

Similarly, for BAM.PR.Z:

Similarly, for BPO.PR.I:

Based on current market conditions, I suggest that the FloatingResets that will result from conversion are likely to trade above the price of their FixedReset counterparts. Therefore, I recommend that holders of IFC.PR.A, BAM.PF.J, BAM.PR.Z and BPO.PR.I convert their holdings to the corresponding FloatingResets. I will note that once the FloatingResets commence trading (if, in fact, they do) it may be a good trade to swap one issue for the other in the market once both elements of each pair are trading and you can – hopefully – do it with a reasonably good take-out in price, rather than doing it through the company on a 1:1 basis. But that, of course, will depend on the prices at that time and your forecast for the path of policy rates over the next five years. There are no guarantees – my recommendation is based on the assumption that current market conditions with respect to the pairs will continue until the FloatingResets commence trading and that the relative pricing of the two new pairs will reflect these conditions.

Readers who are not as Assiduous as they should be occasionally get upset at my conversion recommendations because I make no attempt whatsoever to make my own estimate of the average 3-month bill rate for the next five years and tailor a recommendation accordingly. I do not do this because it cannot be done with any degree of conviction whatsoever; anybody who tells you that they can reliably predict market yields five years in advance is a charlatan. Market Timing is a snare and delusion; financial markets form a chaotic system in which things that have no rational relevance today can be the driving forces tomorrow. I did not predict the market effects of the COVID pandemic six months before it happened; I did not predict the market effects of the Russian invasion of Ukraine six months before it happened, either; I don’t know anybody who did. All we can ever do is compare similar instruments and attempt an educated guess about relative value; for example IFC.PR.A vs. its possible Floating Rate counterpart. Comparing either one of them with cash or equity over the short term is an exercise in futility.

So what to do? Construct your portfolio to meet your needs and your risks, based on the long-term characteristics of the various alternatives. If, for instance, you are financing your position with a variable rate mortgage based on prime (not a wise move, but some people do it), your lower risk (higher certainty) option is the FloatingReset, as it will reset every three months in accordance with the three month bill rate, which is closely related to prime. Prime and the three month bill rate are similar instruments; prime and the five-year bond rate are less similar; prime and equity prices are highly dissimilar. My purpose in making these ‘convert or hold’ recommendations is to show the potential for short term trading gains between the FixedReset and its FloatingReset counterpart which are, as previously noted, similar instruments. Thus, for instance, if your portfolio requirements indicate that the FixedReset instrument is better suited for you, you might wish to elect to convert to the FloatingReset anyway; this would be reasonable (but not guaranteed!) to the extent that you have a reasonable (but not guaranteed!) expectation that the FloatingReset will be trading higher than the FixedReset for a long enough period to allow you to swap the issues on the market and maybe take out $0.25/share on the swap.

That’s how you make money in the market, taking out small profits as many times as opportunity permits. That’s what proprietary traders (and properly operated hedge funds, deserving of the name) do – and proprietary trades, backed with sufficient capital, are the only group of market participants that consistently make profits.

Those who wish to convert are advised that the deadline for notifying the company of such a desire is 5:00 p.m. (Toronto time) on December 16, 2022 for each of these issues. Brokers and other intermediaries generally set their internal deadlines a day or two in advance of this date, so if you wish to convert there’s no time to waste! Note that brokers will, in general, try to execute the instruction on a ‘best efforts’ basis if received between the two deadlines, provided that the procrastinating shareholder grovels entertainingly enough.

DBRS has announced that it:

changed the trends on Fairfax Financial Holdings Limited (Fairfax or the Company) and its related entities to Positive from Stable. DBRS Morningstar also confirmed all ratings, including Fairfax’s Issuer Rating, at BBB (high), with Northbridge General Insurance Corporation’s (Northbridge) and Federated Insurance Company of Canada’s Financial Strength Ratings at “A”.

KEY RATING CONSIDERATIONS
The change in the trends to Positive from Stable recognizes Fairfax’s resilient, diversified and growing franchise; consistent underwriting profitability; strong liquidity position; and sound regulatory capital. The Company is a major international property and casualty (P&C) insurance and reinsurance player with a significant presence in key global markets through its geographically diversified insurance and reinsurance operating subsidiaries. Fairfax maintains ample liquid assets at both the holding and operating companies, as well as access to committed lines of credit. Fairfax’s earnings are subject to volatility as a result of exposure to natural catastrophe losses and the impact of financial market fluctuations on unrealized investment gains and losses. The Company’s subsidiaries maintain appropriate regulatory capital ratios with buffers above required solvency levels, allowing Fairfax to handle adverse events. The ratings also consider Fairfax’s improved risk profile, driven by the Company’s recent shift towards investing in highly rated and liquid fixed-income securities while reducing holdings of noninvestment-grade bonds. AAA-rated bonds now account for the majority of Fairfax’s bond portfolio.

RATING DRIVERS
DBRS Morningstar would upgrade the ratings on Fairfax and its subsidiaries, if the Company maintains its improved risk profile and overall profitability while reducing its financial leverage ratio.

Given the Positive trend, a downgrade in the near future is unlikely. However, the trend would revert to Stable if there is deterioration in the risk profile and overall profitability, or sustained elevated financial leverage.

RATING RATIONALE
DBRS Morningstar views the Company’s franchise strength as Strong/Good, reflecting the size and diversity of its core operations. Fairfax has developed an extensive portfolio of global insurance and reinsurance subsidiaries over time, which the Company continues to expand through organic growth and prudent strategic acquisitions. Management of Fairfax’s insurance and reinsurance operating subsidiaries is decentralized, with each organization having its own autonomous management team. The breakdown of premiums written by line of business has remained consistent over the past five years, with casualty insurance accounting for just more than half of the gross premiums written. The Company ranks among the top five providers of commercial P&C insurance in Canada based on 2021 direct premiums written. Fairfax’s largest U.S.-based subsidiary, Odyssey Group, ranks among the 25 largest global P&C reinsurers. The Company’s U.K. subsidiary, Brit Limited (Brit), is the second largest Lloyd’s of London syndicate and a market leader in specialty insurance and reinsurance. Fairfax can compete with larger global players using various platforms in selected markets where it can achieve underwriting profitability. The Company’s gross written gross premiums have increased progressively over the past five years to $23.8 billion reported for year-end 2021.

Fairfax’s Good risk profile is supported by the Company’s strong underwriting and risk-limit controls, effective claims management, and appropriate reinsurance coverage for aggregate claim events or large losses. Moreover, Fairfax has appropriate internal controls and has been able to operate successfully in multiple jurisdictions. There has been a significant increase in the proportion of AAA rated bonds and a decline in the proportion of bonds rated BBB and below in the bond portfolio, resulting in a material improvement in the credit risk profile of the Company’s fixed-income investment portfolio.

DBRS Morningstar assesses Fairfax’s earnings ability as Good. The Company is characterized by disciplined underwriting, supported by a long-term value investing approach that sometimes may introduce earnings volatility. The Company has a history of acquiring well-managed insurance companies, ensuring that it retains management to continue running these businesses. The results for the first nine months of 2022 (9M 2022) were negatively affected by market volatility, caused in part by the rapid increase in interest rates globally. As a result, Fairfax reported a consolidated net loss of $816 million as of 9M 2022. Nonetheless, Fairfax expects to report a small profit for full year due to realized gains ($1.3 billion on a pre-tax basis) upon the sale of the Company’s pet insurance business, which will be reflected in Q4 2022 earnings. The hardening reinsurance market is expected to contribute positively to Fairfax earnings in the short to medium term.

DBRS Morningstar assesses Fairfax’s liquidity profile as Strong/Good. Fairfax maintains a strong financial position at the holding company level, with approximately a $873.5 million total for cash and liquid investments as at Q3 2022. DBRS Morningstar considers this level of cash and investments as providing an important liquidity cushion for any potential uptick in insurance claims from the subsidiaries or potential catastrophe losses. The Company redeployed a significant amount of cash in 2022 to invest in AAA-rated U.S. Treasuries and Government of Canada bonds. This is expected to help increase earnings through interest income going forward while maintaining the Company’s resilient liquidity position. Fairfax maintains a committed credit facility of $2 billion that is available to support liquidity needs. The credit facility was largely undrawn as at September 30, 2022.

DBRS Morningstar assesses the capitalization of Fairfax as Good/Moderate. The Company’s insurance and reinsurance operating subsidiaries are appropriately capitalized. Fairfax’s fixed-charge coverage ratios have been volatile over time because of the impact of International Financial Reporting Standards’ accounting treatment of unrealized capital gains and losses within the investment portfolio. However, it improved significantly in 2021 because of the Company’s strong earnings. The Company’s financial leverage ratio (calculated by DBRS Morningstar on a consolidated basis as debt plus preferred shares to capital) increased to 35.7% at Q3 2022, in part due to the issuance of $750 million of senior debt in August 2022 and a decline in common equity. Any substantial further increase in leverage would change the Positive trend to Stable.

The rating of Pfd-3(high) was unaffected.

Affected issues are FFH.PR.C, FFH.PR.D, FFH.PR.E, FFH.PR.F, FFH.PR.GM, FFH.PR.H, FFH.PR.I, FFH.PR.J, FFH.PR.K and FFH.PR.M.