There have been some questions about this issue recently, both on FWF:
My limited understanding of prefs is that they are a lot less volatile than commons and trade in a “short” range. TD is on its way up. They just bought Commerce Bancorp at a time when our loonie is worth huge. If they do well, even their prefs are going to appreciate somewhat. Even if they don’t do so well, the US. $ will eventually find it’s way back and they’re going to make it on the exchange.
and in my eMail:
The one thing I don’t understand about preferreds is how their shared price is affected. I assume like bonds they trend inverse to the prime rate and I get that part of the discount. Over the past several years I have held preferreds and noticed very little fluctuation in the share price but lately they are falling and I don’t fundamentally understand why as interest rates appear stable (or am I wrong here?). Further, some hold their value better than others (e.g., MFC.PR.A versus PWF.PR.F – I’d consider ManuLife and Power Financial equally sound companies for the long term yet one share price is falling while the other is not). How concerned does one need to be about share price and if they do go down what are the factors that will bring them back to book value (e.g., something is making ManuLife more stable than Power and I don’t understand what that is). Sorry, if the question comes across as naive but I find it hard to get my head around all the factors affecting these preferreds. Thanks in advance.
Well, let’s begin with the first statement: the thing to remember about preferred shares is that they are fixed income investments. A $25.00 par-value preferred share paying $1.3125 annually to yield 5.25% will never change its dividend just because the company is doing well. Whether the issue is priced at $30 (to yield 4.375% of market price) or at $20 (to yield 6.5625% of market price) is another matter entirely.
‘They never change their dividends?’, you ask, ‘What, never?’ Well … hardly ever. Every now and then a company will seek to change the terms of a preferred share issue (extending the maturity date of a split-share preferred is a recent example) and sweeten the dividend to make the change more palatable. Such examples are notable mainly for their rarity.
Another exception is “fixed-reset” issues, in which the company resets the fixed-rate every five years and gives the holder the option to convert to floating rate. BCE.PR.A / BCE.PR.B is an example of such a pair. The company’s motives in setting the rate, however, will be to minimize their expense, not to ‘share the wealth’ if they do well.
The price of preferreds will be affected by the fortunes of the company only to the extent that the company’s ability to pay the agreed dividends and principal changes. In the case of TD Bank, an improvement in their financial position will have an extremely limited effect, because both the markets and the credit rating agencies agree that the probability of them being able to meet their committments is pretty close to 100% right now; therefore, any possible increase in this probability is extremely small and therefore will have a very limited effect on market price.
On the other hand, a deterioration in the company’s ability to pay can have a very marked effect on market price. Recently, for instance, Weston has run into difficulties – not as exciting as the fears of imminent bankruptcy that plagued Nortel a few years back, or the silliness that affected Bombardier preferreds, but difficulties nevertheless, and their ability to pay the agreed dividends is not considered to be as secure as it once was.
WN.PR.E is very similar in its terms to SLF.PR.A, and therefore it should respond similarly to general financial market pressures – any differences will be almost entirely due to company-specific factors. I have graphed the flatBidPrice of these issues … you can see that the detioration in Weston’s credit quality has had a huge effect. Credit, credit, credit! You always have to pay attention to credit!
As far as Weston is concerned, an investor might well look at what they’re doing and take the view that they’re going to do so well that market perceptions of their ability to pay will become much rosier; in such a case, we’d expect the spread between SLF.PR.A and WN.PR.E to narrow; and hence, WN.PR.E would (if the analysis is correct!) outperform. This type of analysis is called Credit Anticipation and represents a blurring of the lines between fixed income and equity analysis. As far as TD is concerned though, they’re recognized as such a strong company already that “ability to pay” simply doesn’t have much room to improve.
OK – on to the second question!
My correspondent is quite correct in his understanding about the inverse relationship between interest rates and preferred share prices, but I have to quibble over the use of the “Prime” interest rate.
“Prime” is for very short term loans and is related to the Bank of Canada’s overnight target rate. Preferreds, particularly perpetual preferreds, will be related to the long rate – and the corporate long rate at that.
The two are not necessarily directly related. Long term bonds – those maturing in 20-30 years – are sensitive to perceptions of inflation, while short term bonds – those maturing in less than 5 years – are sensitive to monetary policy as executed via the overnight rate. The Bank of Canada might, for instance, cut overnight rates to 1% … not very likely, perhaps, but possible! In such a case, short rates would decline (trading at a relatively constant spread to overnight), but long rates would almost certainly skyrocket, as investors decided that such easy money would fuel inflation.
Additionally, I will stress that it is Corporate long rates that we are concerned with when analyzing perpetual prefs. According to CanadianBondIndices.com, corporate long bonds have returned -3.82% in the year to October 9 and the yield is about 5.9%, compared to about 5.2% at the beginning of the year. Government long bonds, on the other hand, have returned -1.25% … a fair loss, but the fact that this is so much less than the loss on corporates indicates that spreads have increased. In other words, the perceived risk of holding corporates has increased and investors want more money in compensation.
Additionally, there will be a spread between Corporate Long Bonds and Perpetual Preferreds due simply to the fact that there is a different pool of investors. Pension funds, for instance, will not normally hold preferreds; since pension funds are not taxable, there are no tax advantages to be gained by receiving dividend income rather than interest. And retail panics a lot, besides; since there is no institutional hot money (or less of it, at any rate) cruising around looking for a cheap buy in the preferred mariket place, price swings can be more pronounced.
With respect to the two specific issues mentioned in the eMail: MFC.PR.A is a retractible issue; in December 2015, holders are entitled to get their $25 capital back from the company. There are some details to be understood about this – holders might actually get $26.00 worth of common stock, which they would then have to sell – but basically, an investment in MFC.PR.A is roughly comparable to an eight-year bond. I wrote an article comparing perpetuals to retractibles a while ago; and a more recent one comparing retractibles to bonds. PWF.PR.F is a perpetual; a fair number of perpetuals have been issued in the past year; and the recent credit crunch has scared off a few investors who are more concerned with price fluctuations than with income.
There are many investors who want only retractibles; they will not look at perpetuals regardless of price. Which is why retractibles of operating companies are usually so expensive and not worth buying!
Information regarding the attributes of preferred share issues is almost always available on SEDAR (as long as the prospectus was issued within the last 10-odd years); mostly available on my summary website PrefInfo.com (I track almost all of the liquid issues … the tiny little guys are a bit more hit-and-miss); and often available on the company website, as either a summary or a full prospectus – sometimes both! To find a company website, get a quote for the issue from the TSX, then click “Company Information”.