{"id":2993,"date":"2008-09-14T18:38:55","date_gmt":"2008-09-14T22:38:55","guid":{"rendered":"http:\/\/www.prefblog.com\/?p=2993"},"modified":"2008-09-14T18:38:55","modified_gmt":"2008-09-14T22:38:55","slug":"acopra-negative-yield-to-worst-positive-yield-to-issuer-best","status":"publish","type":"post","link":"https:\/\/prefblog.com\/?p=2993","title":{"rendered":"ACO.PR.A: Negative Yield-to-Worst; Positive Yield-to-Issuer-Best"},"content":{"rendered":"

I recently had a contest about ACO.PR.A<\/a> which has been won by Assiduous Reader adrian2<\/i><\/a>.<\/p>\n

The question was:<\/p>\n

So: here\u2019s the question \u2026 how might a rational investor reason that paying $27.00 for this issue has enough chance of at least a half-way decent return to make it worth while? This investor knows that the yield to worst is negative and that he\u2019s taking a chance \u2026 why might he buy it anyway?<\/p><\/blockquote>\n

ACO.PR.A closed at 26.62-75 on Friday, so the situation isn’t quite as dramatic as it was when the bid was $27.00. However, the portfolio of possibilities for this issue on Friday, according to HIMIPref™ was:<\/p>\n

Call 2008-12-31 YTM: -1.78 % [Restricted: -0.54 %] (Prob: 40.10 %)
\n Call 2009-12-31 YTM: 2.35 % [Restricted: 2.35 %] (Prob: 1.01 %)
\n Soft Maturity 2011-11-30 YTM: 3.68 % [Restricted: 3.68 %] (Prob: 58.89 %)<\/p><\/blockquote>\n

So the YTW was -1.78%.<\/p>\n

Why would an investor pay such a rich price for the issue? Well, there was a hint of the answer buried in my article about retractible preferreds and bonds<\/a>:<\/p>\n

One may sometimes make a reasonable argument that YTW is not the most appropriate method of calculating yields. Say, for instance, that a company has the ability to issue preferreds that pay $1.25 p.a. and has an issue outstanding that pays $1.40 and is currently callable at $26.00, with this price declining by $0.25 annually for the next four years. If the issue is trading above $26.00, the YTW scenario will almost certainly be an immediate call. However, since the company can save $0.25 by delaying redemption, the net cost to the company of leaving the shares outstanding for another year is the dividend less the saving, or $1.15 (during the declining call-price period). Since this is less than the rate it would pay on a new issue, the company may well prefer to wait.<\/p>\n

The question of what to believe is a complex question\u2014complex enough, in fact, that I am currently devoting a great deal of time to researching the matter. Most investors will be well advised to rely on YTW.<\/p><\/blockquote>\n

In other words, Atco (the issuer of ACO.PR.A) may look at the issue on 2008-12-1 and say – ‘well, this issue pays $1.4375 annually, or 5.75% of par (as dividends, which costs more than interest) … we’d better redeem.’<\/p>\n

But according to the redemption schedule, they can save $0.50 off the redemption price every year by waiting! If we were going to analyze this precisely, we would look at the situation from their point of view as a loan of $26.00 which amortizes down to a $25.00 balloon payment on 2010-12-1 (the first date they can redeem at $25.00) via quarterly blended payments that include principal. But from a back-of-an-envelope, conceptual perspective, we can say that it’s a loan of $25.50 with an cost of $1.4375 dividend LESS the decrease of $0.50 in redemption price, for an all-in cost of $0.9375 … which comes to about 3.67%, a financing cost calculated to bring smiles to the most hardened CFO, even if it as expensive dividends.<\/p>\n

These calculations will be incorporated into the next release of HIMIPref™ – yes, I am working on it, albeit slowly – as “Yield to Issuer Best”. To select YTIB from the table of possibilities, I will be determining the disparity of each redemption option from the yield curve – that is, cash flows for the instrument will be discounted by the self-consistent yield curve to arrive at a net present value for each option. The lowest NPV will determine the YTIB. I do not know, at this point, how influential in the valuation YTIB will be relative to YTW … but hey, it’s worth looking at!<\/p>\n

Incidentally, ACO.PR.A was added to the TXPR index in the last rebalancing<\/a>, despite what might be considered to be relatively low average trading value (HIMIPref™ indicates $18,374 worth of shares daily, TMXMoney calculated 1,600 shares<\/a> (the difference doesn’t bother me; HIMIPref™ is an adjusted exponential moving average; I believe that TMXMoney is an unadjusted rolling average, virtually guaranteed to show a higher result). A large part of ACO.PR.A’s current price may well be buying from indexers.<\/p>\n

The following graphs regarding ACO.PR.A have been prepared and uploaded:<\/p>\n