The March issue of PrefLetter has just been sent to those who have previously indicated that they would like to see a copy.
I am still on schedule for an official launch in April, but it might be tight! Not everything is under my control and there’s a lot of waiting around to do when starting a new venture.
If any other readers would like to see a free copy of the March prototype, please eMail me. Comments will be greatly appreciated, but are not compulsory.
You indicate in the newsletter that if you are going to take the risks associated with P3s you want equity style returns. You have said in the past that it is reasonable to allocate up to 5% to a single P3 issue. The default settings on HIMIPref portfolio method assume this will occur. Is there an inconsistency in what you have said or are you saying that HIMIPref’s recommendations of P3 anticipate equity style returns?
On a related matter, I understand the price hit that a P2 can take when it falls to P3 can be significant. But is the creditworthiness of a P2 (low) materially enough different from a P3 (high) such as to warrant taking larger positions in the former and much smaller position in the latter, if at all, purely on the grounds of creditworthiness? Further, while creditworthiness is clearly a risk factor, is not the risk of downgrade from P2 to P3 also a material enough risk factor to consider applying at least as stringent constraints on the amount allocated to P2(low)s as to P3(high)s?
It’s a matter of diversification. The newsletter is designed for small investors (and for those advising small investors) and anticipates a longer holding period than is typically the case for portfolios managed in strict accordance with HIMIPref™, which takes a very active approach.
P3 credits are not the worst things in the world. According to DBRS
They may not be something I’d like to call “investment grade”, but I’m not going to call them “crummy junk” either. Provided that they are held only in the context of a diversified portfolio, I am comfortable with the idea of recommending them (via HIMIPref™).
For newsletter subscribers and my Aunt Fanny, I will not recommend such issues. The volatility will be relatively higher than other issues, the portfolio will not be sufficiently diversified and I am simply not comfortable with the idea … because they are too equity-like. Which is not to say that they are more equity-like than bond-like … just that they’re too equity-like to be recommended for relatively small holders who are putting all their money in just a few issues and don’t want to have to worry about their positions every day.
I will go even further: if an investor is planning to hold just one or two issues of prefs on a buy-and-hold basis then these issues should be Pfd-1, because Pfd-2 issues are too equity-like for such an investor.
Regarding proposed constraints on Pfd-2(low) issues: You may be interested in the DBRS Corporate Default Study – 1977 to 2005. In this study – fascinating, by the way, for those of us who are interested in such things – DBRS reproduces its “Rating Factor Scale” which attempts to assign a measure of risk on a self-consistent scale to the letter grades. There is a huge jump in the number from BBB(low) [the lowest investment grade] to BB(high) [the highest junk grade].
One problem with the study is, of course, that it refers to bonds. And another problem is that there simply have not been enough Canadian preferred share defaults for any kind of robust statistical analysis. I would certainly like to refine the treatment of creditworthiness in HIMIPref™ but there are two major problems
With respect to the second point above, I’ll point at my two favourite examples: Nortel & Bombardier. Granted, both these companies had problems. Significant problems. And they were downgraded by the rating agencies because of these problems. But their market behaviour during the period of their unpopularity grossly exagerated these problems … Nortel Prefs trading at three bucks and change (they’re around $19-$20 now)? I will assert that this had a lot more to do with Nortel being in the headlines a lot and frightening Granny than it had to do with a hard-headed evaluation of credit.
I can be a little bit more precise than the market. I can look at two packages of cash flows and say something like … ‘well, if the market eventually values these two packages in the way it usually evaluates similar packages, then this one is cheaper than that one’, and be right more often than I’m wrong (knock wood! past performance is no guarantee of the future!). But if I attempt to impose too much precision on the analysis of an imprecise market, I am not just wasting my time, but I’m fooling myself.
So possible improvements to the HIMIPref™ treatment of creditworthiness are being thought about. And they’re being planned as enhancements for the future. But ultimately, I think, such changes will be evolutionary rather than revolutionary.
And, it should be noted, there are user-definable constraints in the HIMIPref™ portfolio-method for maximum weight of a single issuer in the Pfd-2 grade. At some point, these constraints might be refined so that Pfd-2(low) could have a different maximum from Pfd-2 … but that too is an evolutionary refinement for the future.
Thanks for the edifying response.
Is BBB(low) broadly equivalent to P3(low)?
There’s a lot of overlap in the scales and a lot will depend on the particular covenants of the particular preferreds and the capital structure of the issuing company.
For example, how should the ratings agencies account for the risk to principal of a perpetual? The issuer can delay repaying the debt until Doomsday and not be in default of their covenants. This is not a scenario that applies to bonds.
As well, consider the corporate structure of Brookfield Asset Management. This company has more principal value on the Street in preferreds than it does in regular bonds, which is unusual. For a given total of bonds + preferreds, the rating of the bond will increase with an increase in proportion of preferreds. Again, this makes any presumption of a strict correspondence “inoperable”, as Richard Nixon would say.
I will go this far: I view the preferred range Pfd-3(high) to Pfd-3(low) to be broadly equivalent to the bond range A- (just barely!) to BB+.
BUT! (there’s always a “but”) bond rating is an inexact enough science as it is. Rating preferreds is even trickier due to the differing covenants, different place in the capital structure, and lack of the same amount of historical data.
I’ve occasionally disagreed with DBRS in this blog on the rating of specific issues, but by and large I’m happy to go along with their analysis. It’s a tough job forecasting the future, and they are subject to the law of tiny numbers even more than is an investment manager. To return to their default study cited above, for instance: