[HaroldCrump]

Greetings all,

BMO has released an IPO for a new series of preferred shares
Bank of Montreal
Non-Cumulative 5-Year Rate Reset Class B Preferred Shares
Series 23

It's one of those rate reset ones based on the 5-Year Government of Canada Bond Yield + 2.41%

I'm considering this for my TFSA.

The initial fixed rate period is until Feb 2015.

One risk I see is interest rates will rise during the first 5 years leading to a fall in value of the shares.
However, it appears these are perpetual shares so in 2015 the rate should reset based on the then GoC yield.

Any opinions?

Cheers

-Harold

 

[tojo]

Greetings all,

BMO has released an IPO for a new series of preferred shares
Bank of Montreal
Non-Cumulative 5-Year Rate Reset Class B Preferred Shares
Series 23

It's one of those rate reset ones based on the 5-Year Government of Canada Bond Yield + 2.41%

I'm considering this for my TFSA.

The initial fixed rate period is until Feb 2015.

One risk I see is interest rates will rise during the first 5 years leading to a fall in value of the shares.
However, it appears these are perpetual shares so in 2015 the rate should reset based on the then GoC yield.

Any opinions?

Cheers

-Harold

Harold, should also mention that they pay 5.40% annually….notice how these rate reset prefs are dropping in yield with each issue - in line with narrowing spreads. Compare this with MFC.PR.D, which trades at a premium, issued a couple months ago at 6.6% +4.56% 5-year GOCB reset terms.

Just some comments to your post:

- If possible, hold these outside of your TFSA or RRSP, for the tax-advantage treatment of prefs.
- It’s been debated before it other threads, but it may be to your advantage to pick up some of the investment grade discount perpetuals trading below par for both higher current yield ( ~ 6 – 6.5%) and possible capital gains. Beware that rising rates will have a negative impact on the price of perpetuals, taking into consideration the current environment of narrowing spreads (Corporate vs. Gov. Bonds).
- The price of reset prefs are somewhat insulated from rate movements as they move closer to reset time: In times of rising rates, the option at reset time likely be a call by the issuer to avoid paying the premium. Conversely, in times of dropping rates, the option at reset will likely be a call as well, for the issuer to reissue at lower rates. Resets are basically designed-to-be-called in five years, as they were first offered back in the winter of 2008, when prefs, particularly perpetuals, were getting hammered left, right and centre. These terms were built in to make them more attractive and buyers typically see them as relatively safe, but with limited upside. New issues of these always sell well and close within 15 – 30 minutes of posting.
- The biggest risk to these is if, in 5 years time, the 5 Government Bond rates are so low (like now!) that BMO may elect to reset at a low 5 year rate + 241bp so that you may actually end up with less than the current pref yield of 5.4%.
- If you plan to build a pref portfolio, make sure you diversify…don’t concentrate solely on perpetuals, resets etc. They all behave differently depending on the rate environment.

 

[SRQinvestor]

Tks Tojo for the background and info. What other prefs would you put into your pref portfolio? Any suggested names?

 

[leslie]

Warning! Togo did NOT recommend MFC, as indicated by your comment "What other prefs..". He was making a point about the rapid change in market risk premiums.

That issue is now trading at a current yield of 6.1% but there is an implicit capital loss of 1.4% built into the premium price (estimate), so it's 5-yr yield to call is only 4.7%. You can do better elsewhere.

 

[HaroldCrump]

In times of rising rates, the option at reset time likely be a call by the issuer to avoid paying the premium. Conversely, in times of dropping rates, the option at reset will likely be a call as well, for the issuer to reissue at lower rates.

Thanks tojo for your insight.
Can you please further explain why in the case of rising rates, the rate reset preferreds will be recalled?
Specfically, what you mean by "a call by the issuer to avoid paying the premium".
Why would the issuer need to pay a premium if they are not recalling the shares?
Why won't they simply reset the rate based on the 5-yr. Govt. bond yield and let it run for another 5 years, instead of incurring the cost of recalling the shares and then re-issuing at prevailing high rates?

Cheers

-Harold

 

[leslie]

I also did not understand that. Would it not be the future rate spread (when the reset is defined by the spread) that will decide whether it gets called, not the interest rates?

 

[tojo]

I also did not understand that. Would it not be the future rate spread (when the reset is defined by the spread) that will decide whether it gets called, not the interest rates?

Yes, I stand corrected, particularly with the BMO issue where the premium is a fairly narrow spread, much less than the MFC issue, which has a higher chance to be called at 456bp above the 5 year GOCB at reset....

 

[leslie]

There is another issue with these reset preferred that has not been mentioned since I signed on.

Most have the reset defined as the 5-year treasury yield plus a spread. But others I have seen use a 6-month Tbill yield plus a spread. Of course the 'normal' yield that pref shares trade at, above Tbill rates, is a LOT greater than the spread above 5-yr treasuries. Yet the ones I looked at (I cannot remember which) did NOT have a higher stipulated spread.

And they will also face the problem of 6-month t-bills being much more volatile and subject to the whims of government rate-setting. Maybe the small spreads stipulated are because the issuer presumes a flatter yield curve than today's, with higher short-term rates.

The use of the short-term rate ignores the market's prediction, at the time of reset, of the future changes to market rates over the 5-yr term for which the rate is set.

My point is that these have a lot more 'unknowns' going on.

 

[SRQinvestor]

My previous question to Tojo and the group was not well worded. I should have asked what other tpyes of preferred's beside Rate Rest and Perpetual Discounts would you see in a balanced pref share section of the portfolio. tks

 

[tojo]

There is another issue with these reset preferred that has not been mentioned since I signed on.

Most have the reset defined as the 5-year treasury yield plus a spread. But others I have seen use a 6-month Tbill yield plus a spread.

My point is that these have a lot more 'unknowns' goingn.

I'm not too familiar with products that have the reset to 6 month T-Bill yield, but most I've seen have two options if these shares are not called:

1. Lock in for another 5 years at fixed dividend based on the 5 year GOCB + predetermined fixed dividend rate (e.g. 2.41% for the new BMO issue) or
2. Exchange for an equal # of floating rate preferred shares at a floating rate = 3 month government t-bill + the above spread.

I believe at each reset date you can flip-flop between the options. The floaters would be redeemable (not retractable), so still perpetual in nature.

 

[tojo]

My previous question to Tojo and the group was not well worded. I should have asked what other tpyes of preferred's beside Rate Rest and Perpetual Discounts would you see in a balanced pref share section of the portfolio. tks

SRQ, if you had asked this a few months ago, your options would have been much more attractive and you would have done very well in constructing a pref portfolio. The spread has narrowed so quickly that many classes of prefs are no longer bargains. Nevertheless, its a good idea to become familiar with them in case a future scenario / environment prompts you to take action. I don't consider myself a high-level expert, but I do have a large % of my portfolio in prefs and have done very well the last few months with them - so consider this a call to those more knowledgeable to chime in, since we are all here to learn and I'm certainly all ears for that.

The names I've provided are for examples only, and not meant to endorse or pump the stock:
- perpetuals: you can construct a large % of your portfolios with these, e.g. SLF.PR.A, PWF.PR.K
- Fixed resets: I don't see many bargains here, new issues are not as attractive anymore. NA.PR.P had a nice 6.6% + 4.79% at reset term, but now trades at a ridiculous premium.
- Floaters: Still some bargains, you should pick up some as a hedge against rising rates. The yields are not very good currently but can be very attractive when rates go up, e.g. BAM.PR.B
- Retractable: act much like bonds because you have the option to redeem. YPG.PR.B, TD.PR.M. Most are expensive however.
- Splits: BNA.PR.C, note that these are retractable as well, which provides the holder an option to force the issuer to purchase the shares back (usually at par) at a predetermined date.
- Ratchet Floaters: Again for rate protection, but terms can be somewhat confusing: BAM.PR.E

Again, anyone who can help out, please chime it... as advice is appreciated since I'm still adding to my pref positions when I see a comparative bargain.

 

[leslie]

I don't agree with the basic premise of the question.

Each of the different types creates different risks/rewards and has different expected price volatility. But there is so many differences between issues, within any 'type' grouping, that doing asset allocation by 'type' won't accomplish what you think.

E.g. presuming the reset preferreds will all be called (and are super-safe) is not a true generalization. Some older ones clearly won't - ever. Others are impossible to value or predict their price movement - the resets based on 6-month T-bills.

No matter how you slice and dice the category there will always be more 'criteria' like cumulative/noncum/cumIfDeclared, or changeOfControlProvisions/non, or AssetBaseProtection/none, etc.

There is also the problem of people using the info from threads like this to buy issues WITHOUT doing the necessary analysis of the prospectus themselves and doing their own weighing of costs/benefits.

 

[tojo]

I don't agree with the basic premise of the question.

Each of the different types creates different risks/rewards and has different expected price volatility. But there is so many differences between issues, within any 'type' grouping, that doing asset allocation by 'type' won't accomplish what you think.

E.g. presuming the reset preferreds will all be called (and are super-safe) is not a true generalization. Some older ones clearly won't - ever. Others are impossible to value or predict their price movement - the resets based on 6-month T-bills.

No matter how you slice and dice the category there will always be more 'criteria' like cumulative/noncum/cumIfDeclared, or changeOfControlProvisions/non, or AssetBaseProtection/none, etc.

There is also the problem of people using the info from threads like this to buy issues WITHOUT doing the necessary analysis of the prospectus themselves and doing their own weighing of costs/benefits.

Leslie, you are absolutely right in that we should all practice due diligence before rushing out and buying each name that is mentioned on this thread. But I don’t think you are giving the poster enough credit here – the questions being posted are responsible, and for the most part, so are the responses. I don’t see any evidence to suggest that the board members are jeopardizing their financial health by irresponsibly purchasing securities that they may have little knowledge about. Your posts in this thread have convincingly alerted us that we need to proceed with caution, and that there are more to understand regarding fixed resets, asset classes, cumulative payouts etc then has been uncovered in this thread. I think that we can put fear aside for a while and discuss strategy. You are no doubt a very knowledgeable individual with regards to understanding the pref world. What is your strategy? Perhaps give us some real-life examples on your plan and how you deployed it? I think we are all responsible and intelligent enough to weigh the pros and cons of each opinion. We are here to learn and as I indicated, I’m all ears!

 

[SRQinvestor]

Tojo, thank you for the information and views on the various types of preferred's. I did purchase some of the 6%+ fixed resets a few months ago before premiums became excessive as well as some of the perpetuals before YTW yields dropped. I will research the other types and any names mentioned before running off to buy them but I appreciate your comments and any other points of view other readers are willing to offer. I follow the PrefBlog regularly to be informed on the market, trends, new issues etc. Always looking for other points of view as times and markets change. Tks again.

 

[tojo]

Tojo, thank you for the information and views on the various types of preferred's. I did purchase some of the 6%+ fixed resets a few months ago before premiums became excessive as well as some of the perpetuals before YTW yields dropped. I will research the other types and any names mentioned before running off to buy them but I appreciate your comments and any other points of view other readers are willing to offer. I follow the PrefBlog regularly to be informed on the market, trends, new issues etc. Always looking for other points of view as times and markets change. Tks again.

You're welcome SRQ...it can be a mean cruel world out there, and years from now, when we look back at the crash of 08/09 I hope we can say that we've all learned something ... and the more we can help each other, the better off we'll be...all the best.