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Rate-Reset Preferred Shares - fall in price when interest rates fall?

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Discussion starter · #41 ·
You have not made yourself clear.
  • Do you agree with me that all debt prices SHOULD rise when interest rates fall? You seem to agree in your #39 post when talking about 'behaving irrationally' and market' inefficiencies'.
  • But then you say I 'don't accept the reasoning that has been provided'. Which implies you disagree with me, and agree with all the experts saying prices should fall when rates fall.
  • My objective is to educate people on how the stocks SHOULD be priced? Are you objecting to this thread because you DON'T want people to know - so that you can profit from their errors?
  • You claimed in #37 that "Investors are clearly pricing in the effect of low interest rates at reset." Are they? How do you know? You challenged me with a list of specific stocks and I provided perfectly rational alternate explanations based on risk, which you ignored. I pointed out the logic that interest rates affect all issues equally, yet not all issues have fallen in price - therefore it is illogical to presume that interest rates were the cause of the general drop in price. Which point you also ignored.



I will make myself clear. These points have been made upstream.
  1. RateRest preferred shares are debt instruments that obey the same rules as all other debt. When interest rates fall, the price of existing debt rises, and vice versa. A drop in rates makes the larger payments from existing securities more attractive.
  2. If you ignore the possibility of any change in risk, the rateRest should act exactly the same way a normal 5-yr corporate bond will act. Their distributions will be equal and change at the same time, rolling over at the same price.
  3. Market arbitrage should prevent any divergence (ignoring changing risk). E.g the day a 5-yr bond matures it will be priced at Par because it will be called. The owner could then buy the company's new debt at the then current market yield. If the price of the rateReset were priced lower on the day of the reset, no one would buy the company's new debt. Why pay full value for the debt when you could get the exact same $income forever in the future, for the lower priced rateReset? .
  4. No company would IPO a rateReset with a higher yield than it could issue a normal bond for instead. The yields of bonds and rateResets should stay the same - so rateResets cannot move down in price while normal bonds rise in price (due to lower interest rates).
  5. If Treasury rates rise to (say) 10% by the next reset date, why would anyone bid up the rateReset price, to drive down its yield to the stipulated 5% that rateReset investors supposedly demand? Why pay more for a 5% yield from a risky company, when you could get 10% at a lower price from the risk-free government?
  6. The proof that there is not some set 5% yield at which this special asset should trade is shown by the widely different stipulated spreads for different issues by the same company. This is also proven by the widely different IPO coupons from different issuers at any point in time.
  7. A company's decision to call an outstanding issue or IP another is not determined by the relation of market interest rates to some set 5% demanded by rateReset investors. The decision is determined by the alternate financing options - no matter what the market rates.
  8. The two Yield calculations published and quoted by the experts and the media are useless and misleading. When the rateReset price is over $25 then yes, the Yield to Call is appropriate. But when the stock price is lower than $25 neither the Current Yield or the YTC has any meaning. The Current Yield ignores the reality that the distribution will change at the next reset. The YTC presumes a $25 maturity that is not a reality. Investors should calculate the Effective Yield that incorporates the current 5-yr Treasury rate.
  9. There is no way to know exactly what factor is driving market prices. You CAN say for certain that interest rate changes at reset should not change prices. But there is a list of rational possible reasons for the rateReset market to have correctly fallen in price. And there is also the possibility that price fall was irrational - caused by the experts' misinformation.
  10. A change in the risk spread the market demands will have a large impact on the price of a rateReset, because new risk is essentially perpetual. It will not be repriced at the next reset date, like a corporate bond will. A change in risk is the only reason for the price of the rateReset to not = Par value at reset.
  11. An investor's expectations at the point of purchase have no impact on the stock's /bond's pricing today. The past is irrelevant. Only the options available today are relevant. Also, the investor's expectations today about the future interest rates have no impact on the stock's price. It will impact his decision to buy/sell only. The market has already considered this in its pricing of Treasury and Corporate debt for different maturities.
 
#42 ·
Yes, you have made yourself clear in that you have defined a set of rules that all debt instruments should be following. But is has become obvious that rate resets are not following these rules to the letter. There is an element of investor psychology that is at work here that are not in alignment to your rules. I believe that if an investor were to follow your logic on how you think resets "should" act he/she will lose money, because as interest rates are falling, prices are falling. Your objective to educate people on how resets should be priced will do them a disservice, as these things are acting in the opposite of what you are saying they should. At this point I see no reason to continue this discussion. I have put sufficient capital in the rate reset market. I'm expecting rates to rise in a few years and profit in the process. Lets see if your campaign was a successful one and then we can compare notes.
 
#43 ·
Depends what one is trying to do here:

1-Change investor behaviour. Good luck with that.
2-Profit from mispricing due to investor confusion about how these products work.

#2 seems like the fruitful path to follow. Whether rate resets behave one way or another is kind of irrelevant if in the long run your expectation for how they behave (based on the model described here) is accurate--long run performance should converge to the expectation of the model despite short term price fluctuations.
 
#44 ·
So, I want to get this straight.

According to Leslie. Rate reset price should go down if rate increases.
According to the other camp. Rate reset price should go up if rate increases.
Which means that Rate Reset is a guaranteed buy right now. If Leslie is right, rate reset price is already down, so it won't go down any further. And we've just discounted the future where rate increases.
If the other camp is right, then Rate reset prices will surely go up.
So the possibilities are: Stay at this price level, or go up.

All agree? We should buy.
 
Discussion starter · #47 · (Edited)
@ tojo I stated the topic of this thread at the start - should the price of a rateReset fall as interest rates fall? It seems you refuse to either agree or disagree with the statement. You have decided it does not matter to you, and have concluded that no one else should care either. Beats me why you have posted here then.

@ andrewf Your original post asked my opinion on mis-pricing. My answer has not changed. Before concluding the asset is mispriced, you must first determine how it SHOULD be priced.

  • Step one - clarify that the math is indisputable, prices should rise when interest rates fall, not the opposite as claimed by the experts.
  • Step two, since the price drop was NOT caused by falling interest rates, ask what other possible causes are there?
  • Step three - acknowledge that no one can definitively state one subjective cause or another for market movements. Not me and not tojo.
  • Step four - conclude there is a possibility of market mis-pricing because investors have been mis-advised by the experts re interest rates.
  • Step five - keep your hubris under control and acknowledge that Mr Market is rarely wrong, so look for valid reasons for a price drop.
  • Step six - consider the possibility that prices have dropped because the market see more risk.
Before coming to any conclusions, you must start with the step 1 - the subject of this thread that you both refuse to address.
All contributors on this thread have refused to consider or acknowledge the possibility of step 6. What prices will do in the future, and whether this is a good buying opportunity depends on your full analysis of all 6 steps.

Evidence that the price drop has been correctly priced by the market due to increased risk.
  1. Mr Market is not stupid and will arbitrage prices to maintain comparable yields across different types of debt.
  2. A few companies have IPO'd recent rateResets at spreads equal to the market's pricing of the spreads of existing shares that have fallen in value. They would not have sourced rateReset financing unless a normal bond issue would also price in this high spread. This proves that the pricing is NOT specific to only rateResets, and is due to the risk faced by owners of all kinds of debt.
  3. The 'correct' spread is widely variable both over time for the same company, and between companies at the same time. Small changes in sentiment can swing this measure because it is so variable.
  4. If the drop on Treasury rates were the cause of the general rateReset market fall, then all issues would be equally affected. But that is not so. The market is only pricing in a higher spread for those companies that have obviously become more risky.
  5. The corporate spread for US bonds has increased by about 1% this year. (I have no access to Cdn data).
  6. Even assuming the price drop was caused by misled retail investors, that effect would not explain a 20% drop. Since interest rate reset themselves every five years, the sum total of 5 years of 1% smaller payments would only equal $25principal * 1% short payments * 5yrs = $1.25 = a 5% drop in price. Not nearly 20%
  7. The price effect of a 1% increase in the risk premium is much larger because it is not corrected by the next reset. So it's value is as if perpetual. An additional 1% added to a 4% yield causes the price to drop form $25 to $20. About what has happened.
  8. The Treasury rate used for resets has been lower than the rate 5 years previous ever since these shares started being issued in 2008 (except for a short span in the depths of 2008-09). Yet no one freaked out and drove down prices then. What is different today? The difference is the market's opinion of their risk. Even though Treasures were lower for resets in 2013 and 2014 may were priced ABOVE par and called because the market thought their risk premium should be lower.
  9. The risk premium priced by the market (about where it is now, but on the downslope) for investment grade rateResets averaged 3% (above 5-yr Treasuries). The risk premium priced into Perpetuals was the exact same 3% (above longterm Treasuries). Since no one disagrees with the pricing of Perpetuals this implies the risk priced into rateResets is 'correct'.
By refusing to come to terms with Step 1, you have blinkered yourself to all the rest of the analysis. I don't know what HAS caused the price drop, and neither do you. All that is known is that the price drop is NOT validated by any drop in Treasury rates.
 
#49 · (Edited)
leslie, maybe you misapprehend what I have said. I take no position on whether your thesis is correct, I'm only interested in what implications there are if your model for how rate resets should be valued is correct. If we also assume the Mr Market is correct in pricing these securities where they are today, the other moving piece are credit spreads implied by current pricing. It is up to you to assess whether that risk premium is attractive, or the changes in it are justified by the change in circumstance.

Your stated goal for this thread was to see if anyone could disprove your thesis. But absence of evidence is not evidence of absence, so at some point you will have to decide whether you are comfortable with the likelihood you are correct. You're not going to 'prove' that your model is correct.
 
Discussion starter · #50 · (Edited)
I recently had correspondence with an ex-regular (now promoted) on BNN MarketCall. Here are his responses to my thinking (presented as questions). I believe I am paraphrasing honestly.

Q1: Has the current spread (over Treasuries) of normal corporate debt (investment grade), also increased from the average 2.2% spread stipulated in the RateResets' prospectus to the average 3.0% spread at which RateResets are currently trading?

A: He says there has been a small 0.2% increase this year, but nothing like the 0.8% increase in RateReset spreads. This pretty much demolishes my idea (upthread) that the increased spread (relative to Treasuries) of RateResets is due to an increase in risk - which would be found in normal corporate bonds as well. Seem the references posted at #15 don't apply to Canada.
​

Q2: If normal debt is NOT trading at these higher spreads, why are companies IPOing new rateReset Preferreds at these high yields? Why would the companies not issue the cheaper normal debt.

A: He admits there is a big difference.
E.g. AltaGas Ltd. recently came to market with a 5-year RateReset preferred share with a spread of +4.19%. In comparison, their Jun-2020 senior unsecured bond currently trades at a +1.85% spread over 5-year Treasuries. In comparison, their Aug-2044 bond (that is 29 years) currently trades at at 4.14% spread over 5-yr Treasuries.

Possible reasons he offers - (i) Preferred shares are perpetuals without a maturity and (ii) rank lower in the capital structure. This is (iii) offset by the preferential tax on dividend income. But those reasons have always been true, and historically debt/preferred yields have been roughly equal. The risk of long-life debt comes from both repayment risk and interest rate risk. The RateReset preferreds get rid of the interest rate risk because they reset. They are not comparable to long bonds.

He argues that these RateResets are more cheap than issuing more common shares. But at the commons stock's recent price the preferreds will cost the same as common shares. And TransAlta's debt/equity ratio is about normal so there is no reason to prefer 'preferred equity to 'normal debt'. None of which is an argument for why the company did not issue normal debt instead.​

Q3: If normal debt IS trading at these same high spreads, is not the reason for the RateReset's drop in price because of this increase in risk, and NOT because of the lower $coupons at reset - as all the experts claim?

A: He replies --- " This is definitely part of it. But what is missing in your analysis is the concept of negative duration. Because these preferred shares are re-setting at low spreads over Canada bonds, their long term cash flow is also going to be much lower, which in turn justifies a discount price." I believe he inadvertantly said "... re-setting at low spreads" when he really meant " ... resetting at low coupons". But I dispute the 'negative duration' argument. There is only 'negative duration' when you mistake which interest rate your security is benchmarked against. E.g. for Floating Rate Preferred shares ...

"Some people may think that since Floating Preferreds go up in price when Prime rates rise, they violate the basic rule that 'when rates rise, bond prices fall'. The term 'negative duration' is used. But they don't violate the essence of that rule. You just have to rethink what is meant by it. Bonds rise in value when their benchmark's interest rate falls because the securities' distributions are now larger than what the market is paying.

What matters is the spread between the securities' distributions and the market yield. This spread is changed by either the security's distribution changing, or the market yield changing - the two ends of the spread. The 'market rate' benchmark for Floating Preferreds is the 5-yr Treasury rate, not the Bank Prime. When the Bank Prime rises, the securities' distributions increase, which creates the same effect on the spread as a fall in the benchmark 5-yr Treasury rate. So the Floating Preferred's price rises."(ref)​

In contrast, the RateReset's benchmark is the same 5-year Treasury as dictates their distributions. So there can be no 'negative duration'.​

Q4: Is it at all possible for just one type of debt (RateResets) to trade at a set yield, no matter what the interest rates are in the rest of the market? How can the price of RateResets fall (to maintain that higher yield) without arbitragers selling full-priced, but lower yielding normal bonds, and buying the cheaper RateResets with a higher yield?

A: He agrees that the current yields of RateResets should stay in line with all other deb - that this is not some set yield (eg 5%) that causes the price to adjust to get that yield. He cites their lack of liquidity and retail investor mispricing as reasons for the failure of arbitrage to keep their yields down. But get real - a 20% mispricing is enough to get any arbitrager's blood boiling. He cites that "many preferred shares are held in segregated accounts, and so can not be borrowed by trading desks or large institutions hedge funds in order to gain exposure." I'm not sure what that is referring to - the arbitrage play would be to short the cheap RRprefs and long the bonds, so there is no need to 'borrow to short sell'.​

added later - CONCLUSION
Nothing has been added to the rational of today's pricing - except for the fact that normal bond yield have NOT increased along with the RateReset yields - so their drop in price is not because of increased risk.
He sort-of agrees with me that RateReset yields should trade in line with all other debt in Q4, but he contradicts that stance with his mention of 'negative duration' in Q3.
He thinks there has been market mispricing but cannot give adequate reasons why arbitragers are not doing their job.
He cannot explain why companies are IPOing RateResets at these high yields when they could be issuing normal debt at lower yields. So again the market's normal mechanism for price correction fails.
Since 'risk' is not the explanation, there are only one other options - the market is mispriced ------- which I am loath to accept because 'the markets' are just not that stupid, unless the mispricing has been caused by all the experts's false claims (that prices SHOULD fall when rates fall) ---- the reason I started this thread.
 
#51 ·
So it does come back to mispricing?

I don't know how else to square the current prices much less than par implying a higher credit spread than at IPO. And if that higher credit spread is not reflected in other debt instruments for the company it strikes me as an opportunity.
 
Discussion starter · #52 ·
I added a list of the unresolved issues at the bottom of my post above. I am not a buyer until I can figure out WHY exactly the market is mispriced. Even if all the retail investors have been actively misled by the 'experts', that does not explain why the smart money and issuers themselves, have not corrected the mispricing. I am wary of what I don;t understand.
 
Discussion starter · #53 ·
I am not the only one shaking my head about the pricing of this market. Canadian Western Bank's Q4 supplemental information shows they booked an unrealized loss from holding preferred shares = $54,457 (,000). That is $0.68 /sh on a stock priced at $24 --- 3%.of the company's value. If you add that value back to the EPS and take its percent of the total quarter's EPS that is 34% of profits.

I have no idea why the bank is in this market. It is not big enough to be their playground. Maybe they did bought-deals for companies' IPOs and could not offload those shares without a loss ... and concluded they would hold until pricing normalized. Just guessing.
 
Discussion starter · #54 · (Edited)
FYI - I have two emails into AltaGas asking them to explain why they financed with preferreds at a 4.2% spread when they could have used normal debt at 1.85% spread. They have not responded.

In the news today http://cawidgets.morningstar.ca/Art...8C9508&culture=en-CA&IdType=CS&Id=CAN:RY&MaxCount=10&popup=true&_=1449682159865 is Royal Bank IPOing those 6yr rateReset preferreds that are really more like bonds. Just like AltaGas they are issued at a yield of 5.5% while today's price on their 10 year normal debt (July 2025) is only 2.8% http://www.globeinvestor.com/servle...or.com/servlet/Page/document/v5/data/bonds?order=a&sort=ISSUER&type=corp&page=2
 
#56 · (Edited)
leslie said:
FYI - I have two emails into AltaGas asking them to explain why they financed with preferreds at a 4.2% spread when they could have used normal debt at 1.85% spread. They have not responded.
Click to expand...
Could the explanation be that the directors and top management have at stake their director's fees and salaries? The trend line for AltGas is heading towards insolvency. By choosing dividends for preferred (which they can suspend), they can postpone the day of reckoning which they could not with bonds.
Click to expand...
 
Discussion starter · #57 ·
If anyone is interested I have posted my list of investment grade rateResets and Perpetuals as of Dec 18 showing the correctly calculated yields at http://www.retailinvestor.org/RateResetPreferredShares.xls . I have added a sheet at the back doing a reconciliation highlighting issues - Should rateResets have the same risk premium (over their relevant Treasuries, not the same Treasury)? Does the fact that they now trade below par make them perpetuals and so requiring the same risk premium (as well as the duration premium)?

@stantistic. Yes that seems to be a good explanation. But still if that were so obvious why would the debt market not also be charging them higher interest? Then there is the growing list of other companies issuing the same high yields with guarantees - some Brookfield entities, Canadian Utilities, Westcoast Energy. Surely CU is not predicting their own demise.

I have reverted back to believing added risk is the reason for this pricing (of both rateResets and Perpetuals - for the same reasons listed above . The only evidence to contradict that has come from one person's quote of one company's bid price. Found a chart of Canadian Corporate Yields at http://www.ftse.com/Products/FTSE_COM_Assets/TMXFiles/FT_Universe_AllCorp_TR.jpg that show rates have risen. Since fall the risk premium of both Resets and Perpetuals has continued to rise from about 3% to 3.3% - just like the Americans are seeing with their investment grade debt https://research.stlouisfed.org/fred2/series/BAA10Y
 
#58 ·
With a number of preferred share issues dropping 10% or more in the last 2-3 days I did some buying again. Whether it is increased risk or fears of a further rate cut I am really agnostic, but yields as well as discounts to the call price are too tempting to resist. Whenever it gets to ugly I just reminds myself that eventually they will be called so the price in the meantime is not too important.
 
#59 ·
PharmD said:
With a number of preferred share issues dropping 10% or more in the last 2-3 days I did some buying again. Whether it is increased risk or fears of a further rate cut I am really agnostic, but yields as well as discounts to the call price are too tempting to resist. Whenever it gets to ugly I just reminds myself that eventually they will be called so the price in the meantime is not too important.
Click to expand...
I have been watching CPD for over a year and strongly considering jumping in at these lows. I can't say I understand them 100%. Can CPD be at this price in 3 years? Looking for a semi-safe 3 year investment. thoughts?
 
Discussion starter · #60 · (Edited)
An interview on BNN today had a portfolio manager that effectively shares my POV. See Doug Grieve video at Business Day PM - Air Date: 1/15/2016-3:20 PM

To paraphrase him .... The initial rateResets were IPO'd at high spreads because of the risk during the Credit Crunch. Those were most all called at their reset date because of their high spreads. But since then issues have come to market at much lower spreads. He does not say so explicitly, but implies their stipulated spreads were too low.

He expects the prices of these to rise if rates rise. He did not say "because" of a rate rise, but only "if ... then". What he thinks the cause of the price rise will be (if rates rise) is made clear by his differentiation between these low-spread issues and the very recent large-spread issues - which he says to buy now for the larger distributions. So, if rateResets increased in price with rising market rates, then the effect would apply to both the low and large spread issues. Which he says won't happen. So the cause is not 'the rise in interest rates'.

I think what he thinks but did not make explicit was ..."market rates won't rise until the economy improves. When the economy improves the market will demand a lower risk spread. The shrinking risk spread will cause the rateResets to rise in price." He talks about the market-valued spreads today being historically wide, as if he agrees with me that the falling prices of the last year has all been about rising risk spreads, not about falling market interest rates.

EDIT LATER - I take back my presumptions about the understanding of Mr Grieve. I just watched an early video interview of him where he clearly says he agrees with the received wisdom that rateResets increase in prive with rising interest rates. http://www.bnn.ca/Video/player.aspx?vid=741435
 
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