I am furious with the media's campaign of mis-information regarding the pricing of Canada's Rate-Reset Preferred Shares. Experts have been claiming that these shares drop in value when rates fall. You can see these claims by ScotiaMcLeod, RaymondJames, CIBC, another fund manager, and two interviews on BNN yesterday and today, etc, etc, etc. They are singing from the same song book.
Give me a break. In the first half hour of any introductory course in bonds, everyone learns the mantra "rates down, prices up" and vice versa. When interest rates fall, the value of outstanding debt increases in value. Prices do NOT fall. And rate-reset preferred are no different from other debt. So here is a simple example to prove the point.
Yesterday a new issue PrefA of rate reset preferreds was IPO'd by Company
Today another new issue PrefB is IPO'd by the same Company
In five years from today your expectations are that ..
So back to today. Which would you rather own, PrefA or PrefB?
Rates down, prices up. Just like for every other debt security.
____________________________________________
So what has caused the 20% drop in value of Rate-Reset preferred shares this year?
Well the drop in price has certainly be helped by the campaign of mis-information telling retail investors that their stocks are worth less now because the rates have fallen.
Also, those stocks in the O&G industry have increased in risk a lot this year. So their stipulated spreads are now too low, Yield up, prices down.
But never discount the possibility that the market is actually correctly valued and responding to legitimate factors.
First you have to correctly calculate their effective %yields. The 'experts' may well quote the current yields (= current distribution divided by current stock price). This number is irrelevant and should be TOTALLY IGNORED. If the stock are trading above $25 then they will likely be called at reset, so the normal Yield-to-Call assuming a $25 future value is correct.
For all the other rate-reset you work with today's 5-year Tbill rate, Calculate the coupon as if reset today. Subtract today's actual distribution and discount that difference in 5 years of payments back to today. Adjust the stock price by this discounted value. Divide the reset coupon $ by this adjusted price.
Once you have the effective yield, subtract today's 5-yr Tbill rate to find the market's risk spread. Compare that spread to documented spreads on other debt. There is no public information for Canadian debt, so use the US data. This year's spread has increased from 2.2% to 3.3%.
Using all the Rate-reset issues, except for the O&G industry which are too risky IMO, Ignore all those graded Pref-3 or Pref-4. What you are left with is a list of spreads on Investment-grade rate resets that varies from 1.75% to 3.5%. Right in line with the US data - if not more expensive (too low yields mean too high prices).
For the calculations and data.
Give me a break. In the first half hour of any introductory course in bonds, everyone learns the mantra "rates down, prices up" and vice versa. When interest rates fall, the value of outstanding debt increases in value. Prices do NOT fall. And rate-reset preferred are no different from other debt. So here is a simple example to prove the point.
Yesterday a new issue PrefA of rate reset preferreds was IPO'd by Company
The 5-yr Treasury rate was 1%
The stipulated spread on the issue was 3%
The coupon for the first 5 years is set at $25 * 4% = $1.00
The stipulated spread on the issue was 3%
The coupon for the first 5 years is set at $25 * 4% = $1.00
Today another new issue PrefB is IPO'd by the same Company
The 5-year Treasury rate dropped in half overnight and is now 0.5%
The stipulated spread on the issue is 3% still because the risk of the company has not changed.
The coupon for the first 5 years is set at $25 * 3.5% = $0.875
The stipulated spread on the issue is 3% still because the risk of the company has not changed.
The coupon for the first 5 years is set at $25 * 3.5% = $0.875
In five years from today your expectations are that ..
The 5-yr Treasury rate will be x%. It is ludicrous to think you can predict any rate different from this x% for reset of PrefA one day previous. So the expected Tbill reset rate will be the same for both issues.
The stipulated spread will be the same 3% for both issues.
The new coupon after the reset of both will be the same $25 * (3% + x%) = $$$
The stipulated spread will be the same 3% for both issues.
The new coupon after the reset of both will be the same $25 * (3% + x%) = $$$
So back to today. Which would you rather own, PrefA or PrefB?
Both issued by the same company with the same corporate risk.
Both pay the same risk spread over Tbill rates.
Both will be distributing the same $$ coupon at the next reset date in 5 years (give or take a day)
The only difference is that PrefA pays $1.00/yr for 5 years, while PrefB pay only $0.875/yr. PrefA will pay $0.625 MORE in distributions (5yrs * (1.00 - 0.875))..
The Pref A shares will RISE in value between yesterday and today by the discounted value of their extra dividends. Both pay the same risk spread over Tbill rates.
Both will be distributing the same $$ coupon at the next reset date in 5 years (give or take a day)
The only difference is that PrefA pays $1.00/yr for 5 years, while PrefB pay only $0.875/yr. PrefA will pay $0.625 MORE in distributions (5yrs * (1.00 - 0.875))..
Rates down, prices up. Just like for every other debt security.
____________________________________________
So what has caused the 20% drop in value of Rate-Reset preferred shares this year?
Well the drop in price has certainly be helped by the campaign of mis-information telling retail investors that their stocks are worth less now because the rates have fallen.
Also, those stocks in the O&G industry have increased in risk a lot this year. So their stipulated spreads are now too low, Yield up, prices down.
But never discount the possibility that the market is actually correctly valued and responding to legitimate factors.
First you have to correctly calculate their effective %yields. The 'experts' may well quote the current yields (= current distribution divided by current stock price). This number is irrelevant and should be TOTALLY IGNORED. If the stock are trading above $25 then they will likely be called at reset, so the normal Yield-to-Call assuming a $25 future value is correct.
For all the other rate-reset you work with today's 5-year Tbill rate, Calculate the coupon as if reset today. Subtract today's actual distribution and discount that difference in 5 years of payments back to today. Adjust the stock price by this discounted value. Divide the reset coupon $ by this adjusted price.
Once you have the effective yield, subtract today's 5-yr Tbill rate to find the market's risk spread. Compare that spread to documented spreads on other debt. There is no public information for Canadian debt, so use the US data. This year's spread has increased from 2.2% to 3.3%.
Using all the Rate-reset issues, except for the O&G industry which are too risky IMO, Ignore all those graded Pref-3 or Pref-4. What you are left with is a list of spreads on Investment-grade rate resets that varies from 1.75% to 3.5%. Right in line with the US data - if not more expensive (too low yields mean too high prices).
For the calculations and data.
