Preferred Shares Alex Kastanis, CFA. December 2016

Transcription

1 Preferred Shares Alex Kastanis, CFA December 2016

2 Why Invest in Preferred Shares Regular Dividend Payment Revenue that is fiscally advantageous Priority over common shares (bankruptcy) Different structures for different fixed income strategies A good complement for a diversified fixed income portfolio Exchange Traded 2

3 Fiscal Advantage (waiting for update) Source: NBF 3

4 Types of Preferred Shares Perpetual Fixed Rate (straight) Perpetual Rate Reset Perpetual T bill floating reset Perpetual Fixe floater Perpetual floating (including ratchets) Retractables (soft & hard) Synthetics (splits) 4

5 Canadian Preferred Share Market The size of the preferred share market in Canada is approximately $71 billion (as Nov 2016) Market has more than doubled in size over the last eight years Preferred Share Market Breakdown* 5 *Source: NBF, Bloomberg

6 Risks Interest Rate Risk: impact by changes in interest rates Credit Risks: change in the creditworthiness Call Risk: Issuer redeeming when it s to their advantage Extension Risk: Issuer resetting to a lower rate Liquidity Risk: Ability to buy and sell at a given price Dividend Cut 6

7 Credit Rating DBRS credit rating scale Pfd 1 Superior: Indicates superior quality, supported by strong earnings and balance sheet. The senior debt equivalent is AAA to AA. Pfd 2Satisfactory quality: Dividend and principal protection is substantial, but earnings, balance sheet and coverage ratios are not as strong as for Pfd 1. Senior debt equivalent: A. Pfd 3 Adequate quality: Protection is acceptable but the issuer is vulnerable to economic and financial adversity. Senior debt equivalent: BBB high. Pfd 4 Speculative: Protection is uncertain, especially if the economy turns down. Senior debt equivalent: BBB minus to BB. Pfd 5 Highly speculative: Dividend and principal payment is highly uncertain. Senior debt equivalent: B or less. D Default S&P credit rating scale P-1 corresponds to AA to A- (Sound) P-2 corresponds to BBB+ to BBB- (Adequate) P-3 corresponds to BB+ to BB- (Inadequate) P-4 corresponds to B+ to B- (Highly inadequate) P-5 corresponds to CCC+ to CCC- (Speculative) D Default 7

8 Preferred Share Market by Credit Rating 8 *Source: NBF, Bloomberg

9 Non Viable Contingent Capital (NVCC) Principles Governing NVCC OSFI determined that, effective January 1, 2013, all noncommon Tier 1 and Tier 2 capital instruments issued by institutions must comply with the following principles to satisfy the NVCC requirement: Non common Tier 1 and Tier 2 capital instruments must have, in their contractual terms and conditions, a clause requiring a full and permanent conversion into common shares of the institution upon a trigger event. As such, the terms of non common capital instruments must not provide for any residual claims that are senior to common equity following a trigger event. Financial institutions (banks) subject to Basel III Phasinginover10year 10%peryear

10 Non Viable Contingent Capital (NVCC) Trigger Events for Non Viability 1. the Superintendent of Financial Institutions announces that the institution in their opinion has ceased, or is about to cease, to be viable and that, after the conversion of all contingent instruments and taking into account any other factors or circumstances that are considered relevant or appropriate, it is reasonably likely that the viability of the institution will be restored or maintained; or 2. A federal or provincial government in Canada publicly announces that the institution has accepted or agreed to accept a capital injection, or equivalent support, from the federal government or any provincial government or political subdivision or agent or agency thereof without which the institution would have been determined by the Superintendent to be non viable. Issuers not required to redeem following the phasing in Once not qualified for Tier1 Capital more comparable to debt as source of financing ie: loses its main advantage

11 Non Viable Contingent Capital (NVCC) Conversion Formula The Contingent Conversion Formula is: (Multiplier x Share Value) Conversion Price = number of Common Shares into which each Preferred Share shall be converted. The Multiplier is 1.0. The Share Value of the Preferred Share is Par and in most cases $25.00 plus declared and unpaid dividends. The Conversion Price of each Preferred Share is the greater of a floor price of $5.00, or the Current Market Price of the Common Shares.

12 Perpetual Fixed Rate Characteristics No Maturity Date Fixed quarterly dividend Cumulative and non cumulative Callable by issuer after a call date First Call price is $26 dropping $0.25 every year till $25 Once call date is past, issue is callable with min 30 days notice 70% of this structure is currently callable 12

13 Perpetual Fixed Rate Characteristics Long duration Inverse relationship with interest rates 67% of structure from Financial issuers Good investment for barbell strategy or investors looking for long term yield Only $4.575 billion in fixed rate issued over the last 5 years Structure slowly disappearing 13

14 Perpetual Fixed Rate Valuation Straights trade on a current yield basis For issues that are currently callable, yield to call must be examined Relative current yield by credit rating must be analyzed (investors have a preference for strong cash flow issuers and those issues tend to trade at premium) Comparative analysis with issuers long term debt. If issuer does not have any outstanding, use closest comparable Most bank straights are non nvcc with a high call probability 14

15 Perpetual Fixed Rate 9.00% 8.00% 7.00% 6.00% Straights 5.00% 4.00% 10 year A corp. 3.00% 2.00% 10 year Cdn 1.00% BoC Rate 0.00% Jan 05 Apr 05 Jul 05 Oct 05 Jan 06 Apr 06 Jul 06 Oct 06 Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 Jul 08 Oct 08 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Jul 10 Oct 10 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Jul 13 Oct 13 Jan 14 Apr 14 Jul 14 Oct 14 Jan 15 Apr 15 Jul 15 Oct 15 Jan 16 Apr 16 Jul 16 Straight include only high quality issuers Pfd-2 & above *Source: NBF, Bloomberg

16 Perpetual Rate Reset Characteristics No Maturity Date Resets every 5 years 5 year GVT of Canada (GoC) + predefined Spread (if G negative then subtracted from spread) Non financials issued after August 2015 have a min yield guarantee (yield not lower than issued rate) Fixed quarterly dividend Cumulative and non cumulative Callable by issuer every 5 years at $25 16

17 Perpetual Rate Reset If not called, investor has the option to convert on a one for one basis into a T bill floating resets To create a floating reset a min of 1 million shares must opt for conversion Floating reset Floats quarterly 91 day T bill + the same spread as the fixed rate Every 5 years can convert from one series to another 17

18 Perpetual Rate Reset Direct relationship to rate Performs better in rising interest rate market Helps protect against inflation Complex structure to analyze Extension Risk issuer has all the options (reset to lower rate, call if rate above market rate) Since 2013, 47 rate reset have reset their rate (following a reset, the new rate has decreased on average 35%) 18

19 5 Year Government of Canada Bonds 5 year Canadas much higher in when spreads were narrower Weighted average spread highest level 19 Source: NBF

20 Rate Reset Valuation Complex structure with many piece to the puzzle Things that must be looked at Reset Spread (all issues) Reset Date (all issues) Current Yield Yield to call Yield on issuer debt Dividend on common equity for some issuers Credit risk/ probability of dividend cut (all issues) 20

21 Rate Reset Valuation 1 st Scenario Reset with a historically high reset spread and high call probability 1. Analyze the yield to call and compare with issuer bond with similar time to maturity 2. Yield to call with differential over 100bps on a non tax advantageous basis tend to show relative value 2 nd Scenario Reset with a historically low reset spread and low call probability (high extension risk) 1. Project what rate will be following reset 2. Calculate blended rate (current yield + expected future current yield) 3. Compare blended rate with fixed rate averages 4. Compare Blended rate with issuers (or similar) long term cost of financing 21

22 Rate Reset Valuation 3rd Scenario Reset with average reset spread and unknown call probability 1. Given the reset spread estimate the call probability 2. Given the call probability calculate y t c (if call prob 40% with a y t c 8% = 3.2%) 3. Compare y t c rate with issuer debt 4. Calculate worst case, base case and best case long term blended rate 5. Ensure base case is comparable with fixed rate issue 6. Ensure worst case is acceptable rate 22

23 Resets in more Details Spreads significantly narrower in higher interest rate environment *Source: NBF, Ratings Avg. Spread 2008 Avg. Spread 2009 Avg. Spread 2010 Avg. Spread 2011 Avg. Spread 2012 Avg. Spread 2013 Avg. Spread 2014 Avg. Spread 2015 Avg. Spread 2016 Pfd-1 (Low) Pfd-2 (High) Pfd Pfd-2 (Low) Pfd-3 (High) Pfd Pfd-3 (Low) Below I/G or Not Rated Avg. 23

24 Reset Floater Preferred Share Characteristics Created from fixed reset at reset day Floats quarterly 91 day T Bills + Spread Reset floaters have a short duration and perform well in rising rate environment Reset floater less liquid due to lower float Tend to outperform prime floater due its quicker adjusting reference rate Compare price differential with counterparty fixedrate they converge near conversion date 24

25 Perpetual Prime Floating Prefs Characteristics Floats on Prime Pays monthly Include ratchet and non ratchet floaters % of prime for ratchets depends on trading price Ratchets are also exchangeable every 5 years into a fixed floater At least 10 years since issuance Term favorable to issuer = very low call probability Not very liquid Performs well in raising rate environment 25

26 Perpetual Fixe Floater Rate Fixed for 5 years Resets every 5 years at a minimum rate of 80% of 5 year government of Canada Exchangeable into Ratchet floater every 5 years Historically not performed well as issuers has large discretion in determining next rate Only adequate as an investment for short period of times if: 1. Reset day multiple years away 2. Current yield above similar fixed rate issue Only 8 BCE, 1 BAM & 1 BBD currently issued 26

27 Retractable Preferred Shares Soft retractable can be satisfied by issuing shares Hard only in cash Issuer can Call issue after a specified date Investor can Retract his shares to issuer (similar to maturity) after a specified date Investor are not required to retract at the specified date Structure that most resembles a bond Disappearing structure Only 8 issues from 3 issuers 27

28 Synthetic Preferred Shares Split share preferreds are a structured product based on a portfolio of common shares The common shares are split to create two classes of securities a dividend component and a capital component. Split Capital Dividend Preferred Shares 28

29 Synthetic Preferred Shares Dividend cut to common stock have greater impact to splits Large declines in common stock price impact Net Asset Value (NAV) of split The preferred split usually has a 30% NAV downside protection on new issue Retraction date for investor Call/termination date for issuer Illiquid Yield pickup versus common equity portfolio 29

30 Research Services Team Alex Kastanis, CFA Samantha Barrett, CFA, MBA Philippe Heymans Eric Beaudette

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