Saturday, 5 October 2013

Preferred Shares with High-Yield, Safety and Fixed Maturity

A few weeks back we compared fixed income investments and discovered that a couple of preferred shares from split share corporations offered the highest rates available for investments maturing in the next couple of years. Today, we'll update our September 2012 review of preferred shares, looking for promising investments by seeing how preferred shares with a great degree of safety and a fixed maturity date match up across the whole range of years ahead.

What we mean by "safe"
We want to minimize the chance of not getting our money back, so we select only preferreds with an investment grade rating from ratings agency DBRS of Pfd2-Low or higher (see table of ratings in Appendix B of Raymond James July 2013 Preferred Share Report).

Getting your money back also means knowing what you will receive when
Like GICs and bonds which promise to return a fixed amount at maturity, we pick the subset of preferred shares which promise to return a definite amount at a certain time in future.

Unlike bonds and GICs, several of our preferred shares, shown by green highlight cells in our comparison table, have a sliding scale of the amount to be returned. As with virtually all preferred shares, the company issuing the share has reserved the right to buy the shares back earlier than the ultimate maturity date. But in the case of this subset of preferreds, the price paid back is higher the earlier the re-purchase, which is termed a call or redemption by the issuer. For instance, CGI Series 4, 3.75% (TSX symbol: CGI.PR.D) may be forcibly repurchased from an investor owning it at a price of $26.00 till the 15th of June, 2019, then at $25.75 till 15 June, 2020, then at $25.50 till 15 June 2021, then at $25.25 till 15 June 2022 and finally at $25.00 from then till final maturity on 15 June 2023. It is a bit complicating that each preferred share has its own schedule so it is necessary to consult a source such as, which maintains an up to date list of all preferred shares. The July 2013 CIBC Wood Gundy Canadian Preferred Shares Report also has those details grouped together by type of share.

The sliding scale is a plus for the investor, being a disincentive for the company to redeem early as can be seen in the Yield to Possible Early Redemption column of the comparison table. The yield for such sliding scale preferreds would end up being higher for the investor than if the preferred stays in existence till maturity - e.g. Partners Value Split Corp. 7.25% Class AA Series IV (TSX: BNA.PR.D) matures on 9 July 2014 at $25.00 but if the company were to call it anytime beforehand, it would have to pay the investor $26.00 and the yield is almost double.

Comparison Table
The table below of twenty-three preferred share issues includes four sets of important factors to consider - Value, or what will be the yield/return; Call/Early Redemption Factors, or what are the chances the share will be called before maturity; Security, or what is the level of safety and; Liquidity, or how easy is it to buy or sell shares.
(click to enlarge image)

A key question is how much the return will be. Our calculations were done with Shakespeare's free downloadable spreadsheet. We show three answers.

1) Yield to Maturity at Closing Price - the annual return from buying at the market closing price on 3 October 2013 and holding till maturity.

2) Yield to Possible Early Redemption - again we buy at closing price but instead of the maturity redemption amount, we calculate what return would result from the amount promised at the next date at which the company has the right to call the shares. In some cases, like for BNA.PR.D and CGI.PR.D we investors would be happy with a higher return. But in others, such as 5Banc Split Inc (FBS.PR.C), the 2.56% yield to maturity turns into a negative 17.77% return, a big loss. The reason is that paying $10.86 for a share that might be called on 15 December 2013 at $10.00 and pay only $0.13125 dividend up to that date is a losing proposition.

3) Yield to Maturity at Ask Price - It may not be possible to buy the shares at the latest closing price, especially when there is a low volume of shares traded daily. For such shares there is often a large gap between the price on the TSX at which investors are offering to buy, the bid price, and the higher price at which other investors are willing to sell, the ask price. Everyone tries to buy low and sell high! A more conservative estimate is thus the asking price. But that lowers the potential yield, sometimes drastically, as our table shows. Big 8 Split Corp Class C 7.0% (BIG.PR.C) maturing in December 2013 goes from a very attractive 4.65% yield when bought at closing price of $12.07 to a 0.73% loss when the ask price (as of October 3rd) of $12.20 is paid. When the the time to maturity is short and there are not many dividend cash flows to provide return, purchase price matters a lot. As can be seen in the table, there is much less of a hit to yield from paying the ask price for longer maturity securities.

On the basis of yield factors, First Asset CanBanc Split Corp. (CBU.PR.A) and Utility Split Trust 5.25% (UST.PR.B) look to be very unattractive, promising more loss than gain.

Call / Early Redemption Factors
These factors give an idea of the chance that the shares will be called, possibly to the investor's detriment. A danger sign is when the preferred's market price is above the redemption / maturity price, but we need to take account of the sliding scale. Alternatively, for some split share corporations, early cash-out can occur if capital shares are given in by investors forcing preferred shares to be sold. Sometimes capital shares and preferred shares can only be submitted with a preferred share so a premium on one may partly of fully offset the discount on the other for arbitragers seeking to profit from a price below Net Asset Value e.g. CBU.PR.A and UST.PR.B.

Three preferreds appear to be at some risk of early redemption due to a fairly large discount (highlighted in red text) on capital shares that can be submitted for retraction by themselves: Allbanc Split Corp. II (ALB.PR.B), BNS Split Corp. II (BSC.PR.B) and R Split III Corp (RBS.PR.B)

The basic and most important default risk indicator is the DBRS rating, where the CGI Series 3, 3.90% (CGI.PR.C) and CGI Series 4, 3.75% (CGI.PR.D) get the highest rating of the bunch Pfd-1Low. A secondary indicator is the amount of capital share value as a percentage of the total company value. The higher the capital percentage the better. The lowest coverage ratio is Brookfield Investments Corp 'A' (BRN.PR.A) at 45.9%, though DBRS still rates it investment grade. To see that all the preferreds in our list are quite safe, it may be useful to note that preferreds of BCE Inc are rated a notch lower, below investment grade, at PFd-3High.

Many of the preferred shares in our list do not trade in large volumes, often because there are just not many in existence. The result is that it is difficult to buy and sell shares and there is often a big gap between ask (offers to sell) and bid (offers to buy) prices. An investor is wise to trade using a fixed limit price instead of a market price (see BMO InvestorLine's glossary). Our table shows shares with big Bid-Ask spreads and low volume shares in orange text. Poor liquidity is not an insurmountable problem but it can be inconvenient and potentially costly, as the reduced yields using ask price show.

Bottom Line
Putting it all together, we have picked out the preferreds with the best combination of high yield along with good liquidity and protection from the bad effects of early redemption.
  • Allbanc Split Corp. (ABK.PR.C)
  • Partners Value Split Corp. 7.25% Class AA Series IV (BNA.PR.D)
  • Partners Value Split Corp. 4.95% Class AA Series I (BNA.PR.B)
  • Partners Value Split Corp. 4.85% Class AA Series V (BNA.PR.E)
  • Partners Value Split Corp. 4.35% Class AA Series III (BNA.PR.C)
Our picks show in green text colour in the table and the chart below displays the choices by year of maturity. We have not picked CGI.PR.D maturing in 2023 since there are higher rated corporate bonds offering the same or better yield, which we saw in the September 13 post. One good choice that doesn't fit on the chart, since it has no pre-set maturity, is Brookfield Investments Corp 'A' (BRN.PR.A). Instead, the investor has the liberty to retract it (sell it back to the company) at the price of $25.00 at any time.

Disclosure: This blog writer owns BNA.PR.C shares.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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