Tuesday, July 31, 2012

Income Product Risk: Pref Shares

With investors flocking to “income” products it is worth taking a moment to understand the risks that can be associated with innocuous sounding investments in the “income” generating asset pool. The current Canadian regulatory standards apply virtually no meaningful assistance in assessing product risk. As such, many investors fall into the trap of believing an “income” security is similar to the risk profile of “fixed income” securities that provide on-going income. This is not a surprise given that investment advisors/salespeople generally speak of “income” products as a replacement for “fixed income” securities such as investment grade bonds. Given the growth in the number of “income” products, now is a great time to lift the hood on preferred shares; one of the basic income securities growing in popularity.
Preferred Shares (or prefs) is a hybrid product which has features of both equities (common shares) and fixed income (bonds). There are several types of preferred shares and the various types can have very different risk profiles. As a general rule the type of preferred share issued will vary based upon a combination of what the issuing company requires and what terms investors will accept at the time of issue.
Preferred Dividend Position: The primary benefit of a preferred share is first call on dividends at a pre-set rate. The pref share dividend is more secure than the common share dividend and may have assets backing the shares in the event of corporate default. A 3.5% pref share will be paid 3.5% of the face price annually, at the discretion of the board of the issuing company. Should the company not have sufficient cash to pay all dividends, the pref shares have first right to any dividends paid before the common shareholders receive any dividend declared. As always the dividends are paid at the direction of the company’s board of directors. When you hear about a company cutting its dividend that is almost always the “common share” dividend being reduced and only very rarely would it include the “preferred share” dividend.
Features of Pref Shares:Pref shares are issued by “charter”. The charter is similar to the trust deed of a bond issue in that it describes the rights of the pref share holder as a debtor of the company. It is the preferential access to dividends stated in the charter that give these shares their name. In return for this preference the holders of pref shares give up any right to vote as a shareholder of the company. In general the common share holders are entitled to a vote for each share owned (I am ignoring the few companies that have non-voting common share classes as they are the exception not the rule.). The lack of voting rights does not tend to hamper the average retail investor although it may discourage some large institutional investors.
Market Value of a Preferred Share: The preference shares will be sold with a face value such as $25.00 per share and it is this value that the dividend is based upon. For example a 4% pref share issued at $25.00 would pay a fixed annual dividend of $1.00 at the company’s discretion. The pref shares have no claim to any growth in profits and as such they trade at a value that is based primarily upon the dividend guarantee. In this sense the pref share value behaves very much like a bond or debt instrument. The value of the stream of dividends is comparable to the interest yield on a corporate bond. As such, an increase in the market yields of either bonds or new pref shares will cause pref shares to drop in value. A decrease in yields will similarly cause pref shares to rise in value.
Cumulative or Non-cumulative Dividends: Pref shares can have dividends suspended should a company need to do so. However, a “cumulative” pref shareholder must receive all missed dividend payments before any common share dividend can be paid by the company and before any pref share is redeemed by the company. A non-cumulative pref share has no right to recover missed dividend payments when regular dividends are re-started by a company.
Restricted Terms: A preferred share charter may restrict the company from issuing any future pref share series with a senior debt position to the specified preferred share issue. In some situations the restrictions may prevent a company from selling specified assets prior to redeeming the preferred shares referred to in the charter.
Risk Profile: Preferred shares are exposed to a unique set of risks that many retail investors are not aware of. The hybrid nature of the shares provides both additional security and additional risk characteristics. The risks of each pref share series must be determined separately prior to making a purchase.
Debt Risk: An example may be the best way to showcase the unique issues around evaluating pref shares within a company:
Company ABC currently has several series of preferred shares outstanding as follows:
-          One “preference share series A, 4%” and 3 series of preferred shares B.C, and D at 5%.
-          The holders of the “preference” shares are holding a preferred share similar to B, C, and D series holders. The difference is that the “preference” series has a higher ranking of security should the firm default on their obligations.
-          The B, C, and D series are legally defined as “pari passu”, which means they all have equal rights to the firm’s assets. These rights however are subordinate to the series A shares.
-          Should the company go into receivership the series A pref shares will recover their capital before the series B, C or D even though all are “preferred shares”.
The above example is intended to show that a preferred share is a subordinated debt instrument. When determining the risk profile of a pref share it is important to understand the security backing the share series and how it ranks relative to both corporate bonds, loans, and other outstanding pref series of the company. That also means it is important to understand the debt risk profile of the issuing company. The failure to understand this debtor risk is proving to be a significant issue for many investors who hold bank pref shares. More on this later!
Price Risk: Preferred shares tend to trade off the dividend yield as mentioned earlier. The price risk is often misunderstood as it is much more difficult to measure and understand. Again, let’s use a hypothetical example to clarify the issue:
An investor has his eye on two high flying firms that have great free cash flow and solid balance sheets. Not wanting to risk investing directly in the equity markets he decides to invest $10,000 in pref shares of each firm, Sino China and Banana. Subsequent to the purchases each company has a very different experience. Banana launches a new computer tablet and shares soar to massive heights with common share prices tripling in value. Sino China, in contrast, is subject to fraud charges and the company goes into receivership.
So how did our investor do when the share prices fluctuated? Taking the positive first; the pref shares of Banana are still worth $10,000 and dividends are very secure. As a pref shareholder however, our investor receives no direct benefit from the remarkable success of Banana and the increase in common share price. As for Sino China, the company is taken into receivership and eventually taken over by the creditors. There are insufficient assets to pay all debtors and as such banks are paid, bond holders lose much of their investments and the pref shares are priced to $0.00. Our investor gets no dividends and no return of capital from Sino China.
Had our investor bought common shares he would have still lost $10k on Sino China but also would have made $20,000 profit on Banana shares. He would be ahead by a net $10,000.00. Instead he avoided the risk of the equity markets and miscalculated the risk in the pref share market to his determent. As an aside, this example works equally well if you substitute Nortel or Lehman Brothers for Sino China in our hypothetical scenario. The bottom line is that investors need to determine the relative risk of holding pref shares instead of common shares or bonds. The investor needs to consider both an upward and downward scenario for share prices before deciding to buy pref shares.
Interest Rate Risk: Preferred Shares are similar to bonds in that the value of the preferred shares can be greatly impacted by interest rate changes. As you would expect, a pref share paying 6%, all things being equal, would have a greater value than a pref share paying 4% dividend. Unlike bonds, the income payment on a pref share is not generally set for a fixed period. Pref shares are generally issued for a set amount such as $25.00/share and the owner would expect to receive $25.00 on redemption. As discussed earlier, however, pref shares are issued based upon what the market will accept. Given that the big brokerages make more money from issuing companies than from investors in a pref issue; some of the common terms have greatly increased the risk to the investor and lowered the risk to the corporate issuer. This is the only way I can think of to explain “perpetual preferred shares”. These shares are issued with no maturity date or reset date and are redeemed at the option of the issuing company. In effect the issuing company will leave these pref shares outstanding only if the dividend is below the current market rates. This means these shares will trade either at or below the expected debt market yield available to the company. As an example, if the perpetual pref share pays 4% yield then the company will not redeem the shares unless they feel they can issue new shares at less than 4%. If the market rates should rise significantly then the value of the 4% perpetual would be expected to plunge. With no way for investors to improve yield and no way to redeem the shares, the investor must watch the value continue to erode or the share must be sold at a loss based upon the current market price of the share. Interest rate sensitivity of securities is based upon duration which generally means the longer the time until maturity the higher the sensitivity of the security value to interest rate changes. The duration would theoretically be at its absolute highest when there is no maturity date. In contrast, when market yields drop below the 4% the issuing company can call the shares for a forced redemption thus lowering the companies borrowing costs. In short you lose out if market yields rise and you are bought out if yields drop.
Why preferred Shares? The issuing companies generally pay more to raise money via a preferred share issue than from a bond issue. The reasons they would choose to do so reflect the current needs of the company and of the market place.
For example:
-           If the company has poor credit ratings it may not wish to go to the debt market directly and thus will pay a premium in the pref market to raise money.
-          If the company is concerned it may need to miss interest/dividend payments in the future it is easier to miss a dividend payment than a mandatory bond or loan payment
-          If the company finds it cannot sell common shares due to a poor market it may issue pref shares instead. The company may provide an option to convert the pref shares to common shares at a set date at either the company or investor’s option.
Benefits to the Investor: Pref shares do have some benefits that can make the shares attractive to investors.
-                 Greater security than the common shares
-          Dividend income can have favourable tax treatment versus the interest income earned on bonds
-          Dividend rates may be higher than the bond rates available in the current market
-          Pref shares may have conversion rights imbedded in the share terms
Convertible Preferreds: Some pref shares come with an option to convert the pref share to common stock based upon a pre-set formula. Typically these offerings have a set period of time when the holder can elect to make the conversion (retractable prefs) such as quarterly after the 5th year and until the 10th year after the issue date. As a hypothetical example; the pref share may trade at $25.00 and be convertible to common shares based upon the $25.00 pref face value plus all dividends earned divided by the 20 day average market price prior to the conversion dates. Convertible pref shares would be expected to be issued at a premium to perpetual pref shares due to the implied value of the conversion option. Occasionally the company will have an option to force the conversion after a set period of time regardless of the investor wishes. There is also a risk of declining market price for the pref if the convertibility option loses value (i.e. shares drop significantly in price).
Variable Preferred Shares: Our preference in preferred share options would be variable preferred shares. These pref shares have a reset date at which dividends are adjusted to reflect market rates. In these situations the risk of holding a perpetually “under market” dividend rate is mitigated. As an example, the dividend payout may be reset every five years at bank prime plus 4%. This allows the rate to adjust up or down but assures the yield remains somewhat consistent with the current benchmark market rates.
Flat Tail Risk: Pref shares are susceptible to significant losses when markets or companies are in turmoil. The lack of understanding of event based risks are leaving many investors with significant risk that they are not qualified to understand or evaluate. A perfect example is now playing out in Europe with respect to pref shares of large Spanish banks. The banks are experiencing significant losses as sovereign bonds they hold are being reduced in value. This in turn has left a number of banks nearly insolvent and turning to governments to be nationalized rather than facing bankruptcy. As the banks negotiate terms with creditors the pref share investors are left holding the bag. The bond holders can negotiate from some strength as they hold hard asset security in most cases. Many of the pref shares hold only a claim against general revenues. As these banks work out terms with creditors the pref share holders will likely be decimated.
 Now we ask some relevant questions: Did the retail pref share holder know that she was exposed to a significant loss based upon the bonds of sovereign nations being reduced in value? Did the retail pref share holder know that central banks encouraged large banks to hold sovereign debt in their capital reserves even though these bonds were of questionable value when issued, thus putting pref shares at significantly higher levels of risk? Did the average advisor/salesperson understand the risk of holding bank pref shares in a financial crisis?
Preferred shares do have a place in the security markets. They are not however your plain vanilla investments. They are not an equal risk substitute for investment grade bonds. Hybrid, complex financial instruments should not be sold to unsophisticated investors and should not be sold by your basic stock salespeople. I suspect that a number of income hungry seniors will be burnt by poor advice and basic overconfidence. After the fact many will complain they should never have been sold these securities....and they will be right.... and they will suffer significant losses that will not be recoverable. The most likely causes of a large loss will be dysfunctional credit markets, spiking corporate cost of borrowing, and lack of foresight to get out of the security before the prices collapse. Only sophisticated investors with support from top quality independent analysts should invest in complex securities.
p.s. Your mutual fund salesperson is not independent and is not likely an analyst.

Tuesday, July 3, 2012

False Prophets Revisited

On Feb 14th our blog for Weigh House Investor Services commented on the poor job of forecasting by the financial industry. We expressed concern that the market forecasters were glossing over a lot of real problems that had yet to be solved. Specifically on the macro side we referenced the Euro crisis and Greece’s bond default, significant on-going debt issues for consumers, and a dysfunctional U.S. government. Our take on these issues was that advisor/salespeople were ignoring the storm clouds that were obvious to everybody and pushing equities as the best option for your portfolio. The common mantra was “dividends can pay you nearly 4% per year while bonds and GIC’s are stuck at 1-2%”. It seemed "risk" was being treated as equal for equities and fixed income securities.
We had also discussed pending credit downgrades from Moody’s for the big banks and sure enough those downgrades arrived recently and included Royal Bank of Canada. We discussed the dysfunctional U.S. government and we are disappointed to see that no solution is in sight for the pending mandatory spending cuts and the expiry of investment tax credits in the new year. It seems the U.S. politicians will be arguing immigration policy issues when the country drives over the debt cliff!

We pointed out that the Greek fiscal problems were far from solved and now find the world watching the recent Greek elections to see if the tiny population of Greece could cause the whole of Europe to plunge. If Greece should chose to reject Europe’s requirement that Greece drive it’s economy (what little is left) into the ground - then look for a massive bank run across southern Europe as everybody tries to safeguard their bank savings under a mattress.

In the financial markets we noted the challenges brokers were having with selling overpriced IPO’s into the market. It appears that the folks over at FaceBook were too busy counting future option payments to pay attention. FaceBook has the potential to be the worst IPO ever by the time the dust settles but it did serve to expose the price fixing strategies of the deal makers. They clearly were able to prop up an over-priced IPO while waiting for retail suckers to buy in.

On the debt side we commented on how the 99% needed two jobs to pay their debt payments and the housing market was still in the dumps. Now we have seen the Canadian government adjust mortgage insurance policy for the third time in an effort to cool the debt growth in Canada.

When we wrote the article forecasters were priming the RRSP pump to flood the equity markets with what is lovingly known as “dumb money”. The TSX index ETF “XIU” ( it represents the major Canadian stocks) was at $17.82 and would be pushed up to $18.25 by Feb 28th as salespeople drove RRSP deposits into the equity markets. Today, with all the troubles still bubbling, the “XIU” sits at $16.46! It has dropped almost 8% but more importantly for RRSP investors it is down almost 10% since you made your end of February purchase. Even with your 4% dividend yield paying out over the next 12 months, that looks like a bad bet in the short term and who knows how it will look by year end.
So what? Are we suggesting we “knew” what would happen over the last quarter or that we are smarter that the stock guru’s? Absolutely not!

What we can say however is that we saw the high level of risk in the markets the same as everybody else did. It did not take a genius to see this was a pretty likely outcome for both the past quarter and likely for the next several quarters. The key difference is that we were not motivated to ignore the risk in the markets in order to exploit retail investors heading into the hype of the RRSP season.

The solution is for investors to follow a comprehensive investment policy statement. Based upon the policy guidelines it is possible to use RRSP deposits to re balance to the low end of the high risk assets and the high side of the low risk assets. While we do not suggest you can time the markets, we do suggest your financial advisor/salesperson has the flexibility to make tactical decisions to keep you off the train tracks until the obvious danger has passed. After all, what are you paying for if not prudent advice and commonsense for your investing strategy.

Or, referring back to the original blog’s ending statement; it was a time “not to be all in” to the equity markets. At the end of the day the issue is rarely about good forecasting and almost always about having a quality strategy and an advisor/salesperson who follows your investment plan first and his/her commission schedule second.