The title says it all, but the market is again at a point where if you want a double digit return on your money, it has to come from the equity side. With equity comes risk.
Over the past year there has not been a lot of TSX-traded debenture issuance (indeed, the list of traded debentures is down to 94 and there does not appear to be much compelling value in the list – anything trading below par is doing so for what I consider to be a valid reason).
On the preferred share space, while it is easy to make a relatively stable 5% return, the risk you have to take to move up the yield chain goes higher and higher – e.g. Aimia’s preferred shares give you an extra 250bps or so based off of the 5yr reset rate, but you’re more or less investing in a hedge fund with a current market cap of half a billion.
Want less risk? Canaccord’s preferreds reset at about 100bps less than Aimia’s, have much higher revenues, but when the investment banking gravy train stops (and indeed – it will) you can be sure that people like me will be buying these preferred shares for less than half of par value, like we did back in 2016.
The surest 500bps I can find at present appears to be Pembina Pipeline’s minimum rate preferred shares that they acquired from Kinder Morgan Canada (PPL.PF.A/C/E), and in the case of the C and E series, likely to get called out in less than 2 years. Aside from a mention of Birchcliff Energy’s preferred shares, Pembina’s is probably the closest instrument that you can treat as a term GIC instrument with a ‘probable’ fixed maturity. Between now and then, however, things can always change and there could be some credit crisis that’ll blow the capital value of the stock – as witnessed during the CoronaCrisis – what trades at par value today traded at 44 cents on the dollar on “Margin Call Day”, March 23, 2020. It does an effective job of wiping out people that take out excessive leverage to buy these types of issues.
All in all, if your target is to make a 5% income stream, there is still plenty of selection (with capital risk in the event of market stress), but this is a far cry from the days of last year or in early 2016 when finding low risk double digit yields in fixed income was like the proverbial shooting fish in a barrel.
This environment is making me suspicious and indeed elevates my sense of paranoia that we are ripe for something bad to happening.
As preferred shares rise (and yield less), I can’t help but question at what point it would make sense to accelerate my mortgage payments; it seems odd to pay it down when it’s 185bps. However since that’s an after tax savings, if we assume I pay 50% in taxes, that’s comparable to 370bps.
Paying it down quicker eliminates my liabilities, so it’s essentially a risk-free investment for me. Compare that with PPL.PF.A which is a min 490bps, and factor in a 30% bump due to the div credit; that gives me 637*25/24.24 = 656bps. So the long story short, is 286bps worth the risk?
You and every other hedge fund on the planet is asking themselves the same question, the pricing on CAD margin is 65bps above $1.4M so those yield differentials will keep compressing until you get an old fashioned margin blowout. When that might occur? Who knows, but hopefully you’ll have bailed out before then!
One to look at is the Capstone Infrasturce series A. It is part of a group of preferred shares that reset back in 2016 when the 5-year yield was below 1%. Capstone’s preferred share bottom ticked the 5-year yield resetting around 0.56%. The preferred share will reset in July, and based on the current 5-year yield the yield on cost would be 6.22%. The kicker is there is a chance for decent equity upside. Capstone is owned by a private equity firm, and research around the fund vintage it would appear it would be up around 2023/24. Capstone owns a basket of onshore renewables and hydro assets. With these assets being taken out at 4% yields, a 3.71% preferred share detracts from equity returns and can be cheaply financed with debt. Maybe its an Atlantic power situation where you get slightly less than par, but it still an attractive return based on the current price level combined with a higher yield. Best part is the preferred share is to small for instituional investors to take part in, so it leaves something for us little guys.
Capstone is about 2/3rds wind power by revenues, a very hot sector at the moment. Before the presidential election they certainly looked a lot better, I’d think you might get about 50bps more tightening on price but the majority of it is done. The interesting question is whether if you put a gun to my head and told me to 100% allocate to CF or Capstone A, good question… FFH.PR.G trumps the other two!
For me ELF-PF trumps them all. I have used the 5.3% preferred as my cash alternative for 13+ years. EL Financial’s preferred is the safest Canadian stock I have come across, in my investing career. Bought it around $21 in the 2008 crash and kept buying it it all the way up to $24. Even did a spousal loan for my wife to buy it (at 1%) to split income with her.
I think you made a solid choice, short of redemption risk. I’ll point out that during the Covid crash that they still did lose max 24% of their capital value (March 23, 2020), albeit briefly. Somebody over-leveraging themselves at this point would not have been happy had they been forced to sell. But with moderate leverage your choice looks pretty good for the yield spread.
Brookfield asset managment has a billion preferred share issues which aren’t as ‘safe’ in my opinion but is still relatively safe for the same purpose…
I still like the 5-year rate reset BPO prefs. I have BPO.PR.N and BPO.PR.P, which are about $16.50. I see no reason why these won’t move above $20.
Any thoughts on the RCG.PR.B? Seems like it should be less risky with a much bigger wealth manager as the main business vs the old institutional broker. Maybe an outside chance that a bank or someone else with better credit trumps the Canaccord hostile approach and the credit spread tightens?
I hold RCG.PR,b which came from the conversion of my GMP pref shares. Since the conversion it is up over 20% (but all my pref shares have shown huge improvement since last March). As I have a DB pension I have some higher risk pref shares (along with investment grade) and another small holding in my higher risk basket is OSP.PR.A (over 8%). It’s the pref version of a “split share” investment in the energy sector.
An underappreciated aspect of preferred shares is the ability to trade for predictable, incremental income and the clipping of an illiquidity premium. Trading can be intra-issuer (as with a tool such as James Hymas’ Implied Volatility Theory) or inter-issuer (using something like my own Target Spread Theory, which can pretty much be reversed engineered from the title). There are enough company- and capital markets-specific forces large enough to move preferred prices such that they can be easily traded.
The biggest knock to preferred shares is the transient haircut certain to occur at infrequent market moments. This is of major concern to money managers who have to explain mark to market losses to clueless clients. It should not be a concern to a long term investor with the “ability and willingness” to hold. This latter class of investor, as Sacha points out, does not include significantly margined investors.