The Financial Post recently published an article on how rate-reset preferred shares are becoming increasingly popular and are proving to be an attractive alternative for income-starved investors once the income trust market fades into the sunset. After 5 years, the dividend yield on most of these "new" preferred shares resets to a new yield, say the 5 year Government of Canada bond yield plus a risk premium. This reset feature protects the investor from a scenario of rising interest rates. These new issues are proving quite difficult to get at the IPO. Most of the older issues are currently trading at significant premiums to their par value. Investors must also keep in mind that these preferred shares are not risk free investments.
"The virtue of preferred resets is that you can't get hurt too badly. You hold them to the first reset term and if interest rates have moved against you, your pain ends." -- David Baskin
A Year Already?
15 hours ago
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Reset preferred shares fill trust gap
Investors have found a made-in-Canada solution for the big fat distributions that will be lost when income trusts disappear next year -- reset preferred shares.
The latest company to jump on the bandwagon, is former income trust Groupe Aeroplan Inc., which yesterday announced a cumulative rate-reset preferred shares worth as much as $172.5-million.
David Baskin, president of Baskin Financial Services, said both individuals and institutions are hungry for yield.
"Bonds are so unrewarding. GICs, forget about it. Canada Savings bonds, forget about it. So what are you going to do? These [preferred resets] seem to fill a need that people have right now."
While there are risks involved with investing in reset preferreds, the benefits are hard to ignore.
John Nagel, vice-president at Desjardins Securities, preferred shares department, and one of the creators of reset preferreds, said the shares give investors much more flexibility.
"The very low interest-rate scenario that we're in ... if rates are a lot higher five or six years from now, there's the option of going floating or being redeemed. That's very attractive," he said.
Mr. Baskin said the new reset preferreds are replacing fixed-term perpetual preferred shares, primarily because they better mitigate an investor's duration risk -- the risk that interest rates will move against them.
"With perpetual preferred shares that have no fixed maturity date, if interest rates go through the roof, you're screwed," he said.
"The virtue of preferred resets is that you can't get hurt too badly. You hold them to the first reset term and if interest rates have moved against you, your pain ends."
While the credit risk on reset preferreds issued by the banks and lifecos is largely viewed as negligible, Mr. Baskin said the risk of default is growing as the market for the new securities expands across different sectors.
That additional credit risk has been reflected in the higher coupon rate among lower quality issues with inferior credit ratings.
"For [companies rated as] P1s and P2s, they're a slam dunk. "For P3s, it depends on the company and its position in the industry," Mr. Nagel said.
"So some coupons can be quite substantial."
For example, recent bank reset preferreds were issued with spreads above Canada Savings Bonds of 150 basis points, Mr. Baskin said.
Groupe Aeroplan's new issue, meanwhile, offers a spread of 375 basis points.
To date, almost all of the reset preferreds have gained in value from the price they were originally issued. That represents an added bonus for investors who got in early, but it also presents a particular challenge for investors looking to get in on the action now as they may face lower yields and the potential for large capital losses as shares get redeemed on the reset date at par.
Clearly, it's important to think about the exit strategy right from the beginning.
"When you buy it, assume the worst," Mr. Nagel said.
"The secret is to look at these six months or nine months ahead of [maturity], and make a decision. If you think they're going to be redeemed, you should sell."
If the bond yield has risen substantially, the issuer is likely going to redeem the shares to prevent you from cashing in on the elevated rates.
In this situation, it is best to sell before that happens, and take the profit gained from share appreciation instead.
On the other hand, if the bond yield is low and it looks like the shares will be reset, the best bet -- available in the vast majority of cases -- is to convert to floating rate preferred shares, which are usually pegged to the Government of Canada three-month treasury bills plus the spread.
Source: Eric Lam, Financial Post
http://www.financialpost.com/story.html?id=2434776
INVESTOR ANGLE
First introduced in March 2008, there have been some 50 cumulative rate reset preferred share offerings so far, worth about $14.5-billion or a third of the total Canadian preferred share market. The concept has caught on quickly with banks and businesses looking for easy, non-dilutive capital. Among the major Canadian companies to issue similar preferred shares are TransCanada Corp., Fairfax Financial, Yellow Pages Group, and Manulife Financial. The numbers may be different depending on the offering, but Groupe Aeroplan Inc.'s offering is a good example of how the shares work:
Aeroplan first sells the shares at $25 each with an initial fixed quarterly dividend yielding 6.5% annually until March 2015.
On that date, and every five years after that, the yield will be reset to match the five-year Government of Canada bond yield plus 3.75%. Shareholders also have the option on each reset date to convert the shares to a floating rate share, receiving dividends at a rate equal to the three-month Government of Canada treasury bill yield plus 3.75%. However, Aeroplan also has the option to redeem the shares on that maturity date at par.
Source: Eric Lam, Financial Post
http://www.financialpost.com/story.html?id=2434776
Could you discuss some of the risks of the reset preferreds?
IMO the biggest risk is paying more then $25 for preferred shares. In most cases the issuer can redeem (call) the preferreds at $25 (par value) leaving you with a loss.
The reset feature removes most of the interest rate risk on these preferreds versus other types of preferred shares.
...
Q&A with James Hymas
Q: Should preferreds be counted as part of the equity portion of a portfolio, or the fixed- income portion?
A: I count them as part of fixed income, on the grounds that they have first-loss protection and they have a defined yield. Very bad things have to happen to the common shareholders before the preferred shareholders get hurt.
What about these newfangled "rate-reset" preferreds? These are the ones where the yield resets after a certain number of years at a spread over five-year government bonds - unless they're called, of course.
This has proved to be an incredibly popular product amongst retail investors. Retail is generally deathly scared of inflation, and they are prepared to pay quite a substantial yield differential in order to get some inflation protection.
I should point out that these fixed-resets are currently paying in the area of 3.5 per cent now. That's a yield to call [the yield the investor would get if the issue is called at the first reset date]. Given the current environment they are extremely likely to be called, because the reset spread stated at the time of issue is now far in excess of what the issuers need to pay currently.
One reason why this structure became popular with issuers is because they can call them at par after only five years. Normally the perpetuals are only callable after five years at a premium and they only become callable at par in nine years. These rate-reset issues are callable at par sooner and that is not good.
- James Hymas, president of Hymas Investment Management in Toronto
Thanks TD, I will look for below par prefs. Tara Quinn at ScotiaMcleod writes that the rate reset preferreds are usually perpetual, but i suppose that with the rate reset, that would eliminate being stuck with a low yielding stock that no one wants to buy. http://www.ritceyteam.com/pdf/guide_to_preferred_shares.pdf
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