I was on BNN's Market Call this past Monday April 25th. You can view the entire show on our In The News tab.
To say I was shocked during the show would be an understatement. 90% of the calls/emails were on penny stocks I have never heard of but the other 10% of the calls were on the Preferred Share market. I suppose, given what has happened to the pref market, and what I know of prefs, I shouldn't have been stunned into a state of incredulity. We could argue whether prefs are even Fixed Income (they are really senior equity), but the bottom line is, they have been sold to individual investors as Fixed Income for years (reasons for that below). We at High Rock do have 2-3 prefs in our Fixed Income models (along with true fixed income/bonds) , but they are very small % weights and they are Insurance prefs and are fixed rate. We have not, and likely will not own bank prefs, bank common stock, bank sub-debt, for the reasons below... read on.
The pref market got pasted over the past year for two very good reasons. I will get to both reasons in a minute. But first, what I have known for decades about the pref market is equally as interesting...it is a 100% retail market. That is to say, Investment Advisors at the Banks/Dealers get paid an awful lot of commission upfront (3%!!!) to the sell their clients new issue preferred shares. And they do so saying "They are fixed income and have the banks credit". Really?
So why did the market get hit so hard the past year?
1) Because a big portion of the pref market is in rate-resets. What this effectively means is that a lot of prefs had their reset dates coming up and the coupons reset the past year. The new coupon typically resets based on the 5yr Gov't of Canada bond rate. Well, that 5yr Gov't of Canada rate is a not-so-stout, ~.75%. That, plus the spread on the reset, left all of these prefs with total coupons at reset that were half of what they were the past 5yrs. Brutal. You gotta know what you are buying...or what your Advisor is selling you (reading that prospectus should be the Advisor's job).
2) Because bank capital calculations have changed dramatically since 2013. This is largely being driven by the Bank for International Settlements (BIS) and called Basel III. And then each country takes Basel III and adopts their own version (but in compliance). Now I don't claim to be an expert in Basel III and the new Canadian bank capital calculations, but I have a very good friend who is. I have spent over two years picking his brain, reading research, creating spreadsheets etc all in the name of actually understanding what we were investing in (or, in the case of prefs, not investing in). To not do this research and just assume that the pref market was "safe" is the definition of insanity.
I won't completely bore you with all the details but will list a few:
1) Since 2013, all Canadian banks start losing some of what is called Common Equity Tier 1 (CET1) capital. They loose a certain % each year over the next 5yrs. They therefore need to issue securities that qualify for CET1 each year so they are onside of the new CET1 calculations.
2) The new securities that count for CET1 include prefs. So, you guessed it...these banks need to issue a ton of new prefs. Our research shows they need to issue about $5bln/yr over the next 4-5yrs to get onside of the new capital calculations as required by our Canadian Bank Regulator, the Office of the Superintendent of Financial Institutions (OSFI). So what we saw last fall was BMO repricing the market with a Institutional private deal of $650mm at a new coupon of 5.625%. Yes, the pricing on prefs is garnering more Institutional discipline than before. And Bank Sub-debt also counts for CET1 capital. so careful with those too.
3) Prefs and Bank Sub-debt are called Non-Viability Contingent Capital (NVCC). What this means, very importantly, is that if OSFI decides that a Canadian bank is no longer viable, they will declare a "trigger event" and all of this sub-debt converts to common equity (stock) at a ratio of 1.5:1 and prefs convert at 1:1. The reason why OSFI has declared this is so that if there is a bank failure, it will be the common shareholders who bear the brunt of restructuring the bank, not tax payers. So, if that were ever to occur,and you thought you owned a bank bond or a pref, you would be converted to stock.
4) Now the probability of a Canadian bank becoming non-viable and a triggering event occurring is probably pretty slim, however, what has happened is that "spreads" on both sub-debt and prefs have widened out because a) the freight train of supply and b) the very fact that bank securities (sub-debt and prefs) now have asymmetric risk, at least compared to 5+ years ago.
Research. That is one of the cornerstones of High Rock Capital. It takes time, knowledge, hard work, experience and a network/team to share ideas and our research findings with.
We could tell you we go deeper in our research because we have a Fiduciary Duty to all of our clients to always do the right thing by them and that means doing our best every day (including spending the time to do research), and that is all true, but don't forget, unlike most, Scott and I are investing our own capital here so we care that much more than others (and our wives would kill us if we didn't).
Ask your current Advisor to explain his views on NVCC and the Pref market and compare notes to what you now know.
(I am not nearly the writer my partner Scott is, so if this isn't clear enough or you want even more depth, please call or email me).