Buying over-sold rate-reset preferred shares in today’s market
November 17, 2015 by InvestingForMe
Becoming a better, stronger skier has a lot in common with becoming a better, stronger investor. For both tasks you need to 1) know the basics 2) understand the conditions and the landscape 3) assess (honestly!) your own skill level and appetite for risk 4) want to improve (learn new and more advanced techniques and try more challenging runs/investments!) And for investors that want to venture off the preferred share Bunny Runs (like the ones we discussed in our last article), the next step in becoming a better, stronger investor would be to shop around for cheap, rate-reset preferred shares.
Before we leap, let’s review
The market prices for most preferred shares have declined over the past year, but of all the preferred shares the rate-reset preferred shares have been hammered, and hammered hard. Why?
Well, there’s one simple answer. When rate-reset preferred shares were first created and sold to investors (2008-2009), investors were told that one of the biggest risks to their portfolios was going to be rising interest rates. Unfortunately, interest rates have not increased. In fact, they have done the exact opposite. They’ve declined even further! So that 5 years later, when dividend rates began to be reset, rate-reset dividends, instead of adjusting upward, were adjusted downward. In some cases the dividend rates have declined by as much as 50%, sending share prices crashing. Ouch!
Here’s a common example of how that went down.
Case Study: Bank of Nova Scotia (BNS) rate-rest preferred shares issued in 2010
In March 2010 the Bank of Nova Scotia sold a rate-reset preferred share (BNS.PR.Y) to investors for $25.00 per share and paid an initial fixed dividend rate of $0.9625 or 3.85%.
In March 2015 the share’s dividend rate was reset to a rate equal to the sum of the Government of Canada 5-year Bond yield (GCAN5YR) plus 1.0%, or $0.455 (1.82%) per share and the share’s market price dropped to $18.95, today.
The result? If you had bought the shares at $25.00, you would have received $4.8125 in dividends over the past 5 years and lost $6.05 per share in market value for an overall, simple, rate of return of -0.1% per year. (Not a great outcome!) And for the next 5 years you’ll only earn 1.82% on your original investment.
So, given this less than desirable track record, who would want to buy any rate-reset preferred shares today?
Well, actually some people do want to because they’re up for bargain shopping knowing full well that there could be some risks. So, if that sounds like the kind of investing opportunity you’d be interested in, buying a beaten-up rate-reset preferred share at a discount price, there are a couple of things you need to first consider.
Rules to bargain shopping for rate-reset preferred shares
- Understand the math: To estimate what a share’s new dividend payment will be, after the dividend rate is reset, you must multiply the new dividend rate by the share’s original par value, or $25.00 (i.e., not the share’s current market value). For example, in the BNS example above, the new reset dividend rate is calculated as the 5-year bond interest rate (0.82%) plus 1.00%, which equals a new dividend rate of 1.82%. … And now comes the important part! To calculate the actual dollar amount of dividends paid by the company, you need to multiply the shares par value, or $25.00, by 1.82%. This gives you new annual dividend payments of $0.455, per share, which if you paid $18.95 per share, works out to a 2.40% annual dividend yield. (Now, that’s a bit better than 1.82%, but still not great!)
- Know a share’s credit rating: To figure out which share will truly give you the best bang for your buck, you have to make sure that you’re comparing shares that have the same credit ratings. In other words, you need apples-to-apples comparisons. In our example above, the BNS shares have a DBRS credit rating of Pfd-2 (high), which is a fairly strong investment rating, so you want to be sure, for example, if you were shopping around, that you’re comparing it to a share with a similar rating. Note: You can find a share’s credit rating in its full description in our Data Room section of our website InvestingforMe where you simply click on the share’s symbol.
- Know the share’s main features: Before you invest, you should know when and under what circumstances/price the company can change the character (or features) of the shares. The main features to be aware of for the BNS shares are its Redemption, dividend Rate-Reset, and Conversion features. All three of these features may influence the share’s market price. Note: Once again you can find a more detailed discussion of this topic in our Classroom section of our website InvestingForMe, or if you prefer, watch our video.
So, while this Bank of Nova Scotia preferred share currently offers a better annual return than that offered by a Government bond maturing in 5 years, at 1.82% it’s still not a great return. So, are there other opportunities you could look at?
Some shopping options
Here are just a few of the beaten up rate-reset preferred shares that you might want to take a look at:
- Fairfax Financial Holdings Limited (FFH.PR.E): This share has already had its dividend reset to a lower rate and it currently trades at $15.15 per share, pays $0.7275 or 4.80% for the next 4.5 years. On March 31, 2020 the dividend will be reset at an annual rate equal to the sum of the 5-year Government of Canada Bond yield plus 2.16%. The share currently has a DBRS credit rating of Pfd-3 - stable trend. The share has two dominant features: 1) its dividend rate-reset feature and 2) its convertible feature where the shares are convertible into shares that pay a Floating dividend rate.
- Shaw Communications Inc. (SJR.PR.A): This share will have its dividend rate reset on June 16, 2016. The shares currently trade at $15.51 and pays $1.125 in dividends. If the 5-year bond interest rate stays at current levels (0.82%), then its share’s dividend will be reset at approximately $0.705 for a current yield (based on today’s $15.51 share price) of 4.54%. The shares currently have a credit rating of Pfd-3 - stable trend, and its most important features are the dividend rate-reset and convertible features where the shares are convertible into shares that pay a Floating dividend rate.
- Enbridge Inc. (ENB.PF.V): This is a U.S. $ denominated preferred share (meaning it trades and pays its dividends in U.S. dollars). This share will pay U.S. $1.10 per share until its dividend rate is reset on March 1, 2019, when the rate will be reset to equal the sum of the 5-year United States Government Bond Yield (currently 1.72%) plus 2.82%. Right now, these shares trade at U.S. $18.68. If the 5-year bond interest rate stays at current levels (1.72%), then this share’s dividend would be reset at approximately U.S. $1.135 for a current yield (based on today’s U.S. $18.68 share price) of 6.07%. The shares currently have a credit rating of Pfd-3 (high) - stable trend, and its most important features are the dividend rate-reset and convertible features where the shares are convertible into shares that pay a Floating dividend rate.
- Veresen Inc. (VSN.PR.C): This share currently pays $1.25 in dividends and will have its dividend rate reset on March 31, 2019. The shares currently trade at $17.45. If the 5-year bond interest rate stays at current levels (0.82%), then its share’s dividend will be reset at approximately $0.9575 for a current yield (based on today’s $17.45 share price) of 5.48%. The shares currently have a credit rating of Pfd-3 - stable trend, and its most important features are the dividend rate-reset and convertible features where the shares are convertible into shares that pay a Floating dividend rate.
So, there you have it, just a few of the opportunities out there. By investing a little time and energy, you’ll be able to find investment opportunities that are within your level of risk tolerance and meet the guidelines as set out in your personal Investment Policy Statement.
Next time we’ll look at the benefits of switching out of a beaten-up rate-reset preferred share into an even more risky, beaten-up preferred share. Stay tuned for Rate-reset preferred shares: Black Diamond runs for the Experienced Investors only.
Read the 1st article in this series - Wouldn't it be great if investments came with a rating like a ski run?