Newsletter March 27, 2019
Why Have Rate Reset Preferred Shares Done So Badly?
As many investors are painfully aware, with few exceptions, rate reset preferred shares are trading below their issue prices. Investors have been repeatedly burned and wonder what happened. Investors have pushed the yield on even the large-bank rate reset preferred shares up to about 5%. At that level, these may now turn out to be reasonably good long term investments no matter where interest rates go from here.
A decade ago, rate reset preferred shares were introduced as a new financial “invention”, designed by the major banks to raise Tier I capital during the time of the financial crisis.
Investors were attracted by their relatively higher yields at a time of extremely low and rapidly falling interest rates. And there was the expectation of higher yields when the rates would reset in five years’ time, at which point, presumably, the economy would be back on track and rates would be on the rise again.
The initial issues were snapped up by investors. The positive response encouraged the banks, and other companies, to produce more. Today, rate resets dominate the preferred share market.
They achieved their goal of raising capital. But investors were whipsawed as the market value of many of these issues fell as interest rates failed to perform as expected and as what was arguably an inherent flaw in the structure of these preferred shares was revealed.
The reset feature was supposed to protect against capital losses if (as was expected) interest rates rose. Instead, most (but not all) issues of rate resets have suffered capital losses since their issue date.
Let’s look at TD Bank as an example. It has 11 rate reset issues outstanding. As of March 26, 2019 investors had suffered capital losses of about 25% on three of them. Another four showed losses of about 14%. And at times the losses were far larger, depending on market conditions. Losses on non-bank rate resets were often even greater.
So, what happened to cause these unexpected losses? For starters, we have to understand that every rate reset preferred share has an initial yield that is equal to the yield on the Government of Canada five-year bond plus a market “spread”. The key feature of rate resets is that after five years the dividend is reset to the then current yield on the Canada bond plus a fixed reset spread. The “problem” is that the fixed reset spread may turn out to be lower than the “required” market spread as time passes.
Let’s track the performance of one TD issue, TD.PF.A which was issued in May 2014 and will reset on October 31 of this year.
As the five year chart shows, these shares initially held firm at or slightly above $25 for about ten months. They then fell precipitously, bottoming out around $16 in January 2016. After that came a long, slow, moderately volatile recovery. The shares rose to between $23 and $24 for the first nine months of 2018. But then came a drop back to the $18 range in December and $18.70 at the time of writing.
Let’s look at why these gyrations happened. There are a lot of numbers here but bear with me to understand why these rate resets have behaved so unexpectedly badly.
Stage 1: PF.A shares were issued when the five-year bond yield was 1.50% and with an initial spread of 2.40%. This translated into a yield 3.9% on a $25 initial price, or $0.975 annually. The reset spread was set at 2.24%.
Stage 2: TD issued a similar rate reset, PF.D, on March 3, 2015. At that time, the five-year bond yield had fallen sharply to 0.81%. And the market spread had increased to 2.79% for an overall yield of just 3.60% on $25, or $0.90 annually. Its reset spread was also 2.79%.
At that time PF.A was reasonably competitive with PF.D since it would pay a dividend that was $0.075 higher for the next four years but would then reset at a yield that was $0.1375 lower than PF.D would reset. What is notable here is that, despite the sharp decline in the five-year bond rate, the PF.A price remained close to $25 at this time. Therefore, contrary to some reports, it is not only (or even primarily) lower market interest rates that have been responsible for the losses on rate reset preferred shares.
Stage 3: The price then declined rapidly over the next ten months and touched $16 in early January 2016. To explain this consider that on January 7, 2016, TD issued PF.G. At that point, the five-year bond yield was just 0.15% lower than the March 2015 issue at 0.66%. But the new preferred had a dramatically higher initial spread of 4.84% for a total yield of 5.50% on $25 or $1.375 annually. It had a reset spread of 4.66%.
Meanwhile, PF.A’s dividend of $0.975 was lower and its reset yield would be a hefty $0.605 lower than PF.G’s reset level. Since PF.A’s current and future dividend was far lower than PF.G’s, in order to “compete”, it traded at about $17 just after PF.G was issued.
Investors in PF.A had suffered a large, unexpected capital loss of about 32% as of January 2016 due to the huge unexpected rise in the market spread applicable to TD’s new rate resets. That higher spread was not unique to TD but affected all rate resets. Various market forces had caused that spread to increase (or “widen”). In early 2016, stock markets in general were down sharply and investors became much more risk averse. Investors’ appetite for rate resets also likely fell due to the very bad experience suffered over the previous nine months.
Stage 4: Then PF.A recovered to above $23 in the summer of 2018. That’s explained by the fact that on September 6th of that year, TD issued PF.K when the Canada five-year bond was at 2.16%. The spread was 2.59% for a total yield of 4.75% on $25 or $1.1875 annually. PF.A recovered because it no longer had to compete with a market spread of 4.84%. It remained below $25 because of its lower dividend and its somewhat lower reset spread of 2.24%.
Stage 5: So, how do we explain the recent plunge in PF.A to near $18 and its current price of $18.71? Well, TD issued PF.L on January 17th of this year when the five year bond was at 1.92%. The spread (set, as always by the market) was 3.28% for a total of 5.20% on $25 or $1.30 per year. In comparison, PF.A would pay at its annual rate of $0.975 for the next ten months (three quarterly dividends) and then reset paying (0.0145+0.0224) times $25 or $0.92, assuming the five year bond stayed at its current level of 1.45%. In order for PF.A to compete in the market with PF.L, its price had to fall to its current level.
It’s not entirely obvious why the market spread had increased to 3.28% as of January 17, from the 2.59% level of this past September 6th. It certainly has something to do with a lower risk appetite on the part of investors and also the general decline in the markets in December that had made many competing investments cheaper. I believe it also has something to do with rate reset investors having been burned and having endured such a wild ride over the years. When the price of rate resets once again started to fall in the past few months there was a lack of investors willing to step in, even at lower prices. It’s something of a case of once bitten, twice shy.
What this boils down to is that rate resets were designed to float at five-year intervals with changes in the five-year government bond yield. But there was no provision to float with changes in the market spread over and above the five-year bond yield. It was mostly the unexpected and sporadic increases in the market spread that caused the capital losses. The reasons for this are not entirely clear but seem to relate to investors becoming more risk averse at times.
At this time TD’s various rate reset preferred shares have yields between 4.3% and 5.4%. Assuming that the five year Canada bond stays at its current yield of 1.45% (which it will not), these shares will reset at yields ranging from 4.6% to 5.8%. Their prices range from $18.71 to $26.20. Despite the bad experience of the past, my view is that these and other rate reset preferred shares are worth considering for those looking for yield, and particularly in taxable accounts.
An earlier version of the above article was recently published in The Internet Wealth Builder, where I am a contributing editor.
Why do most Canadians oppose all tax increases, even on the rich?
It’s been my observation that the great majority of Canadians oppose income tax hikes of any kind for anyone. Many also favor income tax reductions for corporations. Even closing loopholes that allowed high-income professionals to artificially “split” their incomes with their non-working spouses and children received little support.
People with no investments do not seem inclined to support reducing some of the tax breaks and incentives that investors can take advantage of.
And there appears to be little opposition to proposals to lower corporate income taxes.
This strikes me as a bit odd. People are often fairly selfish and jealous by nature, yet at this time they do not seem inclined to support higher taxes on people far richer than themselves or even on corporations.
It’s possible that the reason for this is that people believe that higher taxes on corporations and the rich would harm the economy and therefore harm most Canadians over time.
But I believe that a more plausible reason is that people have developed a strong distrust of government. The narrative that, for example, “one out of every three dollars collected by government is wasted” is increasing believed. When corporate income tax reductions are proposed, people do not seem to believe that anyone would have to make up for the lost tax revenue. Rather, they seem to believe that the government can and will reduce its expenses accordingly.
There is little doubt that government employee wages and benefits are often higher than those paid in the private sector. But it seems very unlikely indeed that government wages or benefits will be cut. Therefore any reduction in corporate taxes seems likely to result in higher government debt and ultimately higher personal income tax rates.
Due to their distrust of government, people may be supporting income tax polices that are not in their best interest.
Whether or not taxes on all individuals and corporations are already too high is a debatable point. But the fact that there is such a deep distrust of government is clearly a bad thing.
Discounted Canadian Oil Prices – and government actions
In October and November of 2018, Western Canadian Select (WCS) oil was trading at a huge and record discount of over U.S. $40 to the price for West Texas Intermediate (WTI) crude.
While this was said to be hurting “Alberta” and even “Canada”, there are actually a lot of different players involved and not every player was hurt. Some may have benefited by the discount.
The discount then narrowed very significantly to about U.S. $10 in the past three months after the Alberta government mandated production cuts and announced plans to to lease over 4,000 rail tanker cars to get directly into the business of shipping oil by rail starting as early as July 2019 and ramping up over time.
While the sharply lower discount and far higher price for WCS benefits Alberta in general, it certainly harmed some industry participants greatly. There are companies that had spent millions to build oil rail car filling facilities which was helping to alleviate the glut of oil in Alberta. And there were likely some companies that had contracted for rail shipping capacity in the expectation of buying WCS cheaply and selling it at far higher prices in the U.S. Those companies have had their business models decimated by what could certainly be called government interference in the market.
Winners and Losers
Many variables are involved but let’s take a look at how various players might theoretically be affected in a scenario where western Canada was producing substantially more oil than could be used, refined or transported out, leading to a larger discount on Canadian oil prices. I say theoretical because in reality in late 2018 there were other factors at play including shut downs of some U.S. refineries and to the ebbs and flows in Middle East production and tensions. A theoretical analysis can assist in thinking about and isolating the impacts of Canada’s lack of pipeline and rail capacity compared to production levels.
The following is how I think various players would likely be impacted by an incremental and large discount on Canadian oil caused by too much production / too little pipeline capacity.
|Industry Player||Impact of a substantially larger discount on WCS versus WTI|
|Alberta Government||The Alberta government would be quickly and directly impacted due to lower corporate income taxes and lower royalties from producing companies. There would however, be some offset with higher income tax from shippers and refiners. There would also be a sharp decrease in the demand for and the prices realized in selling exploration land lease rights to producers. To the extent that the lower prices started to cause production and employment declines, indirect impacts would include lower personal tax revenues and lower corporate corporate income tax from the various oil service companies. In short, the negative impact on the Alberta government would be immediate and very large.|
|Federal Government||The Federal government would be directly impacted due to lower corporate income taxes from producers. There would also be indirect impacts if the lower prices caused production and employment cuts. Overall, while the federal government would be negatively impacted, the percentage affect on overall federal revenue would be far less than for the Alberta government|
|Producer selling at fixed price or with fixed-price transport to the U.S. arranged.||Some producers would have pre-sold their production at fixed prices to their customers or by hedging in the futures market. In that case there might be no immediate impact but futures prices would drop and so a negative impact would eventually show up.|
|Producer selling at the spot market Alberta price||There would be an immediate drop in revenues and profits could easily turn negative. Cash flow would likely remain positive but that would depend on the size of the discount.|
|Production employees||Although employees would be fearful, there might be no immediate impact on work hours or wages as long as production was maintained. In the longer term the employment in the sector and possibly the wages would be negatively impacted.|
|Alberta Refiner / petro chemical||Some refiners and petro chemical operations could benefit from the situation through lower input oil costs assuming the value of their refined product was not affected.|
|Regulated or fully contracted pipeline||A regulated “common carrier” pipeline charging a fixed price per barrel transported should be unaffected.|
|Pipeline that is unregulated as to price charged||If a pipeline is selling transport services to the highest bidder it would benefit through higher charges.|
|Rail shipper||A shipper arranging incremental rail transport should benefit greatly. In some cases an oil producer might also arrange incremental rail shipping offsetting some of the harm caused by lower Alberta oil prices.|
|Rail road||The rail road supplying incremental rail cars should benefit greatly, basically sharing the increased margins with companies that arrange the shipping.|
|U.S. Customer or Refiner||In our theoretical case here we are dealing with a discount in the Alberta price but where the U.S. price is unaffected. In that scenario a U.S. customer including a U.S. refiner should be unaffected. That is, the U.S. customers might be paying full price but less of the money reaches Alberta producers and more goes to any party involved in moving the oil.|
|Alberta General Public||Members of the Alberta public not directly or indirectly involved in the oil industry would initially be unaffected. But, over time, there would be an impact due to lower government revenues and a slowing economy.|
In response to the large discount in the Western Canadian Select (WCS) price, the Alberta government mandated modest production cuts and committed to leasing over 4,000 rail cars to get directly into the business of shipping oil-by-rail starting as early as July 2019 and ramping up over time. The production cuts appear to have had an immediate impact. In the early months of 2019 the price of WCS rose very substantially and the discount versus WTI was reduced to a below average amount. With the sharply reduced discount it is apparently no longer economic to contract for additional oil-by-rail shipments at the current WCS versus WTI price.
It is interesting to consider how the various payers might, in theory, be impacted by this successful government action that has very sharply reduced the WCS discount.
I have no direct knowledge, but here is how I think the players would be impacted just based on the rules of economics.
|Industry Player||Impact of a Successful Government Initiative to sharply reduce the discount on WCS|
|Alberta Government||The Alberta government would directly benefit through higher royalties and higher producer income taxes as well as higher revenues in selling new leases to extract oil. There would also be indirect benefits linked to a stronger economy. However if the higher WCS price resulted form the government’s role as an oil shipper, it might then be losing money on the oil shipments. In that sense, overall, the government would “win by losing”. The benefits would likely far out weight the losses on the oil shipments.|
|Federal Government||The federal government would directly benefit through higher higher producer income taxes. And, there would be an indirect benefit of higher income taxes related to the stronger Alberta economy.|
|Producer selling at fixed price or with fixed-price transport to the U.S. arranged.||In that case there might be no immediate impact but futures prices would rise and so a positive impact would eventually show up.|
|Producer selling at the spot market Alberta price||These producers would likely see an immediate jump in revenues and profits even if they were subject to a modest cut in production.|
|Production employees||The immediate impact could be job cuts due to the mandated lower production. However, if the higher WCS price was achieved though government oil-by-rail shipments then employment levels should be initially unaffected and then begin to rise with probable increased production.|
|Alberta Refiner / petro chemical||These companies would be harmed by the higher cost of oi. They would be unintended victims of government action and might demand compensation.|
|Regulated or fully contracted pipeline||Traditional fully regulated pipelines are not affected by the price of oil in the short term although in the long run, higher prices would likely result in growth opportunities.|
|Pipeline that is unregulated as to price charged||A pipeline that is unregulated as to the prices it may charge would be harmed by a government initiative that sharply reduced the discount on WCS since it is the discount that makes it economic to ship oil out rather than sell it in Canada.|
|Rail shipper||A party that has arranged rail shipments could be harmed greatly. Shippers may have contracted for rail or pipeline capacity on the expectation that they could buy WCS at a heavily discounted price. A sudden collapse of the discount could be ruinous to their existing contracts as well as removing the incentive to arrange future shipping.|
|Rail road||A rail road would be harmed for the same reasons as an unregulated pipeline. The lack of a large discount on WCS would make shipping by rail less economic or uneconomic.|
|U.S. Customer or Refiner||These should be unaffected since we are assuming no change in the price of WTI.|
|Alberta General Public||Members of the Alberta public not directly or indirectly involved in the oil industry would initially be unaffected. But, over time, there would be a positive impact due to higher government revenues.|
Reports I have heard indicate that it becomes uneconomic to ship oil-by-rail unless the WCS discount is at about U.S. $ 15 or higher and these reports indicate that oil-by-rail volumes out of Alberta have decreased in 2019 due to the lower discount caused by the government-mandated production cuts.
The production cuts are designed to lower the amount of oil in storage in Alberta which lowers the discount applicable to WCS and other Alberta oil. But reductions in oil-by-rail shipments by some players have the opposite effect. The Alberta government will ship oil-by-rail even if it is uneconomic. The overall result could be a WCS discount that will be somewhere in the U.S. $ 15 range making private oil-by-rail shipments economic but not highly profitable.
Overall, this is probably a good situation for Alberta since the discount will be sharply reduced from the levels seen in the Fall of 2018. But some players will have been hurt and may demand compensation.
March 27, 2019
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