Fairfax preferreds

[loerke]

The Fairfax preferred offerings are sharply discounted right now, and I'm not sure I understand why. On first glance they seem to me to present a good buying opportunity. I made a good return on Odyssey preferreds in the past and I am considering doing the same here. FFH.PR.G is trading at 18.02 in Toronto, offering a 7% yield. Fairfax has the option to redeem the shares at 25.00 on September 30; at such a discount, it might want to do so, given the very high yield due on the shares. I might be out of my depth in understanding preferreds but from q quick glance it seems like a good opportunity to me.

[benhacker]

Many of Fairfax preferred are rate reset preferreds.  The series G for example is 5% until Sept '15... then it resets from 5% (on $25 par) to 5yr Canadian rate + 2.56% - or roughly 3% at current rates.

 

Buyer beware.

[Txvestor]

I think the yield on these falls to 2.5% plus the 5-Year Government of Canada bond yield, so a shade under 3% as of now, on Sept 30th, at the discretion of Fairfax. I would suspect they will just roll it over at 3% for another 5 yrs. i think the holder has the option to convert to series H shares, i haven't looked at the terms on those.

I suspect the price drop is related to this. That said the drop in price gets your yield back up to 5% and if you are expecting deflation and needing income, i could think of worse places for your cash.

[benhacker]

The series H conversion turns them into a 3mo rate + 256 floater... also not valuable at this time.

 

$18 CAD may be an ok price, but just be sure you know what you are buying.

[loerke]

Thanks to you both for the careful, informed responses. I just read the series G prospectus, and you're right -- the yield drops sharply after September, and the option to convert to series H doesn't seem to be worth much. Still, I bought a few shares around 18 CAD, which means the yield after September works out to around 4.2%, and possibly higher if Canadian rates go up -- and if rates don't rise, then the price of the preferreds is likely to remain strong as the yield looks more attractive to investors. Strikes me as better than buying most corporate bonds out there, though it comes with somewhat greater risk. I'm just too nervous to buy the Fairfax common shares at the moment, though I've owned them in the past.

[A_Hamilton]

I look at it this way:

 

FFH issued these pref's when the market was substantially underestimating the risk of rates staying lower for an extended period (the market became more aware over time which is why the spreads on each series moved up over time), and, they did these offerings when the CAD was near par to the dollar. They likely converted all proceeds to USD immediately upon completion of the offering to hedge Northbridge back to the dollar.

 

Now, with certain series trading at a discount to par, and the CAD trading at a much cheaper price versus the USD, FFH has the option of using some capital to buy these things back through its normal course bid. They are unlikely to call these at par unless they've reduced the number of prefs outstanding to such an extent that it is not worth keeping the issue outstanding, or, the company wants to close out its hedge on Northbridge's activities. The interest rate is just too low for them to call it otherwise!

 

I'll give the hat tip on these pref's to Brian Bradstreet as it looks like the work of his genius, but I'd also be happy to learn that someone else at FFH deserves the credit!

 

 

 

 

[obtuse_investor]

Bumping up this topic. :)

 

FFH rate reset preferreds have been effectively tracking the Canada 5yr Bond (see attachment). Some of these are yielding to reset (YTR) at 6%. What confuses me is that they are trading at the same levels as 2016, when the Canada 5yr bond (https://ycharts.com/indicators/canada_5_year_benchmark_bond_yield) was at 0.6%. It is at 1.6% right now.  Is the market forecasting that Canada 5yr bond will drop back to 0.6% (which would imply a recession from today's levels). Even if that happens, these preferred may be a good value right now, since they are already discounting a negative future.

 

Best case: It is status quo 2 years from now, and these reset to (1.6 + 3.98 = 5.6%); which will lead to ~20% capital gain as well.

Worst case: Reality is that BoC is unable to lower rates, if US economy is strong. So, in worst case US and Canada hit a recession, leading to a zero bound once again. These will reset to about 4.5%, with minimal capital loss on the books. You're making 4.5% while you sit through a recession.

 

Not a bad risk/reward for a fixed income portion of the portfolio.

 

Am I missing something?

 

[wisowis]

FYI there are a couple of pages of relatively recent discussion about the FFH prefs starting here: http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/canadian-prefs/msg353578/#msg353578

[obtuse_investor]

FYI there are a couple of pages of relatively recent discussion about the FFH prefs starting here: http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/canadian-prefs/msg353578/#msg353578

 

Thanks! I missed that thread.

It is interesting that that thread is focused on the ability of FFH to pay because it was mainly happening during the Q4 market swoon.

[StubbleJumper]

FYI there are a couple of pages of relatively recent discussion about the FFH prefs starting here: http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/canadian-prefs/msg353578/#msg353578

 

Thanks! I missed that thread.

It is interesting that that thread is focused on the ability of FFH to pay because it was mainly happening during the Q4 market swoon.

 

 

It didn't at all focus on ability to pay.  It focussed on risk adjusted return.  FFH has securities in the preferred space, but there are any number of other issuers that also have preferreds, so how to you rank their risk adjusted return?  And, how do you stack up the preferreds vis-a-vis the common? I have not seen much value in preferreds other than the notion that some how, some way, yields-to-worst will tighten and there'll be a capital gain on the back-end.  Maybe.

 

Or you can buy a chartered bank common with a 4-5% dividend rate which will likely grow and which will likely give you some capital gains.  In the worst case scenario, how many years would it take for one of the chartered bank commons to out-perform an FFH preferred?  Would it be 5 years in the worst case scenario?

 

 

SJ

[obtuse_investor]

 

It didn't at all focus on ability to pay.  It focussed on risk adjusted return.  FFH has securities in the preferred space, but there are any number of other issuers that also have preferreds, so how to you rank their risk adjusted return?  And, how do you stack up the preferreds vis-a-vis the common? I have not seen much value in preferreds other than the notion that some how, some way, yields-to-worst will tighten and there'll be a capital gain on the back-end.  Maybe.

 

I agree that there are likely other preferred shares that present much better risk/reward. I just haven't done my homework.

 

 

Or you can buy a chartered bank common with a 4-5% dividend rate which will likely grow and which will likely give you some capital gains.  In the worst case scenario, how many years would it take for one of the chartered bank commons to out-perform an FFH preferred?  Would it be 5 years in the worst case scenario?

 

 

With Canada's housing bubble finally unraveling after decades of credit binge, I wouldn't be counting on Canadian chartered banks' dividends to be stable. To me the worst case is quite horrible indeed. If the housing market reverts to the mean, we are likely talking a lot of pain for the Banks' shareholders.

 

Back on topic... your arguments have convinced me to stay away from the FFH preferreds though. :)

[StubbleJumper]

 

It didn't at all focus on ability to pay.  It focussed on risk adjusted return.  FFH has securities in the preferred space, but there are any number of other issuers that also have preferreds, so how to you rank their risk adjusted return?  And, how do you stack up the preferreds vis-a-vis the common? I have not seen much value in preferreds other than the notion that some how, some way, yields-to-worst will tighten and there'll be a capital gain on the back-end.  Maybe.

 

I agree that there are likely other preferred shares that present much better risk/reward. I just haven't done my homework.

 

 

Or you can buy a chartered bank common with a 4-5% dividend rate which will likely grow and which will likely give you some capital gains.  In the worst case scenario, how many years would it take for one of the chartered bank commons to out-perform an FFH preferred?  Would it be 5 years in the worst case scenario?

 

 

With Canada's housing bubble finally unraveling after decades of credit binge, I wouldn't be counting on Canadian chartered banks' dividends to be stable. To me the worst case is quite horrible indeed. If the housing market reverts to the mean, we are likely talking a lot of pain for the Banks' shareholders.

 

Back on topic... your arguments have convinced me to stay away from the FFH preferreds though. :)

 

 

While this might constitute "whistling past the graveyard," it's worth taking a historical look at Canadian banks' dividend history and how they've approached other downturns.  In particular, the financial crisis of 2008/09 and the last major recession of 1992/93 are interesting.  Income gets hammered for a year or two as provision for credit losses rises, but the dividends were not cut.  Some of the banks issued equity, but the dividends were not cut.  In some cases, there were no dividend increases, but the dividends were not cut.  In fact, you can go back several decades and not find a dividend cut from a big-5 Canadian bank.  The central theme is that a Canadian bank avoids cutting its dividend at all costs.

 

As I said, to a certain extent, that's whistling past the graveyard.  If income is vapourized for 3 or 4 years, the story could end up being different this time.

 

 

SJ

[obtuse_investor]

 

While this might constitute "whistling past the graveyard," it's worth taking a historical look at Canadian banks' dividend history and how they've approached other downturns.  In particular, the financial crisis of 2008/09 and the last major recession of 1992/93 are interesting.  Income gets hammered for a year or two as provision for credit losses rises, but the dividends were not cut.  Some of the banks issued equity, but the dividends were not cut.  In some cases, there were no dividend increases, but the dividends were not cut.  In fact, you can go back several decades and not find a dividend cut from a big-5 Canadian bank.  The central theme is that a Canadian bank avoids cutting its dividend at all costs.

 

As I said, to a certain extent, that's whistling past the graveyard.  If income is vapourized for 3 or 4 years, the story could end up being different this time.

 

 

SJ

 

I appreciate the historical context. I can totally believe that one of the prime ways of attracting equity capital is to pay a stable or increasing dividend.

 

It is a complete shame that people who buy equity for the 4% dividend would continue to hold, while the management issues 20% equity, wiping out ~5 years of dividends in one fell swoop.

[StubbleJumper]

 

While this might constitute "whistling past the graveyard," it's worth taking a historical look at Canadian banks' dividend history and how they've approached other downturns.  In particular, the financial crisis of 2008/09 and the last major recession of 1992/93 are interesting.  Income gets hammered for a year or two as provision for credit losses rises, but the dividends were not cut.  Some of the banks issued equity, but the dividends were not cut.  In some cases, there were no dividend increases, but the dividends were not cut.  In fact, you can go back several decades and not find a dividend cut from a big-5 Canadian bank.  The central theme is that a Canadian bank avoids cutting its dividend at all costs.

 

As I said, to a certain extent, that's whistling past the graveyard.  If income is vapourized for 3 or 4 years, the story could end up being different this time.

 

 

SJ

 

I appreciate the historical context. I can totally believe that one of the prime ways of attracting equity capital is to pay a stable or increasing dividend.

 

It is a complete shame that people who buy equity for the 4% dividend would continue to hold, while the management issues 20% equity, wiping out ~5 years of dividends in one fell swoop.

 

 

In some respects, it depends on your perspective, your objective, and your time horizon.

 

If you had an investor who desired an eligible Canadian dividend for tax reasons for a 20 year time horizon and wanted "low risk" of it ever being cut, a perpetual preferred share from a lifeco, bank or utility might fit the bill.  You buy the perpetual and you collect up the ~5-6% divvy and then 20 years later you unload your perpetual for what will probably be either a small-ish capital gain or a small-ish capital loss. 

 

I would propose that a Canadian bank common dividend probably has about the same risk of being cut or suspended, but the dividend runs in the 4-5% range, which is a hair lower than the preferreds.  If the investor with the 20-year time horizon buys that common share, he'll sit back and collect his eligible Canadian dividends for 20 years, and the divvy will almost certainly grow considerably over time.  We know that 20 years will encompass at least one economic cycle, if not two economic cycles.  We know that the banks will likely report low (near zero?) earnings for 3 or 4 years during that time frame, and they might issue more shares during the 1 or 2 downturns (as you've noted, possibly 20% more shares on one or two occasions).  But, despite the share offerings, we also know that the oligopolistic banking sector will probably rack up an annualized ROE of 15-20% over those 20 years which will almost certainly result in a considerable capital gain, irrespective of the share issuance.

 

All of this sounds like a free lunch, right?  I'd say that it's *almost* a free lunch from the perspective of risk adjusted return.  The common does carry a couple of risks that are not present in the perpetual preferreds, notably that this time might actually be different.  Past practice aside, dividends might not increase in the future, and they could theoretically be cut or suspended.  The ridiculous return on equity might not continue in the future (how much of past ROE was driven by the collapse of the 4 pillars?).  There might be considerable policy risk in holding the common if a future government was ideologically predisposed to breaking down the barriers and fostering greater competition, *or* if a future government was ideologically predisposed to taxing the fat-cats as an avenue to achieve greater social justice.  So, it's not a free lunch, but over a long enough period, I'd say it's an asymmetric bet.

 

I don't want to seem like a brainless cheerleader for the Canadian banks, but I just like to use them as a point of comparison to preferred shares.  I have nothing against preferreds in particular, but I just don't see much value there at present.  If the preferred yields to worst were half again as large, I might view it differently.

 

 

SJ

[Cigarbutt]

With the evolution of prices (specific securities as well as preferreds in general) and the general level of interest rates, the risk and reward profile has evolved for Fairfax preferred shares. Getting interesting. I remain split between the possibility to buy now versus to wait for a negative rate trajectory to manifest combined with noise related to a major catastrophe.

https://www.raymondjames.ca/branches/premium/pdfs/preferredsharesreport.pdf