ORH.A Today

[bablu]

oec2000 ..

 

Do you mind giving a primer on how this retractable shares work and what are these split corp preferreds all about ?

 

Thanks for your time in advance..

 

[oec2000]

Do you mind giving a primer on how this retractable shares work and what are these split corp preferreds all about ?

 

Split share corporations are usually set up to invest in specific asets (in case of BAM Split Corp, it is to invest in BAM shares). The split corp issues both capital shares and pfd shares - funds raised are used to invest in the specified asset. The pfd shares earn a fixed rate of dividend (or interest) and have a fixed redemption date. The capital shares thus have a leveraged exposure to the underlying specified asset. E.g Pfd is isuued at $25 and Capital share at $10; proceeds of $35 used to buy 1 share of Royal Bank at $35. Dividends received from this RY investment is used to first pay pfd dividend, balance goes to Cap Shs. On maturity date of Split Corp, RY shs sold, pfd shares redeemed at $25, balance goes to Cap Shs. If RY shs are $50 at maturity, Cap Shs holders make out like bandits getting $25. If RY are at $25 or below, Cap Shs holders get zero.

 

In good times, the underlying assets appreciate and the capital shares appreciate even more and the pfd shares trade like bonds. In bad times like now, as the underlying assets fall in value, fears arise that at some point, even the pfd shares might not be adequately covered by the underlying assets. This, probably together with some forced selling in Oct/Nov, cause these pfds to trade to fairly large discounts to underlying value. For e.g., in Nov, BNA.PR.C (another BAM Split Corp pfd) traded to below $8 even though the NAV of the underlying assets (BAM shares) was $45 meaning that the Pfd shares were 1.8x covered.

 

Many of these split corp issues come with monthly or yearly retraction features which allows shareholders to surrender their pfd or capital shs or both for redemption based on a fixed formula. I've attached the BNA.PR.B prospectus as an example - you can read the relevant section on retraction for details. Each retractible pfd has its own terms so you have to check out the prospectus each time. Lots of homework but this is why you get anomalies in the market sometimes. The market seems to have caught on to the BNA.PR.B retraction rights now, unfortunately, and the arbitrage opportunity no longer exists. However, there are other issues on which some arb opportunities still exist but because they are small and illiquid, I would prefer not to specify what they are. As mentioned previously, www.prefblog.com is a good site to go to for information.

 

 

 

 

[oec2000]

BNA.PR.C still carries a Cdn tax-advantaged YTM of about 14% at current prices. If you think that BAM is a survivor, this is still not a bad yield to lock in for 10 years.

[bablu]

Thanks Oec2000..

 

that's very helpful intro...

[StubbleJumper]

Stubble,

 

Agree with you that it's a no-brainer.

 

However, until very recently, volumes have been too low to make repurchases meaningful. If I am not mistaken, there are restrictions on banks buying back their own preferreds. Not sure whether ORH is subject to similar constraints - I can't find anything in the prospectus that precludes them from repurchasing though.

 

Anyone familiar with these rules?

 

 

 

 

FFH is already a big owner of ORH preferreds.  So even if ORH is not in a position to do a re-purchase, the holding company can certainly do it. 

 

SJ

[StubbleJumper]

Question: any other Preferreds out there, in Canada or U.S., that present real value and opportunity in this environment?

 

Stubble's Harris Bank idea makes a lot of sense. (Thanks for bringing it to our attention!)

 

 

Right now, my focus is on US bank preferreds. WFC has a convertible pfd with 13% yield; BAC pfds carry high teens yields; C in the 20s; RBS in the 30s. This does not take into account potential capital gains since they are trading at about only 50%, 25%, 30%, and 20% respectively of par. True, these are not for widows and orphans and certainly the risk of suspension of dividends is high. But, if you believe that in this post-Lehman world, govts will not let any major bank go under, the pfds of survivor banks will eventually trade back much closer to par.

 

This is where I disagree with Stubble's comment that there are no home runs in the pfd mkt. My turn to ask for your feedback or derision, Stubble. :)

 

On my to-review list - Fannie and Freddie pfds. Assuming their par values have not been written down permanently, could one possibly look at these as no-expiry calls on FNM and FRE? If the govt keeps them afloat until the housing mkt recovers, they should eventually get back to health and possibly reinstate their pfd dividends. Am I delusional?

 

Stubble, as to your concern about inflation, this can be taken care of by buying floating rate issues , issues with short fixed maturities or retraction rights, or fixed/float convertibles.

 

OEC,

 

I have no derision for your hypothesis of US bank preferreds being cheap.  The truth is, I don't really know.  I own a few common shares of WFC, and quite frankly I am not in a position to do more than state that it is stronger than other banks.  But frankly, the mess in the US is soooooo bad that I really could not imagine dropping a large part of my portfolio into US banks.

 

I have looked at some US (and other) bank preferreds.  Wells Fargo/Wachovia might be the best of breed.  I have also looked at Barclays, HSBC, and BAC.  I'm mostly seeing preferred yields roughly around 10%.  I am really unsure of whether this yield is sufficient to compensate me for the risk that the dividends might be suspended or the bank might go under (like WM or Bear Stearns, etc).  There are so many good opportunities available that I am hesitant to allocate capital to an investment that yields 10% but is accompanied by such uncertainty.  They may eventually go back to par, which would juice the return, but I can't imagine this happening in the next three or four years (but I can easily imagine ORH calling their preferreds in the next 3 or 4 years!!!).

 

The Harris Bank preferreds are a somewhat unique opportunity to buy a very obscure security of a Bank of Montreal subsidiary that has a solid yield.  I have a much greater level of comfort with BMO than with most US banks, as Canada's National Housing Act basically kept our banks on the straight and narrow.  There will be more hurt coming down the pipe for our banks, but it will be manageable.

 

With respect to the FRE and FNM preferreds, is this low risk and high uncertainty, or is it just plain old high risk?  I could easily imagine a scenario where no dividend is paid for the next 6 or 8 years.  There are so many good opportunities out there, why take the risk of permanent impairment of capital?  Even if they're not called, in 6-8 years ORH-A will be a double!

 

I do worry a bit about buying perpetual preferred shares due to the potential impact of inflation.  You are correct that buying the floaters is an excellent way to manage that risk.  However, with ORH, I do not think that any of this will ultimately be relevant as the preferreds will likely be be called before inflation is ever an issue.  With Harris, it is potentially an issue but I must simply hope that the return that I have locked in is high enough to offset a few years of elevated inflation.

 

Anyway, looking around today, I see so many truly solid companies selling at attractive valuations that I am being very selective about what I buy.  Heavens, you could even buy KO today with a reasonable prospect of a modest return from a very predictable business!  Never before in my investing career could I have said that!

 

May you live in interesting times!

 

SJ

[oec2000]

Stubble, thanks for your feedback. Some follow-ups.

 

FFH is already a big owner of ORH preferreds.

 

I know FFH bought some pfds at the time of issue. Have they bought more recently? Where is this info disclosed?

 

I have also looked at Barclays, HSBC, and BAC.  I'm mostly seeing preferred yields roughly around 10%.

 

The HSBC issues are yielding about 10% but I am seeing much higher yields on the others. A few examples:

 

BCS.PR    - $1.65625 div on $10.71 yields 15.5%.

BAC.PR.L  - $72.50 div on $443 yields 16.4%. And, this is a convertible too!

BML.PR.I  - $1.59375 div on $8.34 yields 19.1%. (Old Merrill issue which has converted to a BAC issue).

WFC.PR.L  - $75 div on $590 yields 12.7%. (Old WB issue.) Convertible into 33 WFC shares which would make it a better alternative to holding WFC common. I could be wrong about the conversion rate but have not been able to verify with IR yet.

RBS.PR.Q - $1.6875 div on $5 yields 34%.

C.PR.I  - $3.25 on $13.90 yields 23%. Convertible into C.

 

And these are based on Monday closing prices. After today's plunge, the yields are that much more juicy. Is there a problem with my data?

 

Moreover, these are merely current yields  - i.e. they do not factor in any price appreciation. Even if you assume a 5-10 year time frame for the recovery to play out, we are talking about IRRs in the 25-35% range, maybe more for the convertibles. This is why I think the risk reward profile is interesting.

 

Btw, the WM pfds were all converted into JPM pfds. I haven't checked but presume the same happened with BS pfds.

 

Also, there are nuances with some of the prds that effectively make them more like sub debt giving shareholders the ability to trigger an event of default if dividends are not paid for a sustained period.

 

As for FNM and FRE pfds, I think they should be viewed purely as perpetual call options. Even if they paid no dividends for 10 years but then recover to $20, buying at $1 still gives a 35% IRR!

 

Finally, on Harris, I just scanned the prospectus and thought you might want to know (you probably already do) that Harris Bank does not legally have to make good HPC's obligations if they default. Given that HPC's primary assets are mortgages in Arizona and Calif (??), their risk of default is high. However, I do not think that HB can afford to let HPC default.

 

We are certainly living in interesting times (but having been involved in Asian emerging markets for 30 years, I can safely say that this is not yet the most interesting I have lived through). I believe that they will also be profitable times!

 

[StubbleJumper]

oec,

 

I don't know whether FFH has bought any additional ORH preferreds.  Intuitively, it does make some sense as it would be a solid short-term investment for the holding company...and with their controlling interest, it would be pretty low risk.  More broadly, I think it will be very interesting to see how Prem and Co have deployed cash over the past three months.  I am very much looking forward to the Q4 release!

 

It is true that the preferred yields are a great deal higher for issues like RBS or C.....but, that's just the problem.  I'm not really sure that I want to take a preferred equity position in banks that might be very sick (or is C in the "too big to fail" category?).  While the yields are juicy, there is a significant risk of permanent loss of capital, and I have a great deal of difficulty in assessing the probability of such a loss.  If C is nationalized, what does that do for the existing preferreds?  I'm more comfortable sticking to something a little easier!

 

Thanks for the tip on WFC.PR.L -- it looks like it has some potential as a preferred in one of the stronger banks.  I am working on the assumption that WFC will come through this period fully intact, so a ~13% perpetual yield looks pretty good.  My superficial examination of the security has left me with some confusion about the conversion feature -- the perferreds are convertible into roughly 32 Wachovia common shares.  When the companies merged, a Wachovia share was worth 0.1991 WFC common shares.  So, does that mean that the preferreds would now convert into 32 * 0.1991 = ~6 WFC common shares?  If so, the conversion feature will likely remain virtually worthless for the next 20 or 30 years.  If you get some additional feedback from WFC investor relations on the conversion feature, please do share it!

 

On Harris, yes, I took a careful (and painful!) read through the  prospectus.  It it a somewhat unusual arrangement between Harris Bank and Harris Preferred Capital Corp.  The upshot is that there are no guarantees anywhere that the dividend will not be cut, and they are non-cumulative.  However, it is not really unusual for financials to be non-cumulative.  Given that the parent company is Bank of Montreal, if Harris runs into trouble there are three broad possibilities:

 

1) BMO sucks up Harris Bank's losses into the parent company and recapitalizes the sub.

2) BMO tries to sell Harris Bank to some other sucker.

3) BMO lets Harris fail.

 

In my view, #1 would be the most probable outcome as Harris is a small part of BMO's operations, and financial support from the parent is quite feasible.  It is possible that BMO could try #2, but that would require finding a buyer...in today's environment, only the strongest banks are buying which implies that this likely would be an acceptable outcome for preferred holders.  IMO, #3 is not a realistic option because it may seriously damage BMO's reputation, and may even impede access to equity capital for the parent.  Again, there is no guarantee with Harris, but as long as BMO stays out of trouble, the cards are stacked in favour of not cutting the Harris dividend.

 

IMO, you are thinking the right way about the FNM and FRE preferreds.  They really are a very long term call option that will either pay off handsomely or result in a loss of capital.  I can't tell you which outcome will ultimately occur or how long it will take before we'll know!

 

So many opportunities, so little capital to deploy!

 

SJ