Market Inquisitor

Tamen Dubito

Bullish on Preferred Shares: ZPR.TO

Preferred shares are an interesting synthesis of debt and equity, retaining unique aspects of both securities. Two overnight rate cuts by the Bank of Canada and global macroeconomic instability, has seen rate reset preferred shares tumbling, closely following the 5-year yield. I entered positions in ZPR, a preferred shares ETF, in mid-January and will discuss the bullish view for the Canadian rate reset preferred share asset class.

In 2015, the Bank of Canada cut rates 50 basis points, weighing heavily on the 5-year bond as well as relatively muted inflation even in the face of significant Canadian Dollar devaluation, both due to further collapse in oil prices. This saw an exodus from ZPR, as the fund’s holdings were rate-reset preferred shares, which re-adjust to pay a predetermined number of basis points above the 5-year yield at reset date. As the 5-year yield adjusted to lower short term interest rates, the underlying value of the preferred shares fell significantly, but at this point are pricing in an overly pessimistic scenario.

ZPR and Yields

On ETF structure

ZPR is structured as a laddered ETF, meaning the rate-resets that occur over 5 years are supposed to be blended. I extracted the underlying portfolio of holdings using Bloomberg and created a model to forecast and illustrate some unique aspects of the ETF. The chart below summarizes my findings regarding the “laddered” nature of the ETF, which show a relatively equally weighted distribution between reset years, with a much large allocation to 2019 and 2020 than 2016 and 2017.

ZPR Reset Schedule

In a bear case scenario, rates will be low for the next year or so, and will likely rise above 0.5% by 2017/2018, this perfectly corresponds with 60% of the preferred reset dates which occur in 2019 and beyond.

Approximately 95% of the ZPR portfolio uses the 5-year Canadian bond as their benchmark for their reset. I decided to create a model to see the price sensitivity of the holdings to interest rates. After analyzing historic dividend yields from preferred shares in a stable interest rate environment for multiple securities, it was found that underlying holdings remain relatively unchanged between 4.15% to 4.75%, with an average of 4.45% between all methods used.

Instead of undertaking the impossible task to predict every movement in interest rates in the next 5 years, I assumed an average yield for the 5-years and assumed that every share reset at that rate, after finding the exact basis point spread paid and weighting for each of the 100+ preferred shares, I adjusted the value of the subsequent coupon to match the historic yield preferred shares have traded at historically, an average of 4.45%. The results based on a share value of $9/share are shown below:

ZPR Sensitivity

The percentage represents the current upside total potential for the underlying in a 5-year scenario. The two cells highlighted by the black box represent a very conservative bear case return scenario,as Canadian bond yields are unlikely to average 75 basis points in the next 5-years, interest rates will likely will average between 1% and 1.5%, resulting in a close to 40% total appreciation, this is without factoring in reinvested dividend income, which will conservatively be 4-5%. To sweeten the proposition, ZPR’s dividend is also tax deductible, with the ability to earn up to $50,000 CAD tax free.

Imperfect Assumptions of Model

1) Average 5-year interest rates will perfectly coincide with reset dates. This is impossible to predict and can work both in advantage and disadvantage. The portfolio value can gain significantly if yield spikes correspond to a large number of resets.

2) Market participants will continue to price Preferred shares at a constant yield range (4.15%-4.75%)

Using Derivatives to Boost Returns

The main reason I chose ZPR over CPD (which has a few fixed rate preferred shares and is subsequently less sensitive to interest rates) is that options are available for more interesting strategies and return profiles.

ZPR currently yields 6%, and the yield will continue to deteriorate towards 4.5 to 5% as rates remain  low and more of the preferred shares reset. After analyzing historic returns of both ZPR and CPD, the highest 3 month return in the history of both securities is around 10-12%. Keeping this in mind, I will boost the yield by selling 3 month ~10% OTM covered calls. The current calls 3 months out for ZPR are selling for $0.1. This means instead of making $.15/quarter the position can be making $.25/quarter. If history is any guide, this position will almost never be exercised, and a bit of savvy timing can eliminate the issue entirely.

ZPR Returns

The difference this makes can be seen above in a 5-year total return analysis with an investor that starts with $10,000. This assumes a 21% underlying return over 5 years, $0.05/month for 2016, followed by a constant 4.5% yield (the average that was found in the previous study), as well as a very conservative $0.10 per quarter for the covered calls. 

Market Conditions: The Perfect Storm

This year began as the worst year ever for equities, and spooked many investors; Chinese market plunge and currency depreciation lead to global growth concerns, creating selling pressure across all risky asset classes which worsened as oil broke to 12-year lows. This panic was helped by articles in mainstream like this one, in which an RBS analyst urged clients to “sell everything”, 2 weeks after the S&P 500 had fallen ~150 points.

I believe a large portion of the selling was by “weak-handed” retail investors and some institutional players turning to cash as the specters of the past recession returned and safe haven demand for bonds increased, sending yields lower. At the same point, lower oil also prices reduces inflation expectations for longer term debt securities and also raised the chances of another BOC rate cut, causing the Canadian 5-year yield to scrape against historic levels.

The chart below illustrates the 1-year rolling correlation between 5-year bond yields to WTI oil price and 5-year bond yields to the S&P TSX.

1-year corr

It’s clear low oil prices and high volatility explained a significant proportion of movement of interest rates in 2015 to all of the movement of ZPR throughout 2015, as the Bank of Canada surprised markets with a rate cut in January, causing the 5-year bond yield to fall: a lower bond yield means lower coupons after reset. In the latter half of 2015 and early 2016, the TSX began correlating higher with ZPR’s decline, possibly offering some evidence of increased bearish sentiment in markets.

I attempted to create a multiple regression to predict ZPR’s sensitivity to various factors. Although I was able to create a model with an adjust-R squared of over .95 (using 5-year Canadian bond yields, oil price, TSX Composite level and the BOC Policy rate), I decided against using the model as there was a high degree of multicollinearity between the variables. The Summary Output is displayed below:

ZPR Regression

 The Canadian Rate Cut that got away

Talks of a 3rd Bank of Canada rate hike persisted throughout the week preceding the January 20th decision. A rate cut was unlikely, even considering Stephen Poloz’s dovish tone and would actually hurt Canada’s economy.

It’s important to remember the BOC only controls short-term nominal interest rates, which limits their actual power on the cost of money. The banks are the ones responsible for over 85% of lending to consumers and stated publicly they wouldn’t lower the prime rate and pass savings onto consumers. With consumer sentiment focused on their lower purchasing power of foreign made goods, a rate cut down to emergency rates would send the Loonie lower and lead to a serious deterioration in sentiment without providing any tangible financial benefits. Although the below chart shows that expectations for a BOC cut are significant for 2016, it remains unlikely the BOC will cut, as Canada’s economic situation is currently far from catastrophic.

Economist Projections

Outlook and Positiong

Canada has continued to exhibit resilience in the face of lower oil prices and stagnating growth, with unemployment ticking 0.3% higher from 6.8% to 7.1%, it only represents an increase to 2014 levels and driven largely by Alberta lay-offs. A significant driver of Canadian economic growth has been the elephant in the room, real estate.Real estate accounts for about 20% of Canadian GDP and a negative shock in this sector would likely see the Bank of Canada employ all possible tools in their war chest. It is difficult to predict how bond yields would react in a worst case Canadian scenario, as the CMHC is insured by Canada, and with a Liberal government promising to deficit spend, bond yields could be unpredictable.

Keeping all of the above in mind, I began adding positions between 01/15/16 and 01/19/16 at a VWAP of $8.7 and will continue throughout 2016. I will trim down positions in ZPR above $9.5 as there remains a possibility of the Bank of Canada cutting rates further. There is likely another attractive entry point coming in early to mid-2016 as oil re-tests January lows and Canada’s economic condition becomes clearer. My recommendation would be to add a small position below $9/share, with more aggressive purchasing closer to and below $8.50.

 

 

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8 Comments

  1. tojo

    Nice article. Not too many like this since there is, for the most part, little interest in the rate-reset market after the blood bath these things have taken in the last couple of years. Investors are under the assumption we are headed towards 0 rates and consequently, resets won’t find a bottom. I’ve been adding very aggressively in the last couple of months, not in ZPR, but individual prefs. Using James Hymas’ Excel spreadsheet, I’ve looked countless future scenarios where the BOC5 year goes to 1, 2, 3% etc and determined the potential for very lucrative trades based on the fact that a relatively low pref share price is very highly levered to small movements in the BOC 5 year rate. For example, TRP.PR.C has recently reset to 2.263% (for 25$/share). Therefore, based on a market price of $11.22 you are getting a 5.04% yield at cost. Not bad. In five years time, should the GOC5 yr rise to 1.5%, your yield becomes 6.77% at cost. At 2.5%, that works out to 9.0%, and so on. Lots of potential, but success lies in the fact that one is speculating that we are at the bottom of rates and that there is no where to go but up. Time will tell.

    • Thanks Tojo,

      With the two BOC cuts this year and the global sentiment this year was brutal, nonetheless I think this is a good time to start getting interested. I think there was just too much negative sentiment with global interest rate environment, Poloz saying negative rates were a possibility and BOJ adopting negative -0.1%. I know that 5-year yields could see 0% or even negative rates, this is why I included them in my analysis. I believe if they do head that low it would be an optimal buying opportunity as I believe a move to the negative would be largely sentiment driven and would revert to higher rates in within a year or two. In the short to medium term, I think some possible catalyst for BOC 5-year and other yields will be: 1) Liberals budget announcement… deficit spending? 2) Stabilization of oil prices.. no more cuts needed by BOC and inflation will tick higher 3) Higher import prices from weak CAD leading to higher inflation 4) Possible investor concern with a housing correction and the nature of CMHC insurance.

  2. Tojo

    Thanks for the insight MI, please keep me posted regarding any future developments you see in this area. In 2008/2009 I made alot of money in perpetual prefs when they dropped in price, at which point those yielding in the range of 7 – 12% provided the best returns. I’ve since swapped them all out for resets. I see a similar opportunity here, so long as the economy improves and rates go back up, even slightly. The two go hand in hand. All the best…

  3. DH

    Tojo,
    I’m reading this in disbelief. You’re like an academic who is commenting outside his own specialty. For one thing, the market is pricing these prefers low for a good reason. There’s an inherent risk now in any security that “eventually” involves commodities, oil, RE or banking, that wasn’t widely recognized when many of the fund’s underlying prefers were floated. Indeed the pricing is reflective that some of the funds underlying issues will, at the very least, be downgraded in the future. Second, I’m sure most of the issues pay their dividends in Canadian dollars. Few can accurately predict day to day FX changes, but given the debt level of Canadian governments, businesses and private individuals in the commodity “super power”, in a world that no longer needs commodities, it would be wise to hedge against expected further decline in the base currency. Third, options are not free money. The quoted option position will most likely only be traded at a price that is at a disadvantage to your total risk/reward position, most likely when a bot decides it’s underpriced enough on a real time bases to make it worth a trade for its side. The bad price at execution together with the high commissions for small value options guarantees you would be better off over time without any option trades. An off handed estimate would be a greater than 20% loss in option position real value on each option transaction, including commissions. Consider that the take on roulette for the house in LV is only approx. 3% per transaction and mathematically, the house will have half your starting capital (option transaction value) in under 20 transactions with only that 3% advantage.
    As for CMHC coming to the rescue, let just say “hope for the best”. My opinion is the situation will be fixed with much lower FX rates in the future, above USD.CAD 2.5. It’s the easiest way to bring down the actual value of RE and government employees compared to more productive areas of the rest of the world. After all, review the history of the British Pound before and after WW2. It’s how they eventually solved their problems.

    DH

  4. Tojo

    MI, prefs have been doing extremely well for me. Great gains in the last few days, let’s just hope it continues. You should have a look at James Hymas’ essay on Implied Volatility for Rate Resets. There is a spreadsheet that allows you to calculated under/over valuation. I’ve been using it and has provided me with a good understanding of how resets work and the factors that affect pricing. Good luck with your trades.

    • Hello Tojo, I followed my own advice and waited for ZPR to head lower. Overall, I have averaged down my cost to ~8.6 and actually bought a large chunk at 8.5 and 8.55 in the recent downturn.

      I am also looking at writing June calls for 10 strike, but they have not been filled yet. I think there could be more downside if this market tanks, and with crude inventory numbers today (even though they were ignored) pushing on storage levels, I think you could still see some more downside in this market, as nothing has really been resolved from 1 month ago. I am holding a lot of cash and have been selling into this recent rally.

      Good luck to you!

  5. tojo

    Hey MI,

    just following up on my comments to you from February. The rate reset preferred shares have performed very well for me. Most of the energy prefs have given me 30-70% gains this year. There are still alot of yield and gains left and doing more trades to take advantage. Hope your ZPR trades were profitable for you. Take care.

    • MARKET INQUISITOR

      Hello tojo,

      Glad to hear you are doing so well. I ended up holding until about the recent rally to 10.40. I sold the whole stack at about 10.3 and re-bought a small chunk at 10.15. Reallocated capital. There is still a lot of room for this thing to go up slow and steady, but just diversify out and have some new investment ideas. Will be a lot more active on this blog in a week or two.

      Best,

      MI

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