# Preferred Shares on Sale?



## Smoothie (Jul 11, 2011)

CPD has gone down 7% over last year or so. Pays 4.8%.

I'm considering switching some funds from XSB to CPD. XSB has been less heavily hit. 

I consider both in the fixed-income class. I welcome any comments about this opinion.

I'm thinking that with bond yields rising, CPD may have some potential for capital gain and it yields more than XSB.

CPD tanked to $14 in late 2008, now at $16 down from $17.50 earlier this year.

Sell Bonds, buy preferreds? Any thoughts?


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## neoabraxas (Mar 4, 2013)

That is silly. If bond yields spike CPD will get hammered even more. The yields on bonds are considered the risk free rate. When that rises, dividend yielders get hammered.


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## CanadianCapitalist (Mar 31, 2009)

Why do you hold bonds? If you are holding some bonds to reduce portfolio volatility, holding preferred shares wouldn't work, would it?


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## andrewf (Mar 1, 2010)

The yield is a lie. Distribution yield means just about nothing--what you need is yield to worst (case) or YTW. Conveniently, iShares does not seem to publish this figure.


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## james4beach (Nov 15, 2012)

CPD or preferred shares are not fixed income class. They are equity and full stock risk.

If you're talking about the fixed income part of your portfolio (i.e. low risk, steady positive returns, no equity risk) you should stick to high-interest savings accounts and GICs.


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## AltaRed (Jun 8, 2009)

james4beach said:


> CPD or preferred shares are not fixed income class. They are equity and full stock risk.
> 
> If you're talking about the fixed income part of your portfolio (i.e. low risk, steady positive returns, no equity risk) you should stick to high-interest savings accounts and GICs.


Preferred shares have less stock risk than common shares by definition. That said, they are equities, and for the most part are indeed fixed income (at least perpetuals are). They just are not fixed capital, but neither are bonds before maturity date. FWIW, I include preferred shares in the same category as bonds for simplicity, but not in the same category as HISA and GIC.


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## james4beach (Nov 15, 2012)

Maybe slightly less intrinsic risk than common stocks, but the price sure falls the same way. Look at the 2008 crash and tell me preferreds (at least the ETFs) are somehow safer than common stocks


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## Ihatetaxes (May 5, 2010)

I own about $90k of XPF and while its above water due to the yield over the past couple of years, I'm not happy to see it dropping (although I would be happy to see sub-$19 pricing next January when I buy more).


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## Smoothie (Jul 11, 2011)

CanadianCapitalist said:


> Why do you hold bonds? If you are holding some bonds to reduce portfolio volatility, holding preferred shares wouldn't work, would it?


That's the flaw in my argument, I realized while walking the dog just now. In a portfolio, different asset classes should be uncorrelated. Preferreds are correlated with equities. So unless I'm willing to take a hit on them in another 2008 event, it's prolly better to stick with a bond fund/etf.


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## AltaRed (Jun 8, 2009)

james4beach said:


> Maybe slightly less intrinsic risk than common stocks, but the price sure falls the same way. Look at the 2008 crash and tell me preferreds (at least the ETFs) are somehow safer than common stocks


Preferreds are safer than common stocks because they are senior to commons in bankruptcy proceedings (but junior to bonds). Safer (in terms of risk) should not be confused with price volatility which as you pointed out..... preferreds had large price swings during the financial crisis.


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## HaroldCrump (Jun 10, 2009)

CPD is not a good product for many reasons.
For instance, you don't need to pay 50 bps MER to hold top quality pref. shares from companies like BCE, TD Bank, Royal Bank, Enbridge, and Trans Canada.
Pfd 1 and 2 rated shares comprise nearly 70% of the portfolio.

Unlike bonds funds, you don't get better liquidity or institutional pricing through an ETF instead of buying directly.

ETF like CPD also suffers from the same drawbacks as a bond ETF i.e. no maturity date, possibility of unrecoverable capital loss because of rising yields, and no transparency around YTW.

You don't need an ETF to get 4% distribution yield (give or take)
You can buy half a dozen prefs. from companies like BCE, TD, etc. and meet most of your pref. share requirements.


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## kitbuilder (Aug 15, 2013)

You have to be really careful with CPD now. iShares provides a breakdown of the fund by sector and credit rating, but doesn't provide a breakdown by the type of preferred share. Over the past several years, the proportion of rate-reset shares in the preferred share market has increased while the proportion of fixed-rate perpetual shares has decreased.

I believe this is not a good time to be holding rate-reset preferred shares and that, if a large proportion of CPD is in rate-reset shares, CPD will have a higher downside risk than other rate-sensitive assets like bonds, REITs, utilities, etc.

Rate-reset shares originated 5 years ago in 2008 and are just now starting to reset from their original dividend rate that was offered during the financial crisis. There are various possible outcomes to this reset, but few of them are very good for shareholders at this time:

1. Shares with a high reset spread over the Government of Canada bond yield have a higher likelihood of being called by the issuer. Because the interest rate environment is still low, issuers are best to redeem the existing shares and issue new shares at rates lower than the reset rate of the old shares. If these shares were bought at a premium (and most have been at a premium for several years now), then there is a capital loss.

2. Shares with a low reset spread over the Government of Canada bond yield have less likelihood of being called. However, many of these are now resetting to rates that are actually lower than the original rate! Of course, to compensate for the new lower rate and create a decent yield, prices for the shares will fall. This fall will be amplified by a rising rate environment. So not only does the investor face a paper loss, they also earn the luxury of receiving smaller dividends! For an example of this scenario, take a look at the 2-year chart and dividend payments for BNS.PR.P.

It is this second scenario of shares actually resetting to lower rates in a rising rate environment that I believe gives the higher downside risk to CPD than a typical bond fund. However, if rates are higher in another 5 years and these same rate-reset shares start resetting at higher rates, CPD could become more attractive: The opposite scenario could occur where prices rise due to the higher dividends.

Just 1 year ago, CPD was trading with a yield of 4.60%. This was with a monthly distribution of 6.6 cents/unit and a price of $17.22. Today, the distribution is down to 5.684 cents/unit and the price down to $15.94 for a yield of only 4.28%. At the current distribution, the price would need to be $14.83 to be back to the 4.60% yield. A higher interest rate environment where investors demand a 5% yield would require the price be only $13.64, and that's assuming the distribution doesn't keep falling. So, we could see CPD prices fall much lower yet.

For disclosure, I like preferred shares and have owned CPD since the days when Claymore managed it. It's 14% of my overall portfolio. But I'm definitely becoming more uncomfortable with CPD lately and starting to feel that its best days are behind it for now. The question is whether to just hold tight and collect the dividend income, adjust the asset class by selling some CPD to buy individual high-quality preferred shares at a discount, or reduce the overall allocation to preferred shares. I'm certainly in no rush to rebalance into CPD.


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## Squash500 (May 16, 2009)

kitbuilder said:


> You have to be really careful with CPD now. iShares provides a breakdown of the fund by sector and credit rating, but doesn't provide a breakdown by the type of preferred share. Over the past several years, the proportion of rate-reset shares in the preferred share market has increased while the proportion of fixed-rate perpetual shares has decreased.
> 
> I believe this is not a good time to be holding rate-reset preferred shares and that, if a large proportion of CPD is in rate-reset shares, CPD will have a higher downside risk than other rate-sensitive assets like bonds, REITs, utilities, etc.
> 
> ...


Excellent post. However I notice that the August CPD distribution is now back up to 6.1 cents per unit.


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## atrp2biz (Sep 22, 2010)

kitbuilder said:


> I believe this is not a good time to be holding rate-reset preferred shares and that, if a large proportion of CPD is in rate-reset shares, CPD will have a higher downside risk than other rate-sensitive assets like bonds, REITs, utilities, etc.


This sounds backwards to me. Fixed rate prefs would essentially have an infinite duration. Rate resets would have a lower duration due to the rate reset.



kitbuilder said:


> 1. Shares with a high reset spread over the Government of Canada bond yield have a higher likelihood of being called by the issuer. Because the interest rate environment is still low, issuers are best to redeem the existing shares and issue new shares at rates lower than the reset rate of the old shares. If these shares were bought at a premium (and most have been at a premium for several years now), then there is a capital loss.


The spread over the GOC bond yield is based on the credit quality of the issuer. If issuers call their prefs, the spread over GOC of any new subsequent issuance will be still based on their credit quality. Issuers would be incented to do this if their credit profile has changed since the previous issuance.



kitbuilder said:


> 2. Shares with a low reset spread over the Government of Canada bond yield have less likelihood of being called. However, many of these are now resetting to rates that are actually lower than the original rate! Of course, to compensate for the new lower rate and create a decent yield, prices for the shares will fall. This fall will be amplified by a rising rate environment. So not only does the investor face a paper loss, they also earn the luxury of receiving smaller dividends! For an example of this scenario, take a look at the 2-year chart and dividend payments for BNS.PR.P.
> QUOTE]
> 
> This is absolutely true. That's why for these issuances, you see a creep downwards in market value as the pre-reset distributions are eaten up. It's all in the discounted CF analysis of a pref.


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## dime (Jun 20, 2013)

Certainly preferreds have been hammered down like every other asset class with yield and duration. Investors are always seeking reliable and safer yield, so much of the move has been to shorter duration fixed income investments. 

Preferred shares can provide portfolio diversification. And they not only provide yield, but if the price is right you can earn some capital gains as well. This is the million dollar question; what's the right price? 

With all the selling lately the market has been pricing in the rise in future rates. Is it now a good time to buy? Please do tell if you know! But until then maybe we can figure it out. Lets look closer, and please feel free to comment and give corrections!

The US preferred share ETF PGX publishes useful stats and states an "effective average maturity" of 6.7 years, and a yield to worst of 7.4%. Seems like an attractive yield - is it now oversold? Compare that to the ETF JNK which has lower grade credit with an average maturity of 6.8 years and yield to maturity of 6.73%. 

Floating and rate-reset preferred are a better way to go than perpetuals as they will periodically adjust to changing rates. 

So what's currently a fair rate of return for the rate reset Canadian preferreds? Lets take a look at how the market is currently pricing the top grade Bank fixed-resets:

Prefblog's latest post says that : FixedReset has an average current yield of 5%, with 4.02 % yield to worst at 4.17 avg duration. 

Certainly this seems lower than what you can get in the US with high yield bond ETFs or the PGX. In the US, BB rated bonds have yielded very similar to preferred stock since 2003. 


So whats a fair yield for a bank preferred rated Pf 1? Let's look at some current and projected yields:

1Yr reset:
BMO.pr.o is almost certainly going to be recalled in less than a year, and at last trade of 25.75 it has a YTW of 3.4% which is above prime rate. Seems fair. Similary RY.pr.x is similar and has a YTW at or slightly under prime. BMO.pr.p is a 1.5 yr and has a YTW at or slightly under prime (it's likely to be called in Feb 2015). 

2.5 year reset:
BNS.PR.Z has a 2.5 year reset, has a yield of 4% to 2016, and resets at 5Yr GOC + 1.34. At this rate it might not be called. Let's estimate 4.29%. So it's yield is currently 1% over prime. It's current yield seems fair, but for how long? It's likely the BOC isn't likely to raise rates until 2015. 

4.7 reset:
BNS.PR.p is trading this week with a 3.45% yield to 2018, with about a 4.7 year reset. If it's called it yields 5.6%, if it resets, it's at the 5 yr GOC+2.05. Let's estimate 2.95%+2.05 or 5% by 2018. 

Bank GIC's are below 2.5%, so you get a much higher yield with preferred because you take on some additional risk. Since default isn't likely with these issuers the biggest risk here is the future potential for the share price to fall with a future increase in rates. How much can we expect prime to increase by 2015? Perhaps by 1%? Who knows for certain. 

The risk of rising rates can be reduced by 'laddering' these assets so that you're continually having them reset at higher rates (or be recalled). This risk is also reduced by selecting rate-resets with shorter duration to reset, and with a high yield rate at reset.

Regardless, it's important to note the risk of capital where the price can fall as the market prices expectations of higher future rates. [ie. A loss of ~25% of share value when the yield increases by 1%]

The market is known to oversell in bad markets (2008 anyone?) and preferreds like any stock can oversell dramatically and temporarily drop in price (50%!) until the market recovers.

If you do plan on buying fixed-reset preferred shares, be sure to research your purchase carefully. 
Most of the banks have monthly reports on preferred share with very useful info to study. They mostly have a low average volume, so enter limit orders and bid low.


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## andrewf (Mar 1, 2010)

Thanks, dime. 

Pref shares are probably something that could be quite useful in a portfolio, but require a lot of understanding of the risks involved. Never mind calculating the return scenarios (YTW). Where do you get your YTW figures from? Do you calculate them yourself or get them from a service?

Thanks for taking the time to write this. Carefully selected prefs are probably a good option to supplement a fixed income portfolio with GICs and some HISA, filling the middling liquidity role. The other alternative I was thinking of was something like HFR, a floating rate bond fund.


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## HaroldCrump (Jun 10, 2009)

Floating rate bond funds are a unidirectional bet on rising rates.
If rates level off and stagnate for a while, you will be losing out on yield with floating rate bonds.


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## andrewf (Mar 1, 2010)

Really? HFR yields about the same as XSB. A unidirectional bet on rising interest rates would be to not hold bonds, if you ask me.


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## HaroldCrump (Jun 10, 2009)

XSB is a super short duration bond fund, right?
So yeah it figures that a floating rate bond fund yield will match a short duration bond fund yield, give or take.

In either case, if the theory of a consistently rising rate environment does not work out, investor would be missing out on higher yields of a more diversified bond fund like XBB.

And yes to the last part - stay out of bonds in a rising rate env.


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## andrewf (Mar 1, 2010)

XSB has a duration of over 3. HFR has a duration of ~0.4

XBB has an after-MER YTM of 2.5% or so, so HFR is not much worse. You give up a bit of yield and reduce your interest rate risk to near zero.


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## HaroldCrump (Jun 10, 2009)

To be fair to XBB, it is higher quality and that explains part of the yield difference.
45% of holdings are AAA whereas in HFR only 11%.
HFR has 23% BBB bonds, while XBB has only 8%.

HFR is 90% corporate bonds, whereas XBB seems to be about 20%.

The higher yield is not free.


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## dime (Jun 20, 2013)

I probably should have emphasised in my post more the risk for potential capital losses! I think a stock ETF with a yield that is well diversified with a low beta and standard deviation is likely a less risky way to go for the average buy and hold investor over the long haul. 

It would be stupid to invest in an asset that you know will certainly drop 10% in the future. Take a look at GWO.pr.n (rated Pf1L) which fell from 24.98 in June to 22.51 now, which is a loss of 9.89% of the stock price. The yield rose from 3.64% to 4.04% respectively. ( If my math is right that's like a drop of 25% in the stock price if the yield increases 1%! Ouch!) But is it perhaps oversold now? How likely is it to continue falling at this rate?

With any stock it requires knowing how to value it correctly, buying at the right point in the price trend when at the point the equity is over sold. The you need to know some fundamental reasons why the price will recover to to a higher market price or eventually become over bought. It comes down to valuation and knowing what kind of low 'oversold' price could potentially happen at some point and what the market will potentially pay later on when it's not oversold. 

Preferred share price is mostly based on the yield and call price. For this reason they're described as 'hybrids' of stock and bond.
It comes down to whether bond yields will rise steadily at this current trend in the future. The 5 year GOC has increased 78 points since April. Are we really looking at a steady increase in yields at an annual rate of 1.56%? How likely is it that the GOC 5 year will be at 3.54% in a year? 

Because of the complexity involved the ETF's are always attractive to me for their diversification and simplicity. HPR is attractive because it's active managed. I bought some ZPR because the idea is it's 'laddered'. With either one I still don't know the effective average duration, so I liked the looks of PGX in the US. A low MER is important, because let's say you're investing 30k... that's $198 a year for a 0.66% MER!! So that's what got me looking at individual rate-reset preferreds. 

I got the YTW from the PGX website, and the Prefblog. In the case of individual examples I calculated it (correctly I hope?)
by subtracting from the current yield, the percentage drop from current price to the call price of 25. For example BMO.pr.o at 25.75 would lose 3% of capital (0.75) but earn $1.63 in div. 0.88 / 25.75 = 3.4%


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## andrewf (Mar 1, 2010)

That's a decent estimate, but I think you need to do an annuity calculation solving for the interest rate in each call scenario and then find the scenario that gives the lowest yield to get YTW. Further complicated when you need to make assumptions about reset rates.

I don't feel I understand pref shares well enough to not make mistakes, and the ETFs seem highly mediocre (given that there are some real dog pref shares out there). If Hymas were to start an ETF, I might consider it.


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## andrewf (Mar 1, 2010)

It's true that XBB has higher credit quality. Personally, I'd rather take the credit risk than the interest rate risk.


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## dime (Jun 20, 2013)

andrewf said:


> It's true that XBB has higher credit quality. Personally, I'd rather take the credit risk than the interest rate risk.


Agreed short term corporate is the better bet. In the US the ETF I noticed BKLN is an attractive option, for the floating rate and sizeable yield. Another option with a bit longer duration is SJNK or HYS. 

Regarding preferreds, the staff at Horizions say their HPR has a 'hypothetical' maturity of 7 years, and the website says it yields 5.2% to maturity.


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## andrewf (Mar 1, 2010)

None of the ETF providers seem to provide YTW figures for their pref share portfolios. That's that only yield figure that has any real meaning.


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## dime (Jun 20, 2013)

andrewf said:


> None of the ETF providers seem to provide YTW figures for their pref share portfolios. That's that only yield figure that has any real meaning.


I recommend emailing the ETF directly, they're often quick to respond with useful info.

Staff at Ishares said today
CPD has a YTW of 3.22 , 4.44 YTM, and 4.69 effective duration.


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## andrewf (Mar 1, 2010)

Argh! Why is that not on their website?


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## dime (Jun 20, 2013)

The preferred market has gone bonkers. Good companies yielding over 6%, and other preferred stocks gaining 6% in four days! Oversold and volatile = not for the faint of heart.


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## warp (Sep 4, 2010)

Preferred shares are interest rate sensitive. And these days when very few have maturity dates or retraction dates, this is even more so.

The market is telling you there is a worry that interest rates are going up. The bond market has already told you the same thing.

I own a bit of preferred, but would never buy any bond, (govt or corp), including any bond funds/etf's these days. If/when interest rates rise, you will have some handsome capital losses.


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## al42 (Mar 5, 2011)

I was looking at BMO's ZPR, laddered rate reset preferred's. Seems to be yielding around 4.5% for now.
Anyone have any experience with this ETF? 
I'm a little worried that when these pref's start to reset at lower rates there may be some capital loss as well as
a possible distribution cut. But maybe with the ladder they can keep this rolling until interest rates climb a bit?


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## nortel'd (Mar 20, 2012)

Another Bank with a NEW ISSUE "current offering" for a 5-Year Rate Reset Preferred Shares, Series 5

Canadian Western Bank - 5-Year Rate Reset Preferred Shares, Series 5

The Series 5 Preferred Shares are provisionally rated Pfd-3 by DBRS.

4.40% per annum, payable quarterly for the Initial Fixed Rate period 

Fixed, non-cumulative, preferential cash dividends, as and when declared by the board of directors of the Bank, payable quarterly on the last day of each of January, April, July and October at an annual rate of $1.100 per Series 5 Preferred Share, for the initial five-year period ending on April 30, 2019. The first of such dividends, if declared, shall be payable on April 30, 2014 and shall be $0.2381 per Series 5 Preferred Share, based on the anticipated closing of the treasury offering of the Series 5 Preferred Shares on February 10, 2014.

For each five-year period after the Initial Fixed Rate Period, the Series 5 Preferred Shares will be entitled to fixed non-cumulative preferential cash dividends, payable quarterly on the last day of each of January, April, July and October in each year, as and when declared by the board of directors, in an amount per share per annum determined by multiplying the Annual Fixed Dividend Rate applicable to such Subsequent Fixed Rate Period by $25.00. The Bank will determine the Annual Fixed Dividend Rate for each ensuing Subsequent Fixed Rate Period on the Fixed Rate Calculation Date which rate will be equal to the sum of the Government of Canada Yield on the Fixed Rate Calculation Date plus 2.76%.


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## AltaRed (Jun 8, 2009)

Read the fine print to see if this is a new NVCC compliant issue whereby the prefs can be converted to commons in a banking/financial emergency. Both RBC and National have recently come out with NVCC compliant issues recently, and the market has lapped them up, perhaps unkowningly? The premium being offered over existing non-NVCC compliant issues may not be enough!


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## nortel'd (Mar 20, 2012)

AltaRed said:


> Read the fine print to see if this is a new NVCC compliant issue whereby the prefs can be converted to commons in a banking/financial emergency.


Seems the market lapped these up too.

I read the fine print .... and I think they used a Thesaurus for slightly different spin by cutting and replacing "a new NVCC compliant issue" with "Upon the occurrence of a Trigger Event" ...


_Upon the occurrence of a Trigger Event_, each outstanding Series 5 Preferred Share will be automatically and immediately converted, on a full and permanent basis, without the consent of the holder thereof, into a number of fully-paid and freely-tradable common shares of the Bank determined in accordance with the NVCC Automatic Conversion Formula set out below. 

The “Contingent Conversion Formula” is: (Multiplier x Preferred Share Conversion Value) / Conversion Price = number of Common Shares into which each Series 5 Preferred Share shall be converted.
The “Multiplier” is 1.0.
The “Preferred Share Conversion Value” of a Series 5 Preferred Share is $25.00 plus declared and unpaid dividends on such Series 5 Preferred Share.
The “Conversion Price” of each Series 5 Preferred Share is the greater of (i) a floor price of $5.00, and (ii) the Current Market Price of the Common Shares.



Their credit rating stopped me from backing up truck. Instead I put 200 in the glove compartment.


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## AltaRed (Jun 8, 2009)

The likelihood of a Trigger Event would be very low, but that is (was) one of the main reasons to hold Preferred Shares, an asset class that was senior to common shares in the event of bankruptcy, etc, etc. More possibility of retaining some value after the commons vapourized. If these 'new' Preferreds can now be compromised by forced conversion to commons, that detracts from some of the reasons to hold them. 

I would want more premium over existing non-NVCC compliant prefs from the same issuer to be buying these new issues.


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## andrewf (Mar 1, 2010)

So lets say CWB runs into trouble and common shares fall by 90%. If these prefs convert to equity, 1 pref share @ $25 becomes 5 common shares @ a current value of $183. That's a lot of downside protection, and current CE holders would be severely diluted. My preference would be for the whole capital structure to be convertible up to deposits (where the government then guarantees the deposits and takes control of the bank.


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## AltaRed (Jun 8, 2009)

andrewf said:


> So lets say CWB runs into trouble and common shares fall by 90%. If these prefs convert to equity, 1 pref share @ $25 becomes 5 common shares @ a current value of $183. That's a lot of downside protection, and current CE holders would be severely diluted.


How do you get that? If CWB falls by 90%, the common share would be $3.65 or so. Thus the Conversion Price would default to $5. 1.0x$25/$5= 5 common shares.

5 commons x $3.65 = $18.25 at conversion time. Quite a haircut from $25 par value. One would be banking on a recovery in common equity price to get back to par.

Added: CE holders would get diluted either way because if equity was needed, the gov't would likely take up new equity, probably at the then equity market price. The whole point of these NVCC compliant issues is to mitigate the amount of taxpayer injection at the point of crisis to save the bank. The average investor would be better off not having had the prefs, and instead make an independent decision to buy CWB commons @ $3.65 or so.

These new prefs are only of value IF the crisis does not deteriorate in a common market price less than $5.


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## andrewf (Mar 1, 2010)

They're kind of like a deep ITM covered call.


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