Latest / How Canadian Markets Work / Episode 52: Types of Preferreds (The Protection That Ran Backwards)

Transcript

Episode 52: Types of Preferreds (The Protection That Ran Backwards) · How Canadian Markets Work

0:00
Imagine buying a financial product, right? And
0:04
it's specifically marketed to protect you from
0:06
a particular risk. But then you find out later
0:09
that the actual underlying mechanism, the thing
0:12
providing that quote unquote protection, is exactly
0:15
what ends up wiping out your entire portfolio.
0:17
Yeah, that is a really terrifying scenario for
0:20
an investor. Right. And we aren't talking about
0:23
like, a backroom scam here, or some rogue trader
0:27
just doing whatever, or even a breach of contract.
0:30
We're looking at an instrument that sat right
0:31
in plain sight. It was sold by reputable professionals.
0:35
It followed its own prospectus to the absolute
0:38
letter, and it still managed to blindside thousands
0:41
of retail investors. Yeah, because it operates
0:44
as this perfect mathematical illusion. If you
0:46
picture Like a digital ledger. Every single financial
0:51
promise that's recorded on that ledger has a
0:54
mathematical mirror, right? A mirror reflecting
0:57
the exact opposite economic scenario. And the
1:00
trap here is that buyers were kind of conditioned,
1:03
and frankly they were encouraged, to only ever
1:06
look at one side of that mirror. Okay, let's
1:09
unpack this. Because today's deep dive is taking
1:11
us straight into the mechanics of the Canadian
1:13
financial markets. We're drawing from this stack.
1:16
of highly detailed educational sources that just
1:20
dissect equity structures. And our mission today
1:23
is to deconstruct the architecture of preferred
1:26
shares, but with a hyper -focus on this one...
1:30
highly specific, deeply notorious product, which
1:34
is the rate reset preferred. Yeah, the rate reset.
1:37
And the sources we're working from today, they
1:39
go far beyond just a postmortem of a single financial
1:42
product. They actually provide the sort of master
1:45
class in how to dissect the fine print of literally
1:48
any yield bearing instrument. Yeah, which is
1:50
super valuable. It is. But to understand the
1:53
gravitational pull that rate resets had on the
1:56
market, we kind of have to look backward first.
1:57
We have to look at the structural flaws of the
2:00
Older alternatives they were supposed to replace.
2:02
Yeah, we need to set the baseline here because
2:05
the standard For decades like forever was the
2:10
straight or you know perpetual preferred share
2:13
right and the core mechanic of that is pretty
2:16
straightforward. It's a fixed dividend and there's
2:19
absolutely no maturity date. Exactly. And because
2:21
there's no maturity date, meaning there's no
2:23
contractual date where the issuing company is
2:25
forced to just return your par value to you,
2:29
these instruments carry maximum duration risk.
2:31
Wow. Maximum. Yeah. Because you're locking in
2:34
a fixed payment in perpetuity. So the actual
2:37
capital value of the share is entirely at the
2:40
mercy of whatever prevailing interest rates are
2:42
doing. I always... I visualize a straight, preferred
2:46
as like a seesaw, right? But it's nailed permanently
2:49
to the ground on one side. Oh, that's a good
2:51
way to look at it. Yeah, so that nailed down
2:53
side, that's your fixed coupon. It cannot adapt.
2:56
It won't move. Right. So if central banks hike
2:58
rates and the broader market environment just
3:01
moves up around you, the only part of your seesaw
3:04
that can actually move to balance that equation
3:06
is the price of your share. Yes. So it gets mathematically
3:09
forced down. It does. And when that seesaw is
3:12
nailed down, the reality is just brutal for the
3:16
person holding it. I can imagine. I mean, think
3:18
about it. If your perpetual preferred pays, let's
3:22
say, 3%, and then the going rate for newly issued
3:28
stuff with comparable corporate risk rises up
3:31
to 5%, the secondary market is just going to
3:35
ruthlessly reprice your asset. Because why would
3:37
anyone buy your 3 % when they can get five? Exactly.
3:40
The share price plummets to mathematically manufacture
3:43
that missing yield for whoever the new buyer
3:45
is. Right. And without a maturity date to act
3:49
as like a magnet pulling that price back up to
3:52
par, you are just indefinitely underwater. So
3:54
you're just stuck. Pretty much. So if duration
3:56
is like the ultimate enemy in a rising rate environment,
4:00
the logical pivot for an investor is to say,
4:02
well, I just want to strip the duration out entirely.
4:04
Right. which pushes us into the second category
4:06
the sources outline, which is the floating rate
4:09
preferred. Yes, the floatable. Yeah, where the
4:11
dividend adjusts periodically. So it's usually
4:14
pegged to a benchmark, you know, like the prime
4:15
rate or something. Yeah. And the floating rate
4:18
completely solves the capital preservation problem
4:20
because the price stays relatively stable since
4:23
the yield is just adapting to the market. Right.
4:26
It floats. Exactly. But the trade off there is
4:29
extreme cash flow volatility. Like, if you're
4:33
constructing a portfolio designed to cover fixed
4:36
liabilities, right? Like, say you're a retiree
4:38
and you're matching your income to your property
4:40
taxes or your living expenses. Right, things
4:43
that don't float. Exactly. A floating rate...
4:46
introduces massive uncertainty for you, because
4:49
the moment the central bank cuts rates to stimulate
4:52
a sluggish economy or whatever, your personal
4:55
cash flow just takes a direct hit. So it forces
4:58
the investor into this corner. You either eat
5:02
the capital volatility of a straight preferred,
5:04
or the price tanks, or you eat the cash flow
5:07
volatility of a flutter, or your income tanks.
5:09
Exactly, you're picking your poison. Right. Unless
5:11
you find an exit hatch, which I guess brings
5:13
us to the third traditional variation, the retractable
5:16
preferred. And this one gives the holder the
5:20
option to force the issuer to redeem the share
5:23
at a set price on a specified date. Right. So
5:26
retractables essentially synthesize the profile
5:28
of like a short to medium term corporate bond.
5:31
OK. But there's a catch because the golden rule
5:34
of options pricing dictates that whoever holds
5:37
the option has to pay the premium for it. Because
5:40
the investor is holding the power here to just
5:43
demand their capital back, the issuer is gonna
5:46
compensate for taking on that liquidity risk
5:48
by offering a significantly lower yield up front.
5:51
So it's like less risk, less reward. Exactly.
5:54
Which I mean, put yourself in the position of
5:56
an investor trying to navigate the markets a
5:58
decade or so ago. Right. You are absolutely terrified
6:01
of that seesaw effect of straight preferreds.
6:03
Right. You just cannot tolerate the unpredictable
6:05
income of a floater. Yeah. And then the yield
6:08
on those retractables, barely keeps up with inflation.
6:11
You're looking for a silver bullet. You want
6:13
high yield, you want steady income, and you want
6:16
explicit protection from rising rates. And that
6:18
specific combination, that exact set of investor
6:22
anxieties, it created this perfect vacuum for
6:26
the financial industry to introduce the rate
6:28
reset preferred. It was engineered and marketed
6:32
explicitly to neutralize that fear of a rising
6:35
rate environment. And the underlying arithmetic
6:38
of the pitch was incredibly compelling. Yeah,
6:42
because the mechanics actually look pretty elegant
6:44
on the surface. They do. When you buy a rate
6:46
reset preferred, it pays a fixed, totally predictable
6:50
dividend for exactly five years. Right. And then
6:54
at the end of that five -year term, the instrument
6:56
recalculates. So the new dividend rate is pegged
6:58
to whatever the current... five -year government
7:00
yield happens to be on that exact specific date.
7:04
Plus, a permanent fixed spread that was kind
7:06
of locked in the very day the share was originally
7:08
issued. Great. So let's actually run the upside
7:11
scenario using the structural math from the sources,
7:14
because this is exactly where the market got
7:16
completely hooked. Let's do it. So imagine an
7:18
issuer is pushing a new rate reset preferred,
7:21
and it has a standard $25 par value. OK, 25 books
7:26
a share. And the fixed spread, which is the risk
7:29
premium embedded in the share, is set at 250
7:31
basis points, or 2 .5%. OK. So if I buy this
7:35
at issue, and let's say the five -year government
7:38
yield is just sitting at 2%, my initial rate
7:40
is 4 .5 % because it's the 2 % yield plus my
7:45
2 .5 % spread. Exactly. So on my $25 share, That's
7:49
generating like a dollar and 12 cents of income
7:51
every year for the first five years. Right. I
7:53
have total cash flow certainty for half a decade.
7:56
That sounds great. What's fascinating here is
7:58
how the structure behaves when the investor's
8:02
primary fear actually materializes. So let's
8:05
assume inflation runs hot. Right. Central banks
8:08
tighten everything up. And five years later.
8:11
That five -year government yield has climbed
8:14
from 2 % to 4%. Okay. Your five -year term expires,
8:18
and the reset mechanism triggers. Okay, so the
8:21
new government yield is 4%. Yep. I add my locked
8:24
-in 250 basis point spread, so my new dividend
8:28
rate just jumps to 6 .5%. Exactly. My annual
8:31
income leaps from $1 .12 a year to $1 .62 per
8:36
share. And without you having to execute a single
8:38
trade, your cash flow just increased by nearly
8:42
45%. Wow. The product perfectly insulated you
8:46
from that duration risk that would have just
8:48
absolutely decimated a straight preferred in
8:51
that exact same macro environment. Right. So
8:53
the marketing brochure is completely validated,
8:55
like it's a mathematical masterpiece of capital
8:58
protection. It really is. But I feel like this
9:00
brings us back to that digital ledger mirror
9:01
you mentioned earlier. Yes. Because the pitch
9:04
aggressively marketed the right side of the mirror,
9:06
right? The upside mechanism. But if an instrument
9:08
is hard coded, to dynamically adjust with sovereign
9:11
interest rates, we really have to look at what
9:14
happens when the macro environment flips. Like,
9:17
what happens when rates go down? This raises
9:19
an important question, right? And this is what
9:22
the sources call the symmetric trap. OK. Let's
9:24
run that exact same structural math, but in reverse.
9:27
Let's hear it. So you're holding your shares.
9:30
You're collecting your $1 .12 a year based on
9:32
that initial 4 .5 % rate. Happy as a clam. Right.
9:37
But instead of inflation, the economy enters
9:40
a deflationary recession. Oh boy. So the central
9:44
bank slashes rates to the floor to just pump
9:47
liquidity into the system. And on your exact
9:50
reset date, the five -year government yield has
9:53
completely collapsed to 0 .5 percent. Wow. OK,
9:57
so the reset triggers. The government yield is
9:58
0 .5%. But my permanent spread is still that
10:02
250 basis points. Exactly. So my new rate is
10:05
just 3 .0%. That's right. Which means my annual
10:08
income just instantly drops from $1 .12 down
10:11
to, what, $0 .75 a share. Yes. A 33 % reduction
10:15
in your cash flow. And it's executed entirely
10:18
automatically via the prospectus. Ouch. But the...
10:22
The income shock is actually only the first half
10:25
of the trap. We have to look at how the secondary
10:27
market digests that new lower yield. Right, right.
10:30
Because my share is now only yielding 75 cents
10:32
a year, a new buyer who's looking out on the
10:35
open market, they aren't going to hand me the
10:37
full $25 par value for that meager cash flow.
10:41
No, they're not. Especially if they can just
10:43
take their capital and deploy it somewhere else
10:45
for a better return. So the open market price
10:48
of the share has to fall to bring the effective
10:51
yield in line with other alternative assets out
10:53
there Exactly. So the holder is caught in the
10:56
simultaneous two -front collapse. Oh man, the
10:59
income stream shrinks drastically which you know,
11:02
destroys their ability to live off the cash flow
11:04
if they're retired. Right. And the underlying
11:07
capital value plummets at the same time, which
11:10
destroys their ability to liquidate the position
11:12
without realizing a massive permanent loss. Wait,
11:15
wait, I have to stop you there because I'm looking
11:17
at this mechanism and I'm looking at the marketing
11:19
that sold it and I'm looking at the retail devastation
11:22
that followed. Yeah. How on earth is this not
11:26
classed as institutional miss selling? Oh, I
11:29
mean, the. product was explicitly pitched as
11:32
protection, but it operated as this dual -edged
11:35
sword that completely gutted them on the downside.
11:39
It's wild. But was it legally mis -selling? No.
11:42
Really? No. Every single variable, every formula,
11:45
and every single downside scenario was explicitly
11:48
detailed in the prospectus. Wow. The mechanism
11:51
executed its exact structural mandate. Like,
11:54
it did exactly what it said it would do. OK.
11:56
The product didn't fail. The investor's comprehension
11:59
of symmetry failed. Oh, I see. So the buyer read,
12:02
you know, adjusts with interest rates. Yeah.
12:04
And they internalize that as adjusts upward with
12:07
interest rates. Right, right. ignore the arithmetic
12:10
reality that a variable peg has to work in both
12:13
directions. Exactly, and the behavioral finance
12:15
aspect of this is just critical. Because sales
12:18
teams emphasize the upside, since it addressed
12:21
the immediate visceral fear of that duration
12:24
risk we talked about. Right, the seesaw. Right.
12:27
Investors bought the narrative of protection
12:29
and they just failed to interrogate the math
12:31
on the downside. But, you know, the core symmetric
12:34
trap was actually compounded by secondary features
12:37
embedded really deep in the fine print. Oh, right.
12:40
The sources actually spend a lot of time on these
12:43
underlying quote unquote bonus features. Yeah.
12:46
Which honestly They seem like they were specifically
12:48
designed to weaponize retail inertia. They do.
12:51
Yeah. Like, let's look at the switch options.
12:52
OK. So at every five -year reset date, the holder
12:56
usually has the right to convert their fixed
12:58
rate preferred into a floating rate version.
13:01
Right. And on paper, that switch option appears
13:03
to empower the investor, right? Yeah, sounds
13:05
like flexibility. It offers the flexibility to
13:07
pivot between fixed and floating exposure based
13:10
on whatever the prevailing economic winds are
13:13
doing. Right. But the trap lies in the execution
13:16
mechanics because the switch requires an active
13:19
election. The holder actually has to process
13:22
a corporate action notice, they have to make
13:24
an affirmative decision, and they have to submit
13:27
the paperwork before a really strict deadline.
13:30
And we know exactly how retail investors operate.
13:33
Oh, yeah. People are busy. They do not read their
13:35
brokerage mail. No. Or, you know, they open it
13:38
and they simply don't understand the jargon in
13:40
the notice, so they just put it in a drawer.
13:42
Exactly. nothing, you get the default allocation.
13:45
And that default might just lock you into another
13:48
five years of a fixed rock bottom yield just
13:51
as inflation is starting to ramp up again. So
13:53
the issuer is really just relying on that. passivity.
13:56
Inertia is highly, highly profitable for issuers.
14:00
Wow. But the true asymmetry of these instruments
14:03
is really revealed when you look at the issuer
14:06
call options. Oh, boy. Yeah, because while the
14:09
retail investors are trying to navigate switch
14:11
deadlines and paperwork, the issuing institution
14:14
holds the ultimate trump card. At every single
14:17
reset date, the issuer retains the right to just
14:19
redeem the shares at par value, unilaterally
14:22
extinguishing the instrument. Wait, so what does
14:24
this actually mean in practice? Let's trace the
14:26
logic here. OK. I hold this rate reset through
14:30
a five year period of ultra low rates, right?
14:34
My income has been slashed. My capital is depressed.
14:37
I've basically eaten all the downside risk. Finally,
14:40
the macro environment turns. Rates spike. my
14:44
reset date is approaching, and I am mathematically
14:47
guaranteed a massive jump in my dividend. Like
14:50
the instrument is finally about to work in my
14:52
favor. And the issuing bank can just step in,
14:55
hand me $25, and cancel the share. They will
14:57
absolutely cancel the share. You've got to be
14:59
kidding me. No, and it just comes down to basic
15:02
corporate treasury management. These preferreds
15:04
are primarily issued by financial institutions
15:07
to satisfy... you know, tier one capital requirements
15:10
on their books. So if the five -year rate has
15:13
spiked, the cost of servicing that new mathematically
15:16
elevated dividend becomes super punitive to the
15:19
bank's balance sheet. So the CFO will look at
15:21
the reset rate. They'll determine that they can
15:23
raise capital way cheaper somewhere else. And
15:26
they'll just call the preferred. So I take 100
15:28
% of the downside volatility when rates fall.
15:31
Yep. But my upside is structurally capped by
15:34
the issuer's call option. Exactly. It's a perfectly
15:36
engineered, heads they win, tails I lose scenario.
15:40
And it's all hiding behind the guise of this
15:43
so -called symmetric rate mechanism. It really
15:45
is. The golden rule applies here. Whoever holds
15:48
the option extra extracts the economic value.
15:51
Wow. The institution holds the call option to
15:54
basically protect its own net interest margin.
15:57
Right. Now, I will say it is worth noting that
15:59
the sources do highlight an evolutionary patch
16:01
in the market. Oh, fix. Yeah. So following the
16:05
catastrophic repricing of these assets during
16:08
those sustained low rate environments, the industry
16:11
introduced something called minimum reset provision.
16:13
Oh, right. The floor. Yes, the floor. So newer
16:16
issues carry a clause that dictates you know,
16:20
regardless of how low the benchmark sovereign
16:22
yield drops, the reset rate cannot fall below
16:25
a hard absolute percentage. Exactly. And that
16:27
floor... fundamentally alters the risk profile,
16:31
right? Because it explicitly caps the downside
16:33
cash flow destruction. Right. But, you know,
16:35
relying on the industry to patch structural vulnerabilities
16:38
after the fact is not a great investment strategy.
16:40
Not pitfully not. Which is why the sources pivot
16:43
from analyzing the product to providing a real
16:45
diagnostic framework for the investor. OK, let's
16:48
extract that framework, because the sources lay
16:50
out three vital rules for dissecting any yield
16:53
product. And these apply far beyond just preferred
16:56
shares. They do. Rule one. is like the ultimate
16:59
bullshit detector. They call it the one sentence
17:01
test. I love this rule. If you cannot articulate
17:04
the fundamental mechanism of the investment in
17:07
a single continuous sentence, you lack the comprehension
17:10
required to deploy capital into it. Right. It
17:13
forces you to just strip away the marketing narrative
17:16
and focus purely on the cash flow mechanics.
17:18
Right. So for a rate reset preferred, your sentence
17:21
must literally be. Every five years, my dividend
17:24
is recalculated as the five -year government
17:27
yield plus a fixed spread, meaning my income
17:30
will mechanically rise and fall with sovereign
17:33
rates. Exactly. If you find yourself using words
17:35
like guaranteed or protected or safe in your
17:39
sentence, you are describing the marketing. You
17:41
are not describing the asset. Spot on. And then
17:44
rule two requires you to isolate the structural
17:47
cushion. In any variable yield product, you have
17:51
to look at the fixed components and stress test
17:53
them. So when a rate reset, the locked in spread
17:56
is your only permanent defense against a zero
17:59
interest rate environment. So if you buy a preferred
18:02
share with a tight spread, like let's say 100
18:04
basis points, right? 1%. And the central bank.
18:07
drives the benchmark rate to actual zero, your
18:10
total yield collapses to 1%. Yep. That cushion
18:13
was fundamentally inadequate to absorb a severe
18:16
macro shock. So you basically have to assume
18:18
the variable component will eventually go to
18:20
zero, and then ask yourself if that remaining
18:23
fixed component is enough to justify the capital
18:26
risk. That's the test. And if we connect this
18:29
to the bigger picture, it leads directly to rule
18:31
three. OK. Which is arguably the most critical
18:34
psychological defense an investor possesses.
18:37
What's that? Interrogating the unsold scenario.
18:39
I like that. Because financial distribution relies
18:42
entirely on selling the sunny day. They map out
18:45
exactly how wealthy the structure will make you
18:48
if the macro environment perfectly cooperates.
18:50
Right. So when a broker spends 30 minutes illustrating
18:54
the upside of a complex structured note or private
18:57
credit fund, your job is to completely halt the
19:00
pitch. and explicitly ask, walk me through the
19:04
exact arithmetic of what happens to my yield
19:06
and my underlying capital if the benchmark moves
19:09
violently in the exact opposite direction. Yes.
19:12
And their reaction to that specific question
19:14
is your truest indicator of risk. If the advisor
19:17
pivots to, you know, probabilities or claims
19:21
that such a scenario is just historically unlikely,
19:24
or they try to bury the answer in confusing jargon,
19:28
the meeting is over. You walk out. you must demand
19:31
to see the mathematical mirror. If the structure
19:33
shatters when the variables are reversed, the
19:35
risk hasn't actually been mitigated. It has simply
19:38
been disguised. This is so powerful. So you now
19:41
have the blueprints to spot the symmetric trap,
19:43
right? Yeah. You understand that variable pegs
19:46
cut in both directions, that issue or call options
19:49
act as a hidden ceiling on your upside. and that
19:53
institutional defaults are basically designed
19:55
to exploit retail passivity. Exactly. By applying
19:58
the one -sentence test, stress testing your fixed
20:00
cushion, and demanding the math on the unsold
20:02
scenario, you really just strip the narrative
20:04
entirely out of the perspective. Right. It provides
20:07
a framework for self -defense in an arena where
20:09
the counterparty invariably possesses a huge
20:12
asymmetric information advantage. Here's where
20:15
it gets really interesting, though. We noted
20:17
earlier that the industry eventually patched
20:20
the rate reset vulnerability. They added those
20:22
minimum reset floors. They engineered a safety
20:25
net, but only after a generation of products
20:29
inflicted massive collateral damage on retail
20:31
portfolios. Yeah, it highlights this historical
20:33
pattern where the capital markets effectively
20:36
beta test complex structures using live retail
20:40
liquidity. Which raises a genuinely unsettling
20:43
question about our current market structure.
20:45
Right now, trillions of dollars are just blindly
20:48
pouring into passive ETF structures and algorithmic
20:52
trading models, right? And they're all operating
20:55
under this assumption of continuous infinite
20:57
liquidity. Wow. Yeah. If the financial industry
21:00
only acknowledges and patches a structural vulnerability
21:03
after the math breaks in the real world, what
21:06
are the hidden uncompensated symmetric traps
21:09
buried inside today's passive index funds that
21:11
the algorithms simply haven't triggered yet?
21:13
That is a chilling thought. Right? The digital
21:16
ledger is always perfectly balanced, but you
21:18
rarely realize you're standing on the wrong side
21:20
of the mirror until the glass actually shatters.
21:23
So make sure you can pass the one sentence test
21:25
before you step into the room.