TRI.PR.B, why floating rate preferreds are not for widows or orphans

This is a quick stream of consciousness post on one issue I have noticed in the preferred share universe, Thomson Reuters Corp, Series II (ticker TRI.PR.B). I believe this an issue left over from Thomson Corp days (pre-Thomson/Reuters tie-up).

I actually think that the majority of folks participating in floaters have no clue what they own. They look at current ytm, extrapolate, take the plunge and then pay the price after.

Take Thomson Reuters preferred B. This is basically the equivalent of cheap debt on the part of the issuer.

  

The specs:

• Floating rate preferred, pays 70% x Canada prime x $25 (par)
• 6 m shares o/s
• Callable anytime at par

Here’s the chart through current:

Absolutely ridiculous

There’s only 6M shares o/s, so this thing is highly illiquid. This will trade in conjunction with whatever Canada prime does (and expectations over the future direction of prime). Here’s a historical chart of Canada prime going back 10 years:

Even at the crisis lows, prime never got below 2.25%

I will hazard a guess that prime will likely always be > 0, as it’s a proxy for the business lending rate, so it reflects a spread above risk free rates. Even if risk free rates go sub zero in Canada, there will always be a spread (famous last words)...

So currently, at 3.95%, these preferreds pay:

3.95% x 70% x 25  = $.69125 /14  = 4.9375%, and at the 2018 highs, these yielded $.69125 / 20 = 3.45%

I can only ascertain that the above was a function of a) illiquidity and b) future rate expectations going higher (care of linear extrapolation, which is also stupid). There’s also a c), which I think is the market pricing in a potential “call” feature, the higher prime goes i.e., as prime goes up, issuer calls in the issue as it gets more expensive to fund vs. fixed rate debt

Fast forward to today, prime is still 3.95%, but the bias is leaning dovish, and these yield $.69125 / $14 = 4.9375%

The problem is that this yield is an illusion. It’s not perpetual. On top of this, there is no incentive for the issuer to call this floating rate issue if prime drops, this is a cheap debt equivalent buried in the capital structure of a $37B EV entity...why should management care about calling a $150M CDN o/s issue ($6M x $25) and making pref owners whole when there's close to $9.5B of debt in front of them?

If risk free rates drop, prime will drop, and if prime revisits 2.25%, these will pay 2.25% x 70% x $25 = $.39375 / 14 = 2.8%, but the problem is that the denominator will also adjust

How to value this? I think look at worst case, i.e., prime drops to 2.25% again, what is a cash flow stream paying $.39375 worth relative to individual issuer credit risk and other similar credits? i.e., what discount rate to use? I think you can look up ytm on equivalent Thomson Reuters floating rate debt and use that, or look at other similarly rated preferreds to find equivalent ytm or ytc

The simplistic way is to say “I want to earn 10%” therefore, $.39375  / 10% = I pay $4

Can you imagine if this drops to $4? Probably better to look at what other similarly rated perpetuals are yielding and use that + some variable "uncertainty" factor to figure out what's fair in the worst case. Currently, other Pfd-3H's straight perpetuals (non floating) yield close to 5.75%, add in a spread to account for uncertainty re: variability due to floating rate (which works both ways!), so say another 100 to 150 bps? 

$.39375 / (575 bps + 150 bps) = $5.43!

I’m not saying I want to own this, I just find it fascinating. And it ain't safe!

Now, everything has it's price, buy this cheap enough, and any good news becomes a free call option (i.e., what it someone else buys TRI?) 

Something to watch over time. But certainly no action is required on this at present.