2023 October CAD

Back to archives

-0.76% MTD

-3.0% YTD

"Know WHAT You Own, and Know WHY You Own It."

Peter Lynch

Dear Partners,

For the month of October, the Caravel Capital Fund was -0.76%. October was another volatile month for both equity and debt markets, particularly with major stock indices emerging worse for wear. For reference, from Jul 14 to Oct 31, 2023, the SP 500 fell 8.7%, and the Toronto index is down 8.5%, while the Caravel Fund was up 1.3% net of fees. In October, Caravel’s hedging and high-yield bond portfolios partially offset losses sustained in our holdings in ‘alpha’ trades, several of which we have highlighted in past letters. We expect to rebound nicely in November, having recouped >200% of October’s loss at the time of writing.

We want to take this opportunity to make good on a promise we made in last month’s letter – specifically identifying securities we have been accumulating as part of our “floating à fixed” strategy.

In September, TD Bank announced they were redeeming their series K preferred shares @ $25 par value. TD Bank did this to avoid resetting the annual dividend payment from $1.19 to approximately $1.70, or a 43% increase in their capital cost. Further, that rate would have been fixed with no option to redeem the preferred shares for another five years. For reference, a ~7% after-tax cost of financing (dividends are paid out of after-tax earnings) for TD Bank is the equivalent of borrowing at 9.7%. Ouch! When these were called for redemption, we expected the preferred share market to do some second-order thinking and substantially bid up the prices of similar securities, several of which we had purchased in anticipation. It turns out we gave the market too much credit. Though the preferred Fixed floater market initially bounced, prices fell back over the rest of October. We attributed this to a combination of broad market weakness (see first paragraph) compounded by tax-loss selling. We used the opportunity to substantially add to our portfolio to capitalize on this rare opportunity. Here are our favorites:

Get ready; we think it's about to rain money.

Preferred shares that reset their dividend payments every five years based on Government of Canada bond yields are called Variable Rate Reset Floaters. The fundamental value hidden in these securities is their soon to be massive (read 100%+) increase in their yield (dividend payment) because 5-year bond yields have risen 100% + since 2018-2019. However preferred shares are lower credit quality than the Government of Canada, so the issuers (in our case, investment-grade banks and utilities) must offer a premium yield to what Canada pays to borrow money. This extra yield or “spread” tends to be between 2% and 3% above the 5-year yield. But keep in mind, unlike interest on debt, which is tax deductible; dividends are paid by the issuer AFTER it pays income taxes….not cheap. In addition to the spread above Canada Bonds, dividends received by investors are taxed at a much lower rate than interest, which makes these securities even more attractive for long-term taxable investors.

A TALE OF TWO CITIES

For Issuing Bank… Higher Taxes AND a 100% increase in Interest Rates make Preferred Shares a VERY expensive source of financing for the next five years.  

For investors… A 100% rise in interest rates causes prices of fixed-rate preferred shares to fall...except the dividends on these shares are going reset next year ..... making these preferred shares a screaming buy.

Ok, time for the math.

We would like to illustrate why these securities are even more valuable than just a really attractive yield and because we have given TD so much good press and have yet to receive a bottle of wine of acceptable quality from their executives (our sales and trading coverage is excellent :), let’s use the National Bank Series S preferred shares to walk through why we remain heavily allocated to this trade. If you think of the National Bank series S (NA.PR.S, from now on) as a bond, they are trading at about 75c on the dollar ($18.68/$25.00). This discount is typical among our portfolio's preferred shares and many more. The NA.PR.S’s currently carry a coupon of 4.025% (or a $1.00625 annual dividend), set nearly five years ago when 5-year Canada bonds yielded 1.8%. Today, those five years bonds are 3.9%. In five months, one of two scenarios is going to play out with these preferred shares:

The coupon will be reset from 4.025% to whatever the Canadian 5-year Treasury Bond is yielding at that time, plus a fixed spread of 2.40%. For context, if the coupon were reset today, the NA S’s would lock in a dividend of ~$1.59 annually for the next five years, a 59% increase from its current coupon. For anyone fortunate enough to own these at $18.68, that’s an 8.5% dividend yield. 

1. That is not a typo… an 8.5% DIVIDEND yield fixed for five years on a Canadian Schedule A Bank. That is equivalent to earning about 11.60% before tax if it were an income-paying bond. We expect some of your eyebrows rose, but that’s not even the best-case scenario.
2. If rates rise between now and the reset date, it is more likely the bank will call the preferred shares, like the TD K’s, at $25.00!!   This response would yield a 40%+ return for current holders in five months. Our investment is not predicated on this outcome. As such, let’s focus more on scenario

We are enthusiastic about owning a security that will lock in an 8.5% yield because we can observe today where similar NA preferred fixed-floaters are trading whose dividends have recently reset. We mentioned this in our September letter but will give an example here since we are knee-deep in these weeds and ain’t turning back.

The National Bank Series G preferred shares (NA.PR.G) just reset their coupon to $1.764 per year until November of 2028. The NA.PR.G’s are trading at ~$23.50! Said another way, they are currently yielding a little over 7.5%. If NA.PR.S’s reset today, they’d carry a new coupon of $1.59. Apologies if this part has been boring, but here’s the punch-line: in order for a security paying $1.59 to be yielding 7.5%, it has to be trading at $21.20, or 13% above where the NA.PR.S’s currently are. This substantial upside gives us a comfortable margin for error in the event the NA.PR. S’s don’t trade exactly in line with the G’s from a standing yield perspective, once they are reset.

So even if the NA.PR.S’s trade with a 0.50% higher yield than the NA.PR.G’s after the dividend is reset (highly doubtful), we will still enjoy a 23%+ IRR on them. We will take that, like a Beatle (8 days a week).

You may rightly be thinking, “Sure, but this all assumes flat interest rates over the next five months. How likely is that?” Not very, we reckon, and by now, you surely know that we never assume.

That’s where the second leg of this trade comes in. We’ve mentioned this before as well, but it bears repeating: investors who do not wish to speculate on the movements of Canadian government bond yields over the next 6-12 months can mitigate the interest rate risk that is otherwise inherent to this trade by buying 5-6 year maturity Canadian government bonds. We’d recommend buying about $15-20 face value of bonds for every preferred share you buy from the above list, or roughly equal to the dollar amount spent on a preferred share. As an ancillary benefit, if you have been interested in buying 5-year bonds but are worried about a second round of inflation pushing bond prices lower, your ship has come in (see below).

This chart shows what return you can expect if you buy $15 bonds for every NA.PR.S you can scoop up. We assume for the illustration that the NA.PR.S’s will yield 4.0% more than Canadian 5-year bonds once they are reset, which is CONSERVATIVE. Last but certainly not least, this chart assumes no leverage. If you are an institutional asset manager or trade in a margin account, goose that IRR up 2.0-2.5x. Ay, Caramba!! 

If interest rates rise substantially, we expect to earn multiples of the returns implied by this chart because as rates go up, the likelihood that the preferred shares will be called increases materially. That is a Hedge Fund Manager’s dream. We look forward to sharing these gains with our partners over the coming months.

If you have any questions about this trade or want to say hi, we welcome a phone call from our partners at any time.

We thank you for your confidence and capital.

Sincerely,

Jeff and Glen