2023 September CAD

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2.06% MTD

-2.25% YTD

Opportunities in the Fog of Rising Rates

Dear Partners,

For the month of Sept, the Caravel Capital Fund was up 2.06%, bringing the total net return for 2023 to -2.25%.

Most of the return in September was generated from an investment we shared with our readers in the May 2023 letter, in which we highlighted a new long position in a TD Bank preferred share. Our average cost on these shares was approximately $21.00. We stated then that we anticipated the bank would redeem these shares in October 2023 at $25.00. Our primary rationale was that the bank had enormous amounts of excess capital after the US Justice Department denied TD the opportunity to purchase First Horizon Bank for U$13.4 billion in April, leaving the bank with a PILE of excess capital it no longer needed. Second, the $400 million of preferred shares were only redeemable once every five years (Oct 31, 2023) and if the bank didn’t redeem them, their annual dividend yield would have jumped from 4.75% to almost 7%. Dividends are paid from after-tax earnings. That is very expensive for a bank that doesn’t need the money. As a hedge to our purchase, we shorted other TD preferred shares that the bank left outstanding in March when they thought the First Horizon deal would go through. They could not redeem these securities, which were trading at $24.75, for five years. The coupon was fixed at 6.30% at that time. These are now trading at $22.00, while the bank bought back our preferred shares at $25.00. We had enough foresight to buy other similar preferred shares as we expected the likely redemption would increase speculation of more redemptions. TD and other banks would look at redeeming these rate-reset preferred shares, which is exactly what has happened. In our humble opinion, this opportunity isn’t over by a long shot. We want to share the next opportunity we see coming for rate reset preferred shares we own.

A Quick Refresh

In our August letter, we highlighted our view that long-term interest rates would likely move higher over the next 6-12 months, (Caravel August Letter) not because of inflation but because of the massive ongoing supply caused by pandemic-driven government borrowing. In September alone, long-term interest rates on US government debt rose 11+% and are up 20+% year to date. We don’t see this stopping until the economy slows down to a crawl or the US treasury finishes this refinancing and rebalancing process. 

If it’s the latter, we believe that will occur sometime between July-September 2024. Markets usually anticipate this so that long-term rates might peak in the spring. However, we believe that the economy in the US has begun to seriously slow down due largely to higher long-term rates. As a result, we are getting increasingly convinced the central bank may pivot in the coming months to a neutral or even accommodative posture.

With that foundation, we would like to share how Caravel expects to profit from this going forward, just as we did in September. 

For the 40 years preceding 2021, interest rates have been dropping. During this period, the financial arms of the banks came up with an idea: Floating Rate Reset Preferred Shares. These securities have their dividends reset every five years based on the interest rate on the Government of Canada 5-year bond, which on Oct 12 yielded 4.25%. Brilliant move by banks. Reset your cost to borrow lower every five years in a declining rate environment. Kudos to them. As time passed, investors got wise to this and started dumping these securities, anticipating lower dividends after the next reset. Despite interest rates rising by 400 basis points over the past 18 months, many of these preferred shares still trade today at 60-70 cents on the dollar….fool me once; shame on you. However, the banks are keenly aware that the days of zero interest rates are gone. They are looking down the barrel of very expensive capital. They don’t like this. Preferred shares have a $25.00 par value, and many Floating Rate Reset Preferred Shares are trading in the $16.50 to $18.50 range. Keep in mind the dividend rate is set based on the $25.00 par value, not the $17.00 market value. 

We have identified a number of these preferred shares that will have their dividend reset in the next 6-12 months, about 4 percent higher than where they were five years ago, in some cases more than double the current rate they are paying. We believe one of two things will happen in the next 12 months, in part due to what we wrote in the August letter. If rates stay high as we expect in the short term, the banks will decide the interest rate on these preferred shares is too high and either redeem holders at $25 or live with it and reset these preferred coupon yields up to 7+% based on $25 (~$1.75 annual distribution). Remember that distribution is a dividend! A dividend is taxed much more favorably than income. NOW REALIZE you are buying these shares at a massive discount of 30%, so our yield will be more like 9-10% DIVIDEND! That is the equivalent of buying an income-paying security issued by one of Canada’s big banks that pays 12.75% TO 13.25% WOWZA!!! 

We believe 1 of 2 things will happen: 

1) Savvy investors will buy these preferred shares hand over fist as the dividend is reset, if not earlier.

-OR-

2) The issuers will balk at the increased after-tax cost and call the securities at par. 

We STRONGLY believe if the issuers DON’T call these at $25, the buying will push prices upward to the $21-$23 range from the current $17-$18 level. A nice kicker: we get paid a handsome yield while we wait for either event!! This is a bell ringer, just like Onex was at $60 (currently $81), and the TD preferred shares we highlighted in May that were trading at $21 now redeemed at $25.

You may ask, “Why would we share this idea and not keep it to ourselves?” Simple – we own a material amount already. We regularly rely on one of our cornerstone principles: Analyze, Invest, and then Advertise. We share our ideas once we believe ourselves to be adequately positioned. If it’s as good as we say, the market lifts the prices, and we earn the same return over a shorter period—simple math. We would like to give a well-deserved shout-out to our preferred share sales traders at Scotiabank for highlighting this idea in April. They deserve major kudos.

We have also recently discovered another mispriced security lost in the fog of rapidly rising rates. We are still buying these, and once we have completed buying them, we will share that one, too; however, purchases are restricted to large investment funds and financial institutions.

On a much more solemn note, we share our deepest sympathies for all those affected by the unconscionable atrocities in Israel. If you would like to discuss anything or just say hi, we love catching up with our partners any time.

We thank you for your continued confidence and capital,

Jeff and Glen.