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"A lie that is half-truth is the darkest of all lies." - Alfred Tennyson
"Profit is sweet, even if it comes from deception." - Sophocles
"I do know that the slickest way to lie is to tell the right amount of truth--then shut up." - Robert A. Heinlein
With Preferreds Like These, Who Needs Enemies?
Preferred shares have been attracting wealthy investors for decades, largely because of the lower tax burden and the perceived safety of the dividend stream. But in recent years, certain types of preferred shares have taken a serious wallop, doing damage to their image as secure, steady investments. One type of preferred that saw substantial losses was the "fixed-reset" preferred. In this article, we'll explain what happened and describe another type of preferred that we think deserves closer scrutiny today before anything bad happens. But first, a quick explanation as to why you should care about what we have to say on the subject.
One of the biggest issues we see are clients who have had their advisors' effect trades in their accounts without their prior permission. The industry calls this "discretionary trading". It's important to note that there are advisors who have the proper licence to allow them to do this, but this should be obvious when you open the account because they will have a portfolio manager designation and you will have to sign a number of forms authorizing them to effect these trades in an account specifically set up as discretionary. These accounts are subject to greater scrutiny than non-discretionary accounts, for obvious reasons.
Advisors who engage in improper discretionary trading are taking a serious risk: they could be sanctioned, fined, lose their license, or employment temporarily or permanently, and potentially open themselves to litigation. Nevertheless, every year a large percentage of complaints against advisors is for unapproved discretionary trades.
From what we've seen, discretionary trades are often a "gateway" to other, equally or more serious misconduct, including purchasing inappropriate investments, "churning" (trading for the sake of generating commissions), cancelling winning trades out of, or losing trades into, a client's account without justification, double-dipping on fees, a failure to disclose important conflicts of interest etc. If your advisor is effecting trades without your prior permission, it may make sense to have a closer look at the activity in your accounts and take steps to ensure that you are not at risk of suffering unwarranted losses.
One inappropriate activity that discretionary trading can act as a gateway to is a failure to adequately explain the risks inherent in financial products. Too often, advisors gloss over the potential risks, focusing only on the potential for gain. Most clients don't know that this is a violation of industry rules, which require an advisor to clearly lay out both the risks and rewards of any investment or strategy they recommend to their clients. The "fixed-reset" preferred shares offer an example of what can happen if advisors don't explain, or perhaps don't even understand, the inherent risks in a financial product.
Here's how they work: a typical "fixed-reset" will be issued for a 5- or 6-year initial term, with an initial, "fixed" dividend rate, of, say, 5%. At the end of the initial term, the issuer gets to decide whether to buy back the preferred shares at the issue price (almost always $25) or "reset" the dividend rate using a predetermined spread over the then-prevailing interest rate (usually the 5-year Government of Canada benchmark bond yield). These preferred shares looked attractive to investors who were concerned that interest rates might move up, something that typically depresses preferred share prices. But with this type of preferred, if rates moved up, the interest rate would likely be reset higher, or the preferreds would be bought back by the issuer at the issue price, allowing the investor to reinvest at the then-prevailing higher interest rates. They looked very attractive, and investors gobbled them up with aplomb. But then something unexpected happened: rates dropped, and kept dropping, reaching historic lows, and pundits started opining on the likelihood of zero-rates, or even, perish the thought, negative rates.
From our experience, the thing some brokers forgot to mention to their clients about the "fixed-reset" preferred shares was this minor problem: when rates went down, investors had to face a harsh new reality: the "reset" rate might be substantially lower than the initial rate, and the issuer had no incentive to call these preferred shares back at the initial issue price while rates stayed low. Another risk factor that some advisors neglected to mention was that spreads (the interest rate differential between the preferred share yield and the benchmark Canada bond yield) could widen, making existing preferred share issues less attractive. This is precisely what happened.
The market reacted violently to these changes, sending some of these preferred shares down to less than 50% of their initial price. Investors who thought that their capital was safe were stunned to realize that it could take years of income to offset the capital losses they were seeing in their accounts. Have a look at the chart above. It shows the return of the S&P/TSX Preferred Share Index, the benchmark for most Canadian preferred share investments (recall that few active managers succeed in beating the benchmark after fees; in fact, a recent Globe and Mail article claimed only 36% of active managers succeeded in besting their benchmarks!). In case it's not crystal clear, an investor who purchased the index eleven years ago in 2007 would still be down close to 30% on their investment! It's also easy to see the damage done in 2008-2009 during the Financial Crisis, and in 2015 and 2016, when the Fixed-Resets took a bath. Many investors couldn't stomach this unexpected volatility and suffered real losses from an investment they thought would belong in the "boring" part of their portfolios. Brokers who hadn't properly explained these risks, and the firms that allowed them to stuff their clients' accounts with them, left themselves vulnerable to lawsuits.
Another poorly understood danger that appears to be widespread today, if our clients are any indication, is the inherent risk associated with Non-Viable Contingent Capital (NVCC) preferred shares (and debt). These products were created after the financial crisis to ensure that the Canadian government wouldn't have to step in with public funds in the event of another major crisis. In simple terms, these products convert into common equity if a financial institution's capital ratios fall below a certain level. Why should this worry you? Because when (not if) another major crisis occurs and if it brings capital levels down significantly, investors who were told they had purchased high-quality preferred shares (and debt instruments) may find themselves common shareholders at a most inopportune time, and they have no say in it! If your advisor bought NVCC-structured preferred or debt for you, they had an obligation to explain this risk to you at the time. From what we've seen, in many cases, they didn't. If you bought a preferred share from a Canadian bank or insurance company in 2013 or thereafter, chances are high that you own NVCC-structured preferreds.
In practice, if you own an NVCC preferred share, you are very likely receiving a lower dividend than if you owned the common shares of the same issuer, you have none of the potential for gains that common shareholders enjoy (or, for that matter, future dividend increases), yet, like common shareholders, you have all of the downside risk associated with a major financial crisis! We fail to see how having all the downside and none of the upside while suffering lower cash flow from dividends makes sense, yet we often see substantial purchases of numerous issuers of NVCC preferred shares in client accounts. Could the reason be because new issues of these preferred shares just happen to pay generous commissions to the advisor and their firms? Advisors should be able to explain the rationale for putting their clients into a preferred share investment that gives them all of the downside risk of the common shares with none of the upside.
Ask your advisor why you own these if you do. If you are told that financial crises are exceedingly rare, ask yourself why this structure exists in the first place? Clearly, the government is worried enough about the possibility of another occurrence that they passed new legislation creating these products. They didn't expend all that effort for no reason. In effect, they have ensured that the next time a bailout is needed, the money is going to come from investors rather than the public. Has your advisor explained that YOU are one of those "investors"? The important question is how do these investments benefit you? Your advisor might have enjoyed a healthy commission, but why would you want to take on this risk, when you don't have to? Whatever one might say about this subject, no one can reasonably tell you that the risk doesn't exist. It does. It bears repeating: your advisor should be able to explain the rationale behind the purchase and make you comfortable that the risk you've taken on is worth it. If they can't, you know you've got a problem to deal with, just like our clients, who have launched claims in excess of $20 million against their advisors and their firms. We are reminded of the immortal words of Joel in Risky Business: "It seems to me that if there were any logic to our language, trust would be a four letter word." That's why our motto is "trust, but verify".
In future pieces, we will discuss some of the other "time bombs" we've seen, such as principal at risk (PAR) structured products and cannabis stocks.
Disclaimer: Damocles is not licensed for, and does not provide investment advice. Readers are cautioned not to transact on the information contained herein without doing their own due diligence or consulting with a licensed investment professional. Damocles is a specialized consulting firm that provides litigation support and is engaged in investor advocacy.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.