Rate reset preferred share ladder?

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Peculiar_Investor
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Rate reset preferred share ladder?

Post by Peculiar_Investor »

Our investment policy statement (IPS) allows for the possibility of using preferred shares as a sub-component of our fixed income allocation if there is no further room in our registered accounts for bonds. Recognizing that preferred shares are actually a hybrid security that is neither truly fixed income nor equity, the IPS limits the amount of exposure to preferred shares to around the 25% range of the fixed income portion.

Our asset allocation is currently underweight fixed income and we've got little to no room left in our registration plans to add new bond holdings to our 10 year bond ladder. We currently hold a mixture of perpetual preferred shares and rate reset preferred shares. I'm starting to give consideration to build a 5 year rate reset preferred share ladder, we've already got resets that will happen in 2017, 2020 and 2021, so I'm looking at resets that will occur in 2018, 2019 and 2022 to add to our mix.

Some questions for the audience. Has anyone given consideration or actual implementation of a rate reset preferred ladder? If so, what criteria have you utilized to screen/select particular rate reset preferred shares? Obviously credit rating and issuer concentration is a concern, but do you consider a mix of low spread and high spread rate resets? Would you add floating rate resets into the mixture and if so, why?
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Re: Rate reset preferred share ladder?

Post by AltaRed »

I've been operating under a 'loose' rate reset preferred ladder for the past 5-7 years or so, with 1-2 resets resetting each year. I use the term "loose" because I've also been swapping out resets to take advantage of tax loss selling resulting from the reset 'swoon' of a few years ago and reset dates of the issues I have are based more on opportunity (price) as compared to a more precise reset calendar date each year. Typically I will swap out a tax loss one, for another similar 'spread' issue after the latter has reset and I know the price terms (and they sometimes trade lower around reset date anyway).

My resets are all relatively low spread, investment grade resets on the premise of the potential for cap gains in the future, rather than being called by the issuer. My lowest credit rating ones are ENB issues, with most from the insurance companies (IAG, MFC, SLF) on the premise they may have to be called (per James Hymas) if insurance companies eventually require NVCC compliant issues (I am not holding my breath that I will live long enough to see this).

I do not have any of the newer 'floor' rate resets that may trade at a premium to call price and which may just be 5 year "GIC" money, but that may have been just as effective a strategy in non-reg accounts. It is certainly a simpler strategy at the current time though i believe they were only issued during the 'preferred crisis' and will all be called at the end of the 5 year terms. The time to be in these issues may have passed.

FWIW, I only have prefs in the portfolio due to lack of room in my registered accounts for bonds and GICs. I am not very fond of them as an asset class BUT I believe I can count on them to swoon less in an equity market crisis and be the preferential assets (along with bonds and GICs) that would be sold in such a crisis to supplement cash flow needs (like a new vehicle or a family cash crunch) in any given year where I may want flexibility. Prefs currently form 7% of my portfolio and will hold steady (or slightly decrease) as I age. FWIW2, my remaining FI is only another 7-8% of my asset allocation...so really, I am operating pretty thin at an overall FI at about 15%.
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Re: Rate reset preferred share ladder?

Post by Peculiar_Investor »

Thanks for the input. As I stated in the OP, I've tried to take a top down policy approach to this asset class and am now just fine tuning the strategy. Fortunately all our current preferred shares are in the black, so no tax loss possibilities exist. IIRC I did some tax-loss harvesting last year on the asset class.

Until now I'd taken a somewhat 'haphazard' approach to selecting which preferred shares to own, mostly driven by reading James' PrefLetter and selecting a few issuers from each of the perpetual and rate reset subgroups, typically focusing on his overall monthly recommendations. So far that has worked out decently and has defining been worth the cost of the subscription. Now I'm stepping back and reviewing that 'haphazard' approach and trying to determine if there is benefit in refining the selection methodology.
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Re: Rate reset preferred share ladder?

Post by Bril »

I have somewhat of a preferred share ladder using split preferred shares. Split and retractable preferreds comprise 38% of my portfolio, which is all fixed income. 5% of my portfolio is in reset and perpetual preferreds, so not nearly as concentrated. I am attracted to the split and retractable preferreds due to the retraction feature. I believe split and retractable preferreds are not volatile as resets or perpetuals. Overall investment grade split and retractable shares have not has a losing year since 2008.
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Re: Rate reset preferred share ladder?

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Peculiar_Investor wrote: 28 Nov 2017 10:50 Now I'm stepping back and reviewing that 'haphazard' approach and trying to determine if there is benefit in refining the selection methodology.
May depend on what your long term goal for having prefs in your asset allocation is. I am not nearly as rigorous with my pref ladder as I am with my bond ladder simply because Mr. Market determines what these things are worth at any given time and getting too precise with methodology on circa 7% of my portfolio isn't worth disproportionate time (unlike someone with a significant weighting in this asset class).
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Re: Rate reset preferred share ladder?

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Good comments. I am trying to make sure that I think before I act. As with most investing activities I find I am much more successful when I have thought ahead and then developed and implemented a plan versus 'just doing it' without a plan. The plan doesn't have to be too detailed, just enough that it can be a recipe that I can follow as guidance. Generally I stop at the point where there is enough detail that I can at least attempt to explain it to someone else, i.e. fellow FWF'ers for comment :lol:
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Re: Rate reset preferred share ladder?

Post by longinvest »

Peculiar_Investor,
Peculiar_Investor wrote: 29 Nov 2017 19:56 I am trying to make sure that I think before I act. As with most investing activities I find I am much more successful when I have thought ahead and then developed and implemented a plan versus 'just doing it' without a plan. The plan doesn't have to be too detailed, just enough that it can be a recipe that I can follow as guidance. Generally I stop at the point where there is enough detail that I can at least attempt to explain it to someone else, i.e. fellow FWF'ers for comment :lol:
Here's the actual behavior of three domestic asset classes, on a total return basis, since November 2007:

Source: Portfolio Visualizer
CPD-XIC-XBB.png
I'll let you guess which is preferred shares (CPD), which is stocks (XIC), and which is bonds (XBB). I think that they're pretty easy to distinguish.

I'm not sure I understand how you justify replacing bonds with preferred shares. In 2008-2009 and 2015-2016, I would have been quite happy to pay a little more in taxes for the privilege of owning bonds. Wouldn't you?
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Re: Rate reset preferred share ladder?

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longinvest wrote: 30 Nov 2017 00:49 I'm not sure I understand how you justify replacing bonds with preferred shares. In 2008-2009 and 2015-2016, I would have been quite happy to pay a little more in taxes for the privilege of owning bonds. Wouldn't you?
Thanks for the data points and the challenge. I generally don't backtest, so this does give me some food for thought. I am left to wonder whether the analysis is start and end date sensitive. I am always leary of backtesting because in the past I have found conclusions can be sensitive to the choice of starting and ending dates. It might we worth some of my time to re-test this assumption/bias.

As I stated in the original post,
Peculiar_Investor wrote: 28 Nov 2017 09:53 Our investment policy statement (IPS) allows for the possibility of using preferred shares as a sub-component of our fixed income allocation if there is no further room in our registered accounts for bonds. Recognizing that preferred shares are actually a hybrid security that is neither truly fixed income nor equity, the IPS limits the amount of exposure to preferred shares to around the 25% range of the fixed income portion.

Our asset allocation is currently underweight fixed income and we've got little to no room left in our registration plans to add new bond holdings to our 10 year bond ladder. We currently hold a mixture of perpetual preferred shares and rate reset preferred shares. I'm starting to give consideration to build a 5 year rate reset preferred share ladder,
My justification is largely based on running out of room in our registered accounts for bonds and thus having to hold a chunk of fixed income in non-registered accounts. This adds tax efficiency and taxation characteristics into the equation and preferred shares, via the dividend tax credit, have an taxation advantage over bonds in non-registered accounts. ANother factor, given that I'm currently running a 10 year bond ladder and many rungs are built using strip bonds, for taxation reasons alone I would never hold a strip bond outside of a registered account.

Sensing your next question, so why not just hold our fixed income using a broad-based indexed ETF such as XBB or VAB which doesn't have some of these challenges? The answer is that back when we were accumulating assets, our fixed income allocation was invested using broad-based indexed ETFs, mostly XBB in our case. Once retirement age appeared on the horizon and the fact that we don't have defined benefit plans that would provide an income stream in retirement, I switched to building and maintaining my own 10 year bond ladder so that we have a predictable amount of fixed income maturing in future that form the basis for a retirement income stream.
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Re: Rate reset preferred share ladder?

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Peculiar_Investor wrote: 30 Nov 2017 07:46 I am left to wonder whether the analysis is start and end date sensitive. I am always leary of backtesting because in the past I have found conclusions can be sensitive to the choice of starting and end dates.
To say nothing of the selected index having little to do with the subject of this thread(fixed reset ladder) for most of the period quoted.
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Re: Rate reset preferred share ladder?

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gsp_ wrote: 30 Nov 2017 08:55
Peculiar_Investor wrote: 30 Nov 2017 07:46 I am left to wonder whether the analysis is start and end date sensitive. I am always leary of backtesting because in the past I have found conclusions can be sensitive to the choice of starting and end dates.
To say nothing of the selected index having little to do with the subject of this thread(fixed reset ladder) for most of the period quoted.
CPD serves as one of the oldest Canadian preferred share benchmarks, so provides a decent proxy for comparison purposes. A more direct comparison might be TXPL: New Preferred Share Index with ETF (ZPR) « PrefBlog, but it has only existed since late 2012.

Very minor nitpick, FWF has topics not threads. :)
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Re: Rate reset preferred share ladder?

Post by longinvest »

Peculiar_Investor,
Peculiar_Investor wrote: 30 Nov 2017 07:46 I generally don't backtest, so this does give me some food for thought. I am left to wonder whether the analysis is start and end date sensitive. I am always leary of backtesting because in the past I have found conclusions can be sensitive to the choice of starting and ending dates. It might we worth some of my time to re-test this assumption/bias.
I understand your uneasiness with backtesting; unfortunately, there are too many people who use backtesting for predicting future returns. I don't use backtesting to predict future returns. My goal was not for you to compare the ending values, but to compare the paths. It seems pretty clear to me that one of the three assets had a much more stable path. Not surprisingly, it's XBB, which tracks a market of intermediate duration. Long bonds and RRBs would have probably been more volatile than XBB, if shown on the chart, due to their long duration.

On the other hand, I do find backtesting very useful for finding counterexamples to disprove statements. (A single counterexample is sufficient to prove that something is not always true).

Anyway, I fail to understand how preferred shares could be used as replacement for intermediate-duration bonds in a portfolio. I don't think that slightly worse taxation justifies ignoring the possibility of significantly bigger capital losses. But, that's me.
Peculiar_Investor wrote: 30 Nov 2017 07:46 Sensing your next question, so why not just hold our fixed income using a broad-based indexed ETF such as XBB or VAB which doesn't have some of these challenges? The answer is that back when we were accumulating assets, our fixed income allocation was invested using broad-based indexed ETFs, mostly XBB in our case. Once retirement age appeared on the horizon and the fact that we don't have defined benefit plans that would provide an income stream in retirement, I switched to building and maintaining my own 10 year bond ladder so that we have a predictable amount of fixed income maturing in future that form the basis for a retirement income stream.
XBB and VAB are pretty liquid. I am not a believer in "income investing while ignoring what happens to principal", as if some kind of magic would protect the investor against the possibility of income reduction and capital loss over time. I believe in total return approaches (you know about VPW).

I would only qualify as safe a properly constructed non-rolling RRB ladder extending to age 125 (or whatever the limit on human life) which delivers a stable CPI-indexed stream of money. In general, with the inconvenience of losing liquidity, it is much less expensive to actually go and buy a lifelong stable stream of income from an insurance company. I know that CPI-adjusted life annuities are hard to find, but constructing a non-rolling RRB ladder which delivers a constant inflation-indexed amount of money every 6 months or every year from now until age 125 is even harder (actually impossible). It's pretty easy, though to find life annuities with convenient monthly payments and a fixed 2% yearly increase, which should be good enough given the Bank of Canada's 2% inflation target.
Peculiar_Investor wrote: 30 Nov 2017 09:23
gsp_ wrote: 30 Nov 2017 08:55
Peculiar_Investor wrote: 30 Nov 2017 07:46 I am left to wonder whether the analysis is start and end date sensitive. I am always leary of backtesting because in the past I have found conclusions can be sensitive to the choice of starting and end dates.
To say nothing of the selected index having little to do with the subject of this thread(fixed reset ladder) for most of the period quoted.
CPD serves as one of the oldest Canadian preferred share benchmarks, so provides a decent proxy for comparison purposes. A more direct comparison might be TXPL: New Preferred Share Index with ETF (ZPR) « PrefBlog, but it has only existed since late 2012.
Thanks. Effectively, I used CPD because it provided a longer history. Here's the same assets on a chart which uses the more appropriate ZPR instead of CPD. Unfortunately, it only goes back to December 2012:

Source: Portfolio Visualizer
ZPR-XIC-XBB.png
To my untrained eye, I would say that there are 2 stocks lines and one bond line. I don't see a bond line and a tax-efficient bond-replacement line. :wink:
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Re: Rate reset preferred share ladder?

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Peculiar_Investor wrote: 29 Nov 2017 19:56 Generally I stop at the point where there is enough detail that I can at least attempt to explain it to someone else, i.e. fellow FWF'ers for comment
And comment they do!
longinvest wrote: 30 Nov 2017 11:06 Anyway, I fail to understand how preferred shares could be used as replacement for intermediate-duration bonds in a portfolio. I don't think that slightly worse taxation justifies ignoring the possibility of significantly bigger capital losses.
Thanks longinvest for challenging my plan and giving me many points to ponder. Your comments and comments from others have given my "thought bubble" quite a poke. Hopefully others will still feel free to chime in further. Might need to go back to the drawing board on this one.
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Re: Rate reset preferred share ladder?

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Bril's post above seemed to slip by without comment. I've never tried to understand split and retractable prefs but that appears to be a way to invoke some price stability to 'emulate' the behaviour of a bond ladder whereby there is physical, and perhaps more importantly, psychological certainty on maturity values. I have a bond/GIC/debenture ladder rather than a bond ETF because I know, at least twice a year, I have certainty of capital being returned to me on the maturity of an issue. The same might be said about how one selects prefs and in particular, type of preferred share. Others into split and retractable prefs may wish to comment further, and in particular, volatility vs total return.

I agree with Longinvest that prefs have had volatility* in recent years and can hardly be counted on for stability of capital. That said, over a long period of time, they have to provide a more attractive 'after tax' Total Return than nominal bonds in a non-reg account and hence the reason to hold them. That is why they are a 'hybrid' security.

* Even pref volatility can be mitigated by holding floating reset prefs versus fixed rate reset prefs vs straight perpetuals...and perhaps sretractables. Long term rolling returns are reflected in the risk (actually volatility) one wishes to take.
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Re: Rate reset preferred share ladder?

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longinvest wrote: 30 Nov 2017 11:06 To my untrained eye, I would say that there are 2 stocks lines and one bond line. I don't see a bond line and a tax-efficient bond-replacement line.
If you used GCS.PR.A ( an investment quality split preferred) instead of ZPR to make this comparison it would be much more bond like and performs better than XBB over this 5 year period, even in registered accounts.
AltaRed wrote: 30 Nov 2017 11:44 I've never tried to understand split and retractable prefs but that appears to be a way to invoke some price stability
I was the same but 4-5 years ago but I was getting fed up with low bond and GIC yields and researched other products that produced income and had capital certainty. I looked at convertible debentures as well as the different types of preferreds. For stability I chose to use high quality split and retractable preferreds.
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Re: Rate reset preferred share ladder?

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longinvest wrote: 30 Nov 2017 00:49 I'm not sure I understand how you justify replacing bonds with preferred shares. In 2008-2009 and 2015-2016, I would have been quite happy to pay a little more in taxes for the privilege of owning bonds. Wouldn't you?
Not for me. My taxable portfolio is chock-a-block with fixed rate preferreds and has been since I returned to Canada in 2000. The purpose of that piece of the portfolio is fixed income at low tax rates (effectively zero or less in BC in the first two tax brackets), and it has never let me down.

I used 2008-09 to tax loss harvest like mad. Things that I'd bought to yield ~5% were being tossed out the door at 8-10% to buy other issues with similar yields (often the same issuers). I booked seriously large tax losses to use later and ended up with a portfolio in Jan'09 slightly better than that of Sep'08 in terms of income thrown off and credit quality. Some of the better credits (especially among banks) have been called since; others survive in the portfolio intact to this day, paying every quarter like clockwork. That's what I wanted them to do, and that's what they're doing.

2015-16 didn't really affect fixed rate issues very much. The bloodbath was in the resets, which I don't pay attention to or play with.

I'm perfectly happy having using fixed rate prefs rather than bonds in taxable accounts, and I don't see why I shouldn't continue to be. I don't focus on day-to-day or even month-to-month portfolio "value", so the dips in your blue line are irrelevant to me. Chacun à son goût.
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Re: Rate reset preferred share ladder?

Post by big easy »

Norbert Schlenker wrote: 30 Nov 2017 15:35 My taxable portfolio is chock-a-block with fixed rate preferreds
Fixed rate preferreds aka perpetual preferreds? I've been wary of these because of the possibility of rising interest rates which would cause prices to fall at the same time the dividend becomes less attractive. Of course that scenario hasn't panned out. I use floating resets instead, and accept the lower yields (still higher than bonds and with favorable tax treatment).
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Re: Rate reset preferred share ladder?

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gsp_ wrote: 30 Nov 2017 08:55
Peculiar_Investor wrote: 30 Nov 2017 07:46 To say nothing of the selected index having little to do with the subject of this thread(fixed reset ladder) for most of the period quoted.
CPD serves as one of the oldest Canadian preferred share benchmarks, so provides a decent proxy for comparison purposes. A more direct comparison might be TXPL: New Preferred Share Index with ETF (ZPR) « PrefBlog, but it has only existed since late 2012.
Today CPD is 80% fixed resets but that is very different from its composition since inception. It previously was dominated by perpetuals which react in opposite ways to interest rate changes. I realize it’s the oldest ETF we have but it has been a poor proxy for fixed resets until quite recently and as you point out ZPR is a more pure substitute.

A few years ago CPD and ZPR seemed like opposite sides of the same coin on a daily basis. Of course when credit concerns show up as in ‘08-09, all bets are off.


Nice to see Norbert posting, in agreement as usual.
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Re: Rate reset preferred share ladder?

Post by scomac »

Peculiar_Investor wrote: 30 Nov 2017 11:18
Peculiar_Investor wrote: 29 Nov 2017 19:56 Generally I stop at the point where there is enough detail that I can at least attempt to explain it to someone else, i.e. fellow FWF'ers for comment
And comment they do!
longinvest wrote: 30 Nov 2017 11:06 Anyway, I fail to understand how preferred shares could be used as replacement for intermediate-duration bonds in a portfolio. I don't think that slightly worse taxation justifies ignoring the possibility of significantly bigger capital losses.
Thanks longinvest for challenging my plan and giving me many points to ponder. Your comments and comments from others have given my "thought bubble" quite a poke. Hopefully others will still feel free to chime in further. Might need to go back to the drawing board on this one.
Bump!

With a couple months to ponder P_I what is the current state of your plan?

In the past, I tried to build a ladder myself without much success so am now wondering if the lazy man's appraoch of ZPR may well represent a decent option if for nothing more than a place holder until attractive individual issues come along (cue a subscription to PrefLetter). That said, knowing my general disinterest in putting forth much effort in my investing operations anymore, the ETF might just do the job for me stand alone! Not talking a huge allocation here, but it appears to be a reasonable way of adding cash flow in a tax advantaged manner. CBH and SIN.UN have done an admirable job for me in that regard; this could be another such holding.
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Re: Rate reset preferred share ladder?

Post by Peculiar_Investor »

Not much has changed, I'm still pondering what to do next and haven't reached a clear conclusion on what actions to take. As you might have read in a couple of other topics, I've got some stink bids placed for a rate reset preferred shares that would fit a missing a rung on my partially constructed rate reset preferred share ladder. So I guess my actions are slightly different than my words. Overall I'd say the strategy is still under development and review.

I continue to be a PrefLetter subscriber and eagerly read James theories, recommendations and associated data tables each month. Partially because I read PrefLetter and have some belief that the Canadian preferred share market isn't overly efficient I have come to the conclusion (faulty??) that the preferred share space periodically presents opportunities to the educated retail investor. Then I remind myself that James knows this too and is potentially on the other side of any trade idea that I might hatch.

Another struggle in my thought process is accepting that some of the mentioned ETFs in this space are worthwhile considering their relatively high MERs (compared to broad-based ETFs not Canadian mutual funds) and their internal composition across the various types of preferred shares. I'm not sure that one can properly construct an underlying index for this space, it feels more like slicing and dicing within a sector. I'm a believer in the low cost approach using ETFs that track broad-based indices. I'm against the trend to slice and dice these indices and "actively" managing the slice and dice choice.

Ultimately at this point I can conclude that I learn things by doing rather than researching theory and doing thought experiments. I think I've convinced myself that given the overall structure of our investments and the split of funds between registered and non-registered accounts, there will always be a place for preferred shares in our asset allocation if for no other reason that tax-efficiency.

How's that for a lengthy non-answer.
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Re: Rate reset preferred share ladder?

Post by AltaRed »

FWIW, I don't use stink bids on prefs. Volume is too low to typically fill an order of 1000+ shares without having to chase the remaining portion of the order. I simply use Alerts that tell me when the price reaches my Buy level and then I price my order using Level 2 quotes to fill it in one shot (or two). Prefs are a PITA to buy and sell.
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Re: Rate reset preferred share ladder?

Post by Peculiar_Investor »

AltaRed wrote: 26 Jan 2018 13:43 FWIW, I don't use stink bids on prefs. Volume is too low to typically fill an order of 1000+ shares without having to chase the remaining portion of the order. I simply use Alerts that tell me when the price reaches my Buy level and then I price my order using Level 2 quotes to fill it in one shot (or two). Prefs are a PITA to buy and sell.
I probably should have taken this advice. It only took a month to fill an order.
Peculiar_Investor wrote: 26 Jan 2018 08:05 Ultimately at this point I can conclude that I learn things by doing rather than researching theory and doing thought experiments.
5 year ladder is now completed so the experiment is on.
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Re: Rate reset preferred share ladder?

Post by Peculiar_Investor »

Did some tax loss harvesting today, sold MFC.PR.L at $18.20 and replaced it with MFC.PR.M @ $19.15. Their current dividends are identical, so lost a bit on current yield. but potentially will make that up later this year. MFC.PR.L resets on 19-Jun-2019 with a spread of 216 bp, while MFC.PR.M resets six months later on 19-Dec-2019 with a spread of 236 bp.

I'm looking at the same potential type trade with my 2020 rung, GWO.PR.N, which is also a candidate for a tax loss harvest.
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DenisD
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Re: Rate reset preferred share ladder?

Post by DenisD »

Would be interesting to hear how rate reset preferred share investors did on that portion of their portfolio in the past year or two compared to ZPR. Looks like ZPR gained 14.5% in 2017 and lost 9.4% in 2018.
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Re: Rate reset preferred share ladder?

Post by Peculiar_Investor »

I would think that if anyone reported that data it would be James Hymas on his www.prefblog.com site. I did a quick search and didn't turn anything up.

Personally I don't break down returns on my portfolio to the asset class level, let alone to subclasses such as preferred shares, or their subclasses such as rate resets. But your question has me thinking about how I evaluate the success or failure of this strategy, so maybe it is something I should investigate.
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Re: Rate reset preferred share ladder?

Post by DenisD »

I would think you should be able to significantly outperform ZPR. There must be a lot of slippage trying to manage a nearly $2 billion portfolio in the illiquid preferred share market. Plus there's that 0.5% MER.
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