Entries from October 2016 ↓

Very attractive

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DOUG By Guest Blogger Doug Rowat

As preferred share prices were tanking last year about as fast as Donald Trump’s female-voter approval ratings are this year, I encouraged our clients to hang in there because I saw enormous value in preferred shares, particularly over the long term. I explained that I expected preferred share prices to rally in 2016 because Government of Canada (GoC) 5-year bond yields were too low and destined to rise. Well, I was wrong: GoC 5-year bond yields have gone nowhere, but preferred share prices have still risen sharply, up almost 23% from their January lows, including dividends.

So what gives?

First, a quick primer on Canadian preferred shares. The bulk—more than two-thirds—of the Canadian preferred share market is made up of rate-resets. These are a specific type of preferred share that typically ‘reset’ their dividends every five years based on the current yield of the GoC 5-year bond yield plus a fixed percentage-point ‘gross up’. For example, you may own a preferred share that in three years’ time will reset its yield equal to the GoC 5-year bond yield plus 4 percentage points. If the GoC 5-year bond yields 2% at the reset date, for example, then the new yield on this preferred would be 6%. (The preferred may not remain at par and the preferred issuer may instead elect to ‘call’ the preferred rather than reset it, but we’ll ignore these variables for now.) What this generally means is that rate-resets are sensitive to movement in GoC 5-year bond yields—when these yields move higher, so do rate-reset preferred share prices and vice-versa. In fact, the correlation between the Canadian preferred share market and GoC 5-year bond yields has been more than 80% over the past three years.

This year, however, this correlation has broken down significantly as Canadian preferreds have skyrocketed since their January lows while the GoC 5-year yield has barely budged. Here’s what’s been driving preferred shares higher:

  • The market has been anticipating higher interest rates. While the economy in Canada is at best lukewarm, GDP growth is still positive, inflation stable and our loonie weak. Markets are expecting that the Bank of Canada will eventually have to follow along with the US Federal Reserve, which raised interest rates once last year and is likely to raise again before year-end. To not follow the Fed risks even more Canadian dollar weakness, which could create economic instability. The chart below shows the incredibly tight relationship between the Bank of Canada and US Federal Reserve interest rate policies. Long term, the correlation is 95%. The Bank of Canada can run, but it can’t hide. Eventually it will follow the Fed’s lead.

Canada’s Interest Rate Policy Moves in Lock-Step With The US

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Source: Bloomberg, Turner Investments
  • Oil prices have rallied 89% since their February lows. Not only does this support the higher interest rate argument above because higher oil prices are positive for our economy, but there are a significant number of pipeline and energy infrastructure companies that issue preferreds, so higher oil prices are positive for them operationally.
  • New preferreds have been issued, particularly bank preferreds, with attractive current yields and favourable reset spreads (the ‘gross up’ I spoke about above). Banks have the balance sheet strength to support these yields and naturally they want high market demand for these issues. They also have to compete with an existing preferred share universe that is already yielding ~5%.
    * There has been a noticeable increase in institutional demand for preferred shares. As an example, recent Bank of Montreal new issues have been oversubscribed with very strong institutional interest. I’ll discuss why the ‘smart money’ has been gravitating to preferreds momentarily.

So, while GoC 5-year bond yields have not been the expected driver of preferred share prices this year, many other factors have emerged to fill the gap. We’re particularly encouraged by the institutional money being pumped into this asset class. We think the reason is quite simple: an absence of attractive income-generating alternatives. The yield advantage that preferred shares offer over other yield instruments is substantial. For instance, preferred share yields still vastly eclipse the yields on corporate bonds (see chart below). Globally, the percentage of bonds offering negative yields has also risen dramatically, so international options are limited. So as far as institutional money is concerned, Canadian preferreds are the best game in town.

Yield Spreads Have Compressed, But Preferreds Still Advantageous To Corporate Bonds

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Source: Bloomberg, Turner Investments

Some have argued that the preferred share market faces an upcoming wave of resets at weak spreads that will drive dividends (and ultimately prices) lower. This is a risk, but we think it’s a muted one. There are currently 191 rate-reset preferreds on the market, but only 27 (14%) face a reset next year with a relatively attractive average reset spread of 3.07%. Even fewer preferreds (24 or 13%) face a reset in 2018 at a still-reasonable average spread of 2.59%. In other words, there is likely to be only minor pressure on preferred share dividends in the future—this buys time for interest rates to move higher. Now, if you don’t think the GoC 5-year bond yield will move higher in two or three years’ time then, quite rightly, you should be cautious with preferreds.

But, as I mentioned, the current yield on the preferred share market is very attractive, so you’re getting paid handsomely to wait for even a little bit of traction with bond yields. Institutions have clearly weighed the risk-reward and decided, at least for now, to go where the juiciest yields are. We think you should too.

Doug Rowat,FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.

The head fake

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Well, no wonder Ontario decided not to impose a BC-style, Chinese Dudes tax on real estate. There aren’t any. Well, not many. At least when it comes to North America’s (by far) biggest and fastest-expanding condo market.

So the data’s in. No government stats or realtor Frankenumbers, but private-sector evidence collected from developers and brokerages representing a quarter of all new condo apartment unit sales. Are you prepared to be shocked? Good. You’ll have to wait one paragraph.

The Toronto condo market is Trumpian in size. About 30,000 units will sell this year, and in the third quarter sales roared ahead more than 22% year/year. The reason is simple. With detacheds fetching an average $1.2 million, they were unaffordable to the average moister even before the MST became the law of the land. The average GTA condo price is now $415,600 (up 9.6% in the past year) – which means this market alone is worth $12.5 billion annually. Yuge.

Who’s buying these things?

According to research firm Urbanation, it sure ain’t foreigners. In total non-Canadian buyers accounted for just 5% of sales, with the other 95% going to moist little beavers. But here’s a key breakdown of that number – 52% of those domestic buyers have no intention of living in the condo units, picking them up instead as speculative or investment properties. Only 43% of trades were to locals who plan to live there.

The survey was conducted between July and last month, and included only projects that were in development – pre-construction, being built, or recently completed (this is the hottest part of market). It’s the first time this kind of data has been available.

So, you wanna blame some group for pushing prices up seven times the inflation rate? Go ahead. It’s every fool out there buying a condo from a developer thinking she’ll just rent it out (at a loss), then flip for a taxless capital gain. Man, does she have a few surprises coming.

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That certainly was an interesting Friday.

Things looked peachy for the Dems at breakfast when Washington announced the latest growth number. Wow. Just a hair under 3%, shutting down all the doomers and Repuglicans insisting America’s heading for recession and (maybe) collapse thanks to the nasty idiots who run the Fed and the government.

That 2.9% pop in GDP, by the way, is the biggest in two years, and more than double the growth recorded in the previous quarter. It sure added fuel to the argument that the central bank will undoubtedly raise its key rate in early December and, if the machine keeps on rolling, perhaps twice more in 2017. It also supported the prevailing pollsters’ view that Hillary Clinton has this thing locked up.

But then came lunch.

Word that the FBI has re-opened its probe into her government emails/private server thingy rocked the Presidential campaign, with Trumpian crowds chanting, “Lock her up, lock her up.” While that’s never going to happen (of course), the news was enough to reduce her odds of being POTUS by about 10% in just ten minutes. According to legendary polls analyst Nate Silver, this could drop her magic number to 68%, while Trump has bounced from a low of 12% back into the twenty range.

Could this be Brexit, Part Deux?

While a Trump win is statistically remote, since the US system isn’t based on the popular vote (as was Brexit), the odds of a Clinton loss have climbed.

What would that mean for financial markets? Your portfolio?

Probably similar to Brexit I. In other words, markets would react badly to being surprised, with lots of bets having been made on an outcome that failed to materialize – causing an avalanche of selling to cover positions. Volatility would spike. The US$ would likely falter, causing other currencies and commodities to rise. Given that equity markets are near record levels, you could expect a 5-6% whack in the first few days, while money flowed like a swollen river into safe havens such as US Treasuries.

Also like Brexit, it would be short-lived. After all, whomever’s in the White House, the economy won’t change, corporations won’t make less money, hiring won’t stop, and people won’t quit buying cars and houses. Investors would adapt, in the knowledge that it’s really Congress and its bureaucracy that runs America.

Investors with a balanced, globally-diversified portfolio would hardly notice – just as they did with the UK vote. When stocks were down 6%, their portfolios were off about 1%, then quickly recovered. Those who didn’t panic lost nothing. Those who got their investment advice from this pathetic blog’s comment section, not so much.

But, of course, Trump can’t win. Unless he does.