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
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
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.