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MARK NOBLE, SENIOR VICE-PRESIDENT, ETF STRATEGY, HORIZONS ETFS

March 1, 2019

Note: Fiera Capital Corporation (“Fiera Capital”) is one of Canada’s largest managers of fixed income investments, and sub-advises many of Horizons ETFs’ family of actively managed fixed income ETFs.
In February, Horizons ETFs co-hosted a webinar with Fiera Capital: Are Preferred Shares Oversold? Canadian Preferred Share and Fixed Income Outlook. The webinar was presented by Nicolas Normandeau, Vice-President and Portfolio Manager, Fixed Income, at Fiera Capital.

In the following blog, Mark Noble shares his thoughts on Mr. Normandeau’s outlook on preferred shares and fixed income investing in today’s challenging economic environment.

Outlook:
During the webinar, Mr. Normandeau noted that Fiera Capital’s target for 2019 is approximately a 5% return in Canadian preferred shares. He indicates that we’ve hit the bottom on valuations, but doesn’t expect a lot of price movement to the upside going forward. This is because anywhere between $5-7 billion in new issuances from Canadian financials (banks and insurers) will likely come out in 2019 – which will offer attractive rates relative to current resetting issues.

The 5% return projection assumes that prices will likely hold steady in preferred shares and investors will see almost all of their total return come from the yield on Canadian preferred shares – which is currently approximately 5.4%. In other words, this year is all about the yield. There are few quasi-investment grade solutions that yield in excess of 5%!

Coming out of 2015/2016, there were lofty expectations for preferred shares because interest rates were anticipated to rise, which dramatically increased the reset levels of the rate-reset preferred shares. In 2019, Fiera Capital anticipates only one more interest rate hike – the market is not pricing that in – and it will likely come in late 2019. Interest rates therefore, should not be a tailwind for preferred share prices; but they also shouldn’t be a hurdle.

Fiera Capital’s target range for the five-year government of Canada interest rate, which is used as the benchmark reset rate for Canadian rate-reset preferred shares, is between 1.75% and 2.10%. We are currently around 1.8%.
The reason for the muted expectations on interest rate growth is due to the fact that Canada still faces headwinds in two of its key economic drivers: the price of oil (which has bounced back but remains historically low) and the Canadian housing market (which has recently experienced a contraction). Employment and consumer demand remain strong, which suggests slower economic growth, but still well within the 2% target for the Bank of Canada. Although a recession is unlikely anytime soon, the market has basically been pricing it in.

In December, the market tended to overweight the bad news in the global economy, so all developed economies saw economic forecasts decline and corporate bond spreads widen. Since December, most of the central banks have taken a softer stance on raising interest rates and both the equity and credit markets have responded favourably – with credit spreads coming in nearly 20 basis points since the beginning of the year. Again, all of this potentially favours stabilizing the prices of preferred shares.

The primary reason that Fiera Capital believes investors can potentially obtain an approximate 5% return when all is said and done in 2019 is due to the fact that most of the issuances in the portfolio of the Horizons Active Preferred Share ETF (HPR) will reset to higher spreads over the next few years. To give some context, if the five-year rates stay the same, HPR would be expected to yield (before fees) approximately 5.5% – and going forward to 2022, its yield would be anticipated to increase to nearly 6%.

Of course, this yield is very attractive relative to corporate credit, when you recognize the fact that preferred share dividends are tax-efficient, Canadian-eligible dividends. Therefore, the after-tax yield is actually considerably higher than what you would earn on even non-investment grade high yield bonds – and would be the equivalent to bond income – somewhere in the 7% range on a hypothetical after-tax basis.

Portfolio Positioning:
Since Fiera Capital believes preferred share prices are at lows, but likely not to increase by a significant amount, it stands to reason they will likely target preferred shares that offer the highest total return. In Fiera Capital’s opinion, these are discounted rate-reset preferred shares that offer higher yields.

The most subscribed-to new preferred shares in the market in 2018 were bank-sponsored issues that offered attractive rate-resets – that is, they offer higher coupons than what’s available in the secondary market. However, these issuances tend to trade at a premium – at $25 or above. Fiera Capital has generally avoided these new issuances, instead opting to target similar issuances from the same banks in the secondary market that have a market price below $24 and therefore offer a higher yield relative to their current market price.

Nearly three quarters (73%) of the HPR portfolio is in discounted rate-reset preferred shares –issuances that trade at $24 and lower. HPR has 65% of its portfolio in preferred shares that trade at $22 and lower.

Mr. Normandeau uses the example of CIBC’s latest issuance to explain how targeting existing preferreds in the secondary market can be more beneficial than buying new issues. CIBC’s latest issue has a coupon of 5.25%, which is much more attractive than the coupon of similar issues in the secondary market. However, Fiera found another CIBC issue (the same credit quality) in the secondary market offering a potentially higher yield due to the fact they are trading at a two dollar discount to their $25 offering price. Therefore, on a total return basis (factoring in the yield and potential price return), the secondary market issuance comes out ahead. Fiera Capital is actively seeking these types of mismatches to optimize the total return.

“I was able to buy another CIBC-R issue with similar spread with slightly better reset,” Mr. Normandeau said during the webinar. “That issue was trading for $2 cheaper. I know that the coupon is slightly lower, but that is only about $1 difference and we are getting another $1 discount. With bank issues you should not be buying at a premium – you should sell and wait for new issuances. We like the mid-reset like the CIBC-R, and some of the lower reset of the banks. There is a lot of mismatch between the banks.  With National Bank you can get a 5.50% yield and you can get some BMO at 5.30%. But TD and RBC are trading low 5.00s. That’s why we are active to take advantage of these opportunities,” he said.

The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

Certain statements may constitute a forward looking statement, including those identified by the expression “expect” and similar expressions (including grammatical variations thereof). The forward-looking statements are not historical facts but reflect the author’s current expectations regarding future results or events. These forward-looking statements are subject to a number of risks and uncertainties that could cause actual results or events to differ materially from current expectations. These and other factors should be considered carefully and readers should not place undue reliance on such forward looking statements. These forward-looking statements are made as of the date hereof and the authors do not undertake to update any forward-looking statement that is contained herein, whether as a result of new information, future events or otherwise, unless required by applicable law.

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