BY: MARK NOBLE, SENIOR VICE-PRESIDENT, ETF STRATEGY, HORIZONS ETFS (CANADA) INC.
Preferred shares have been one of the hottest income-focused trades for well over a year now. One reason for this has been a bounce-back in the five-year Government of Canada (GOC) interest rate.
Approximately 60% of the Canadian preferred share market utilizes the rate-reset structure, where the coupon paid on these issuances is set at five-year intervals, at a defined spread over the five-year GOC rate. This makes the preferred share market (in aggregate) generally positively correlated to interest rates, so that when rates rise, generally, so too does the value of these preferred shares. Typically, if rates fall, generally so do the value of the rate-resets.
Canadian preferred shares have pulled back a little in the last two months from their near-term high on April 10, 2017. The primary driver for this is likely because the five-year GOC bond has seen its yield drop below 1% to 0.92%.
Nicolas Normandeau is the lead portfolio manager at Fiera Capital Inc. (“Fiera”), the firm that sub-advises the Horizons Active Preferred Share ETF (HPR) and the Horizons Active Floating Rate Preferred Share ETF (HFP). He believes this drop in interest rates is likely temporary, meaning that we could potentially see another nice bounce-back in the five-year rate, which was trading as high as 1.30% in mid-March.
According to Fiera, the HPR portfolio currently has a yield-to-worst scenario of approximately 4.3%, combined with another potential 3% to 4% if preferred shares retrace their performance to April levels. Investors could be looking at as much as a 7% return on HPR on a total return basis for the year.
Of course, with the U.S. Federal Reserve likely to raise rates (Fiera expects the Fed to raise rates in June), you’re looking at potentially even higher price returns if rates start to rise in Canada in anticipation of the Bank of Canada being forced to raise rates in order to keep pace with both strong domestic economic growth and relative rates with the United States.
Key Points to Consider:
• According to Fiera, the broad Canadian preferred share market was down 3.3% (as at June 2, 2017) from its April 10th highs. This pricing pressure is the result of a combination of the decrease in five-year bond rates and a significant amount of new issues, representing approximately $2.2 billion in new preferred share inventory over the last few months
• On the new issues front, CIBC printed a rate-reset offering with a 4.4% yield. This issue was more than $800 million, of which Fiera, and by extension HPR, was a net buyer. National Bank also had a $400 million issue and there were a number of perpetual issues from insurers such as Intact, Great West Life and Power Financial
• Fiera is avoiding the new perpetual issues because they believe in an impending longer-term rise in interest rates, which puts the value of these issues at risk. Of course, perpetual issues have actually benefitted in the drop in the five-year rate, outperforming rate-reset issue segment of the preferred share market, which is down about 4.4%. As highlighted, Fiera believes this outperformance of perpetuals will be short-lived
• Fiera continues to be a net-buyer of rate-reset preferred shares that trade at a steep discount. On average, these would be the most interest-rate-sensitive of the rate-reset preferred shares, and have therefore fallen further than the broad preferred share market recently, but provide substantially more upside when rates start to rise again
• Despite being overweight discounted rate-resets, HPR still continues to outperform the broad market, and Fiera estimates HPR is still ahead of the S&P/TSX Preferred Share Index by about 100 bps since the start of 2017. Again, pending a return to rising rates, this performance differential will likely increase
• “Best yield trade around”: The recent pullback in preferred shares has not diminished Nicolas Normandeau’s belief that the Canadian preferred trade remains the most attractive income-focused trade in Canada. He is also a portfolio manager on a number of large corporate bond mandates overseen by Fiera’s Integrated Fixed Income team, so he doesn’t have exclusive allegiance to preferred shares. Right now, preferred shares continue to offer about 190 bps of excess yield over investment-grade corporate bonds (4.3% vs. 2.4%). Factoring in the after-tax advantages of preferred shares, where the distributions are taxed as dividends, the spread is actually more realistically about 320 bps
• A 5% yield: On an after-tax basis, HPR yields about 5.6% (as at June 2, 2017). Consider that the trailing yield on the Horizons Active High Yield Bond ETF (HYI) is about 5.7%. You’re effectively getting high-yield returns with close to investment-grade risk
The sub-advisor and investment manager have a direct interest in the management fees of the ETFs, and may, at any given time, have a direct or indirect interest in the ETFs or its holdings.
The views/opinions expressed herein may not necessarily be the views of AlphaPro Management Inc. and 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.