The Canadian preferred share market once again demonstrated its diversification value as it enjoyed good gains while both Canadian bonds and common stocks lost ground in January. The Bank of Canada (BOC) raised its administered rates this month, and that helped the preferred share market absorb significant new issue supply and move to higher prices. The S&P/TSX Preferred Share index gained 1.58% in January. That compared favourably with the FTSE TMX Canada Universe Bond and S&P/TSX stock indices, which declined 0.80% and 1.39%, respectively.
The BOC raised its overnight target interest rate by 25 basis points in January. The increase brought the BOC’s rate closer to the Fed’s lower-end rate (1.25%-1.50%), which was established in December. The BOC’s move combined with a global bond market sell-off led to the 5-year Canada bond yield rising 22 basis points. Rate reset issues trading at a discount-to-par rallied on the higher bond yield, as this meant higher prospective dividend rates. Floating rate preferred shares experienced even stronger gains as their dividend rates will be adjusted upward in three months or less. As well, the BOC’s move suggested that further rate increases were likely later this year, which encouraged buying of floating rate issues.
There were five new issues in January, including the first bank issue in half a year. The Brookfield Renewable Power, CIBC, and National Bank issues came in quick succession in the second week of the month and the $1 billion of new supply caused temporary indigestion in the market. Both Brookfield issues pay distributions that are a combination of income, return of capital, and dividends, rather than all dividends. Details of the new issues were as follows:
Except for the BEP.PR.M shares, each of the new issues was trading at a small discount to par at the end of the month.
During January, only one preferred share issue announced its extension and new fixed dividend rate. The ENB.PR.D shares’ dividend rate will increase to 4.46% from the initial 4.00%, since the shares’ issuance in November 2011, reflecting the increase in 5-year Canada bond yields. As this is being written, we have not heard whether the floating rate alternative was chosen by a sufficient number of investors, but we anticipate that all the ENB.PR.D shares will remain with the fixed rate dividend.
Over the balance of 2018, we believe that most rate reset issues coming due will be extended. However, TD Bank, Bank of Nova Scotia, and Bank of Montreal have five series of fixed rate reset issues (and associated floating rate issues) that will likely be redeemed, because they are not NVCC-compliant, and they can only be redeemed once every five years. The market appears to concur that these issues will be called, as they are all trading close to par.
ETF flows exhibited that investors continue to favour actively managed funds over passive ones. The two largest passive ETFs, CPD and ZPR, each attracted only $15 million of deposits, while RPF, HPR, and DXP received deposits of $72 million, $65 million, and $49 million respectively in the month.
Regarding structured notes linked to preferred share ETFs, only one bank (Bank of Montreal) appears to be offering new ones. We suspect the volume of new structured notes will be lower than last year, because the potential returns have dropped sharply.
Natixis Canadian Preferred Share Fund
The greater-than-benchmark allocation to perpetual preferred issues was one reason for the Fund’s shortfall this month. Another factor was the relatively high cash position while the market rallied. As well, the U.S. dollar denominated holdings lagged as the Loonie appreciated roughly 2% in the month.
Noteworthy transactions included the purchases of the new CIBC and National Bank rate reset issues. We also purchased a floating rate issue of the Bank of Nova Scotia. The purchases invested recent deposits and lowered the cash position of the fund to 4.2% at month end.
Market Outlook and Strategy
Preferred share yields are a little lower than their long-term average of 5.00%, which suggests they are somewhat expensive. We remain positive on preferred shares, because they offer very competitive yields in what is still a very low yield environment. As well, we expect new issue supply will be insufficient to satisfy demand, which will be supportive for outstanding issues.
In addition, we believe bond yields are likely to move higher this year, which will be positive for many preferred share issues. The synchronized global economic expansion is using up spare capacity and causing most central banks to reduce the amount of monetary stimulus that they are providing. It appears likely that the Fed will raise its administered interest rates at its next meeting, which is scheduled for March 20 and 21. The BOC will likely follow suit at its April 18 meeting. Given the possible impact on the exchange rate, we believe that the BOC will avoid raising rates before or faster than the Fed this year. The bond market is unlikely to wait for the central banks to raise their respective rates. Instead, investors will probably anticipate the Spring rate increases as well as additional increases later this year. There is also potential for an acceleration in the pace of inflation that would only increase the expected pace and magnitude of the rate increases.
Higher bond yields will lead to higher dividend rates when issues reset, increasing the values of those issues. Floating rate issues will also experience higher dividend rates if we are correct, and the BOC raises short-term rates two or three times again this year.
For more information about Natixis Canadian Preferred Share Funds, please contact your financial advisor.
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Natixis Investment Managers Canada LP is the manager of the Fund and is an affiliate of Natixis Investment Managers S.A.