Preferred share prices declined at the start of December, but ground back toward unchanged levels in the illiquid conditions in the second half of the month. The early weakness was due to new issue supply, as well as selling related to unwinding of structured note hedges. The S&P/TSX Preferred Share Index returned +0.05% in December.
Floating rate preferred shares, which make up about 6% of the market but account for only 2% of the S&P/TSX Preferred Share index, were the strongest sector in the month, returning +1.6%. Rate reset issues earned +0.2%, as selling early in the month depressed prices. In part, the sales of rate reset issues was linked to auto-call activity of structured notes linked to the BMO Laddered Rate Reset Preferred Share ETF, ZPR. In addition, there was apparently a large, real money seller of ZPR. Perpetuals returned -0.7% on average.
Two new issues came to market in early December. On December 4th, Enbridge Inc. issued preferred shares for the first time in a little over a year. In September, the company had issued $1 billion of a Canadian dollar denominated hybrid security and three weeks later reopened the hybrid for another $650 million. Like preferred shares, the hybrid security receives partial equity credit from the rating agencies, but the interest payments are tax-deductible where preferred share dividends are not. As a result, the hybrid structure has advantages that will likely reduce preferred issuance by some companies going forward. 24 institutional buyers participated in the Enbridge preferred share issue. The Kinder Morgan Canada issue on December 6th attracted only 11 institutional buyers, as the ongoing delays in the Trans Mountain expansion probably discouraged some potential buyers. Details of the issues were as follows:
We did not participate in either new issue because existing issues of both companies offered at least as good value and we did not want to increase exposure to either issuer from existing levels. At month end, the Enbridge issue was trading at a small discount to par, while the Kinder Morgan Canada was slightly above par.
During December, three rate reset issues, BAM.PR.Z, IFC.PR.A, and NPI.PR.C, reset their dividend rates. In all three cases, investors were given a choice of switching to the floating rate series of shares that would pay the respective reset spreads over 3-month Canada Treasury Bills rather than 5-year Canada Bonds. Continuing the trend that has been in place throughout 2017, there was insufficient interest in the floating rate alternative, and 100% of investors will remain in the fixed rate dividends for the next 5 years. The lack of interest in the floating rate alternative likely reflects the yield differential between the bonds and T-Bills. Currently, the yield spread is approximately 80 basis points, which means investors must anticipate at least three 25 basis point rate increases by the Bank of Canada to bring the floating rate dividend close to where the fixed rate dividend would be set. Given the cautious nature of the Bank of Canada with regard to raising interest rates, investors have chosen to lock in the fixed rate instead.
Actively managed preferred share Exchange Traded Funds continued to see substantially better deposits than passive ETF’s. The two largest passive preferred share ETF’s received $16 million of net deposits during December, while the three largest actively managed ETF’s attracted $139 million of net deposits. The shift in ETF assets from passive to active validates our long-held contention that the inefficiency of the preferred share market makes active management a compelling choice.
Natixis Canadian Preferred Share Fund
The fund slightly outperformed the index during December. Security selection was favourable in the period, as the selling pressure early in December occurred mostly in issues that the fund did not hold.
The cash position was reduced to 7.4% as deposits were invested in existing holdings rather than new positions. The fund continues to hold an overweight allocation to perpetual issues; 28.0% compared with a market weight of 21% and an index weight of 18%. Rate reset issues comprised 59.2% of the fund (73% market, 80% index). Floating rate issues accounted for the remaining 5.3% of the fund.
Market Outlook and Strategy
Preferred shares continue to be an attractive asset class. We remain in an low yield environment and the approximately 5.00% yields achievable in preferred share portfolios are very competitive. Demand for preferred shares remains strong, while supply of existing issues shrinks due to redemptions. We believe new issue supply will be insufficient to meet demand, which means preferred share values should gradually rise in coming months. In addition, rising 5-year bond yields will lead to rising dividend rates on reset issues. As well, the lack of correlation to bonds will be valuable if the bond market falters again and bond yields rise.
From a longer-term perspective, interest rates and bond yields appear to be in a rising trend, but we believe that preferred shares will generate competitive returns for the foreseeable future. As can be observed in the chart below, the gap between preferred share yields and bond yields has widened sharply over the last decade. There is ample room for bond yields to rise without coming close to preferred share levels.
We are monitoring the market for opportunities to reduce the current cash balances. The scarcity of new issues in recent months has made liquidity challenging and we prefer not to chase. In particular, we think the ETF-led rally of the last few months has left some issues over-valued. The potential for a mild correction has increased and, if one occurs, we will use it as a buying opportunity. We are also monitoring new issues for ones that offer better value than existing issues.
Looking forward to 2018, we believe that most rate reset issues coming due next year 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. If the banks choose to refinance with new preferred share issues, they will likely be fairly popular as we have not seen a new bank preferred share issue since July.
Please accept our best wishes for a healthy and prosperous 2018.
For more information about Natixis Canadian Preferred Share Funds, please contact your financial advisor.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual fund securities are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer.
This release may contain “forward-looking statements” which reflect the current expectations of Natixis Investment Managers Canada LP and/or its sub-advisor, J. Zechner Associates Inc. (“J. Zechner”). These statements reflect the applicable management’s current beliefs with respect to future events and are based on information currently available to such management. Forward-looking statements involve significant known and unknown risks, uncertainties and assumptions. Many factors could cause actual results, performance or achievements to be materially different from any future results, performance or achievements that may be expressed or implied by such forward-looking statements including, without limitation, those listed under the heading “Risk Factors” in the Natixis Investment Managers Canada LP Funds prospectus, which is available on Natixis Investment Managers Canada LP’s website and on SEDAR at www.sedar.com. Should one or more of these risks or uncertainties materialize, or should assumptions underlying the forward-looking statements prove incorrect, actual results, performance or achievements could vary materially from those expressed or implied by the forward-looking statements contained in this release. Although the forward-looking statements contained in this release are based upon what Natixis Investment Managers Canada LP and/or J. Zechner believes to be reasonable assumptions, Natixis Investment Managers Canada LP and J. Zechner cannot assure investors that actual results, performance or achievements will be consistent with these forward-looking statements. These forward-looking statements are made as of the date of this release and Natixis Investment Managers Canada LP and J. Zechner do not assume any obligation to update or revise them to reflect new events or circumstances.
Natixis Investment Managers Canada LP is the manager of the Fund and is an affiliate of Natixis Investment Managers S.A.