The preferred share market enjoyed strong returns in October. A lack of new issues, concerns about lower bank issuance, and good investor demand combined to push preferred share prices higher. Some selling late in the month, related to ETF redemptions and reduced institutional interest, caused prices to decline slightly, thereby halting the rally. The S&P/TSX Preferred Share index gained 1.97% in October.
As noted in last months commentary, the Bank of Nova Scotia issued a new type of capital security (in USD) that qualified as Alternative Tier 1 (AT1) capital. Canadian banks are obliged to hold minimum levels of Tier 1 capital, which is primarily made up of common stock, but can also include some AT1 capital. Until the BNS issue, only preferred shares qualified as AT1 capital. If other Canadian banks choose to issue similar perpetual notes, it will lessen the need for them to issue preferred shares in the future. This sparked demand for existing bank preferred shares during October as some investors paid up for the potential rarity value. In our view, however, the existing bank issues were already among the most over-valued and lowest yielding issues in the market, and their rally in October is probably unsustainable.
Interestingly, investor demand for rate reset issues remained strong in the month despite the decline in 5-year Canada bond yields that occurred in the period. The roughly 75 basis point rise in bond yields because of the Bank of Canadas (BOCs) July and September interest rate increases were significant factors behind the rally in preferred shares in the summer months. In October, however, bond yields declined about 15 basis points and there was little discernable impact on rate reset share prices.
ETF-related trading in the month was supportive of preferred share prices. The BMO laddered rate reset ETF (ZPR) had $58 million of net withdrawals in October that we believe included unwinding of some structured note hedges. However, deposits to actively managed preferred share ETFs more than offset the ZPR withdrawals, resulting a net inflow to the market from the five largest ETFs of $54 million.
There were no new preferred share issues in October. Looking ahead, November is typically a busy month for non-financial issuers, so we may see issuance pick up. Given the length of time since the last new issue, we believe pent-up demand will make the first issue or two quite successful. Banks, however, are unlikely to issue any preferred shares until after the release of their annual financial results in late November.
National Bank announced that it will be redeeming the NA.PR.Q rate reset issue. The shares were issued in 2012 and do not have Non-Viability Contingent Capital provisions, so National Banks announcement was not a surprise. Over the next three years, we expect banks to redeem all their non NVCC-compliant preferred shares because they will cease to be recognized as capital after 2021. Most of the issues to be redeemed are rate reset issues, which are only redeemable once every five years, so the timing of each issue being called should be quite predictable.
In the only case of a rate reset issue resetting in the month, Valener Inc. reported that there was insufficient interest in the floating rate option and, as a result, all the fixed rate VNR.PR.A shares would remain outstanding.
Natixis Canadian Preferred Share Fund
The reason for the Funds shortfall this month was the elevated cash level in the Fund. Sales of overvalued issues combined with new deposits had increased the cash level due to a shortage of appropriate purchase opportunities. Sales were also increased as we reduced exposure to the recently completed Enbridge/Westcoast and Pembina/Veresen corporate combinations.
Noteworthy transactions included the sales mentioned above as well as purchases of new holdings of Brookfield Asset Management and Fortis preferred shares. We also increased the holdings of several existing positions.
Market Outlook and Strategy
The shortage of fairly valued issues suggests that the overall market may be somewhat overvalued in the short run and the relatively high cash levels will be a good buffer should there be a mild correction.
In October 2016, we noted the start of large scale issuance of structured notes that were typically callable after one year if the referenced preferred shares had appreciated in value, which they have done. If those notes are called, the hedges will be unwound, which could lead to selling of shares. If there is substantial selling of ZPR, we would expect to see rate reset issues retrace much of their earlier gains. We also note that the BOC is unlikely to raise interest rates again until the first quarter of 2018, at the earliest. So, the push to higher 5-year bond yields is on pause, and yields may fall back somewhat as investors discount a more dovish outlook for monetary policy moves. In addition, if we are correct that fund flows into competing products has caused many preferred share issues to rise well above fair value, there is a risk that those issues could correct abruptly when the fund flows slow or reverse. Advisors might want to take profits in the products that have performed particularly well before they correct.
From a longer-term perspective, preferred shares continue to be an attractive asset class. We remain in a 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. As well, the lack of correlation to bonds will be valuable if the bond market falters again and bond yields rise.
We are monitoring the market for opportunities to reduce the current cash balances. New issues may provide that. We are also monitoring for the impact of structured notes linked to preferred shares unwinding their hedges in the coming months.
For more information about Natixis Canadian Preferred Share Funds, please contact your financial advisor.
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