The preferred share market enjoyed a strong month in September even as other fixed income instruments, such as bonds, struggled. Preferred share investors focussed on the favourable economic conditions and good corporate creditworthiness, and ignored geopolitical events and hurricanes. A somewhat surprising interest rate increase by the Bank of Canada (BOC) had positive ripple effects for preferred shares. The S&P/TSX Preferred Share Index returned 1.36% in September.
On September 6th, the BOC surprised many market participants by making a second consecutive 25 basis point increase in its overnight target interest rate. In doing so, the BOC completed the reversal of its rate cuts of 2015. The Bank’s move, combined with weakness in the U.S. bond market, resulted in 5-year Canada bond yields rising 27 basis points in the month. This benefitted fixed rate reset preferred share issues as it would mean higher dividend rates at the next resetting. On average, rate reset issues returned 2.2% in September. The BOC’s move had an even greater impact on floating rate issues, which gained 2.8% in the month. A more aggressive than expected BOC would mean a steeper upward trajectory for 3-month Treasury Bills, which would in turn push floating rate dividends higher. Perpetual issues, in contrast, experienced small declines in value in reaction to higher long-term bond yields.
There were two new preferred share issues in September – Brookfield Asset Management issued a rate reset issue and Partners Value Split Corp. issued 7-year split share, retractable shares. Details of the issues were as follows:
One redemption was announced in September. National Bank will be redeeming its NA.PR.O issue on November 15th. Issued five years ago, the shares did not have Non-Viability Contingent Capital (NVCC) provisions, which meant they had declining value as regulatory capital. As of January 1, 2022, all bank preferred shares lacking NVCC provisions will receive 0% treatment as capital, so we anticipate any shares issued by the banks prior to 2014 (when NVCC language first appeared) will be redeemed at par at the next possible redemption date.
In the last several months, each of the rate reset issues that were resetting their dividends failed to attract enough interest in the floating rate option to cause a floating rate series to be created. Typically, holders of at least 1,000,000 shares must opt to convert to floating rate shares for that series to be created. If fewer shares opt for conversion, they must remain with the fixed rate series. In September, at least five issues (viz. MFC.PR.I, TA.PR.H, BIR.PR.A, VSN.PR.A, and AX.PR.A) were resetting their dividend rates and none had enough interest for the floating rate alternative. Given that global central banks, including the BOC, appear to be in a tightening cycle that will lead to higher T-Bill yields, the lack of interest in floating rate issues is somewhat surprising.
Likely, the reason that more investors haven’t opted for the floating rate series is the differential between the benchmarks for the fixed and floating rate series. Fixed rate dividends are set with reference to 5-year Canada bond yields, while floating rate issues reference the yield of 3-month Treasury Bills. As can be seen in the chart below, the spread between the two benchmarks fluctuates considerably. Currently, if a preferred share was resetting its dividend rate, the fixed rate would be approximately 75 basis points higher than the initial floating rate dividend. For the floating rate series to have a superior dividend rate, the BOC would need to raise rates at least three more times. That might take several months, but it is a legitimate possibility, especially if the U.S. Federal Reserve resumes hiking its rates.
An example of why floating rate shares make sense are TRP.PR.I shares. In January 2016, TRP.PR.C shares were resetting their dividend rate and approximately 1,300,000 shares were converted into the floating rate TRP.PR.I series. Initially, the floating rate shares received about 25 basis points less than the fixed rate shares. However, with the BOC’s two rate increases this year, the dividend rate on the TRP.PR.I shares will be higher than the fixed rate on the TRP.PR.C shares. Further rate increases by the BOC will increase the advantage of the floating rate shares.
Late in the month, Bank of Nova Scotia announced that it would be issuing a new type of capital note that would qualify as Alternative Tier 1 capital in the United States. Prior to this, only preferred shares qualified as Alternative Tier 1 capital, so the new capital notes have the potential to reduce the supply of new preferred issues from Canadian banks if they prove popular with investors. The notes are deeply subordinated to other bank debt, have NVCC provisions that could result in them being converted into common shares, and are rated as barely investment grade at BBB-. An important aspect of the issue is that the bank has the option to stop paying interest on the notes for up to five years. The notes are relatively more expensive than preferred shares for the bank to issue as the interest rate is slightly higher than preferred share dividend rates and the interest is not tax-deductible for the bank. However, the capital notes are targeted at completely different investors than the buyers of preferred shares, so they potentially open a new source of capital for the bank. We will be monitoring the success of the Bank of Nova Scotia financing as it could reduce the supply of preferred issues going forward.
Natixis Canadian Preferred Share Fund
Volatility of the value of individual holdings was the main reason for the Fund’s positive performance this month. Holdings which had lagged the market in August rebounded in September.
During the month, we reduced the perpetual holdings slightly to 30% of the portfolio through the trimming of several holdings. Rate reset issues comprise the largest portion of the Fund at 60%. Floating rate issues make up 4%, while cash levels are at 6%. With the looming closing of the Pembina acquisition of Veresen, we sold the VSN.PR.A holding to reduce exposure to the combined entity toward our operational limit of 5%.
Market Outlook and Strategy
Preferred shares remain attractive. Notwithstanding the recent rise in bond yields, we are still in an low yield environment and the 5.00% yields achievable in preferred share portfolios are very competitive. As well, the lack of correlation to bonds will be valuable if the bond market continues to falter and bond yields rise.
As noted earlier with the new issue from Bank of Nova Scotia above, the new form of bank capital will reduce preferred share issuance by Canadian banks if it’s successful. The lower supply will be supportive of preferred share valuations.
We continue to monitor the market closely for opportunities, both to sell and to buy. In some cases, preferred share prices have risen above fair value, and we will look to realise profits. In other cases, some issues have become relatively cheap and we will add them to the portfolio. Perpetual issues that are yielding more than 5.50% are such examples. We will also be monitoring for the potential impact of structured notes linked to preferred shares unwinding their hedges in the coming months. Last October, 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.
For more information about Natixis Canadian Preferred Share Funds, please contact your financial advisor.
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