The preferred share market had another month of negative returns, the third month in a row. The market continued to take a breather and absorbed some issuer specific news in April. The S&P/TSX Preferred Share index returned -0.42% in the month.
Negative headlines for pipeline issuers dominated the preferred share market in April. Early in the month, Kinder Morgan Canada Limited (KML) announced that it was suspending all non-essential spending and activities on the Trans Mountain Expansion Project, which would expand its pipeline capacity to carry oil from Alberta to the BC coast. It will consult with various stakeholders to reach agreements by May 31st, and if there is nothing agreed to then the project may not go forward. The project faces continued opposition from the BC government despite receiving federal approval in 2016. The federal government has said it is committed to getting the pipeline built. KML’s announcement was viewed as negative for pipeline and energy infrastructure companies, some of which have high capital expenditures going forward that need to be financed. Preferred shares of these companies were some of the worst performers in the month.
Later in the month, the index heavy Enbridge (at about 8% weight) had a negative development regarding its Line 3 Replacement project. A Minnesota administrative law judge made a recommendation to the Public Utilities Commission (PUC) that would increase the cost of the project. While this recommendation is not binding, it is likely to be taken into consideration in the PUC vote expected in June 2018. This is the largest project (cost estimate before this recommendation was $9 billion) in the company’s history and the lengthy approval process has already resulted in delays and cost increases. Enbridge’s preferred shares were some of the weakest performers on the month.
Also, late in the month, TransCanada Pipelines held a conference call after posting results that beat expectations. The company addressed S&P’s negative outlook on its credit rating, in place since the acquisition of Columbia Pipeline over two years ago. TransCanada stated, “we anticipate a rating move by them from A- negative outlook to BBB+ stable, as entirely possible in the near term“. S&P downgraded the company on May 1st, which resulted in the preferred share rating moving from P-2 to P-2(Low).
Perpetual issues enjoyed the best return of the different market sectors in the month, returning -0.20%. Rate reset issues returned -0.57% in the month. Pipeline issuers are less than 1% of the market value of perpetual issues, while they are approximately 21% of the market value of rate reset issues. Floating rate issues were the weakest sector, returning -1.78%.
Investors continued to choose actively managed preferred share ETFs over passively managed ones, although April inflows were the lowest year to date. The three largest actively managed ETFs had combined inflows of $67 million. Meanwhile, the two main passive ETFs, ZPR and CPD, had a net outflow of $16 million.
There was not a new issue in April. With Canadian banks going into their “blackout period” starting May 1st until they start reporting in the last week of the month, it is expected that new issuance will be light in the first part of May.
Natixis Canadian Preferred Share Fund
Some of the recent weakness in the Element Fleet Management preferred shares was reversed. They were the best performers in the portfolio on the month and helped offset weakness in pipeline and energy infrastructure issuers.
Element Fleet Management preferred shares performed well in April, increasing between 3% and 4%. During the month, the company demonstrated that it has good access to funding. They completed an asset-backed security deal that was upsized from US$650 million to US$ 1 billion on strong demand at spreads that were consistent with deals done last year. This indicates that the company can fund its US fleet business cost effectively. We remain confident about the company’s creditworthiness. The company is profitable with significant cashflow generation that more than adequately covers the preferred share dividend requirement and capital expenditures. We believe that the preferred shares will gradually recover value in the coming months as the company continues to report stable operations and profitability.
Noteworthy transactions during the month included the sale of SLF.PR.E to reduce the overall perpetual sector weighting. Also, we sold the remaining SJR.PR.A position. In addition, we purchased some MFC.PR.L which resets in June 2019, FTS.PR.K which resets in March 2019, and EMA.PR.C which resets in August 2018. We anticipate that these issues will reset at higher dividend rates. The cash level at the end of the month was 5.3%, which provides us with the option to buy in a weak market.
Market Outlook and Strategy
In the short run, the preferred share market is digesting some issuer specific news and continues to take a breather from the rally that began two years ago. Since we view the preferred share market as slightly expensive with an index current yield of 4.5% (many issues below 4.00%), some consolidation makes sense. Recent new issues have not received overwhelming interest from either institutional or retail investors. Similarly, demand for preferred share ETFs has lessened in recent weeks. Also, in a few cases the yield on the common equity is higher than on the preferred shares of the same issuer, resulting in potential substitution for some investors willing to accept more volatility.
From a longer-term perspective, most preferred shares continue to be attractive. Relative to bonds, the yields available on preferred shares are significantly higher, even before the more favourable tax treatment is considered. A number of perpetual issues, for example have yields of 5.50% or better. In addition, if the consensus regarding bond yields trending up is correct, rate reset issues will continue to increase their dividend rates. The higher dividend rates, in turn, should be supportive of prices. Another reason for holding preferred shares is their lack of correlation with bonds at a time when bonds are struggling to hold their values.
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.