The Canadian preferred share market initially extended its rally into early April, but prices declined over the balance of the month to finish slightly lower than where they began. In part, the pullback later in the month could have been market fatigue as preferred share prices have risen almost continuously since mid-November. As well, some investors appeared to have been buying rate reset issues in anticipation that rising 5-year Canada bond yields would improve their dividend rates. However, when bond yields hit their lowest level of 2017 in April, that rationale lost support. The decline in bond yields reflected a risk-off shift in investor confidence which impacted preferred shares, as well as common equities. Also, index rebalancing later in the month saw more issues entering the index than being removed. In order to make room for the additions, indexed portfolio managers may have been forced to do more generalized selling of other issues, which led to further weakness in the market. In addition, the issuance of structured notes linked to preferred share ETFs declined, thereby reducing preferred share demand for hedging purposes. The S&P/TSX Preferred Share Total Return index had a flat return of 0% in the month.
Rate reset issues were the weakest performers in April, with an average return of -0.9%. In contrast, straight preferred shares earned 1.2%, and floating rate issues gained 1.1%.
There were two new preferred share issues late in the month:
Both issues seemed expensive to us. Institutional investors appeared to agree with our assessment as only 11 institutional investors participated in the Brookfield Office Properties issue, and only 15 institutions bought the Element Fleet Management issue. Recall that over 80 institutions participated in some new issues in the past year. We did not purchase either new issue, as we identified better values in secondary offerings.
As expected, Bank of Montreal announced the redemption of two older perpetual issues, BMO.PR.L and BMO.PR.K, for May 25th. The redemptions were pre-funded with the issue of the BMO.PR.C rate reset preferred shares in early March.
Late in the month, Home Capital Group, an alternative mortgage lender, experienced a sudden liquidity crisis. Ontario Securities Commission allegations of misconduct by three current and former executives in 2014 and 2015 led to a run on Home Capital’s high interest savings accounts. News that the company then agreed to a usurious bailout loan from a large pension fund only reinforced the appearance of severe financial distress. Home Capital does not have any preferred shares outstanding but the shares of other non-bank mortgage lenders, including Equitable Group and First National Financial, declined in response to the Home Capital crisis. However, the problems seem entirely contained to Home Capital and the preferred shares of the other firms should recover in the coming weeks.
NexGen Canadian Preferred Share Fund
Performance was improved by the overweight allocation to perpetual preferred issues and relatively lower allocation to rate reset issues. Security selection was a neutral factor, notwithstanding that a couple of holdings, including First National Financial preferred shares, experienced significant price declines in the month which lowered the overall Fund return. We believe the declines were transient rather than permanent, and will likely be reversed in the near term.
The rise in preferred share prices since November left some issues overvalued in our opinion. Accordingly, we have been selling those issues over the last few months to take profits, and have been looking for reinvestment opportunities. Unfortunately, new issue supply was limited in both March and April and secondary liquidity was disappointing, which meant cash balances in the Fund rose to relatively high levels. Accordingly, as a temporary position we added CPD, the iShares Preferred Share ETF, to reduce cash and maintain preferred share exposure. By month end, we had found attractive individual issues, and we started to sell the ETF holding.
Market Outlook and Strategy
Our comments from last month remain valid: “From a long-term perspective, preferred shares have moved slightly below their historical average yield of 5.00%, but alternative fixed income investments such as bonds continue to have yields near record low levels. That suggests that the recent growth in institutional demand will remain a significant factor in the preferred share market in 2017. New issue supply, however, is unlikely to be sufficient to satisfy the additional demand and that bodes well for further price appreciation of preferred shares this year.”
From a short-term perspective, the market may consolidate for a few more weeks, but any weakness should probably be treated as a buying opportunity. Ongoing capital expenditures in the energy sector should lead to new preferred share issues that may reinvigorate the secondary market. As well, one or two banks may issue preferred shares once they have released their second quarter financial results later this month.
For more information about NexGen 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.