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In March, the preferred share market moved sharply higher. The speculation regarding preferred share redemptions by banks, started on the last day of February with Bank of Montreal issuing a U.S. dollar Limited Recourse Capital Note (LRCN), and continued in early March when CIBC issued an institutional preferred share. Later in the month, both CIBC and TD Bank announced the redemption of rate reset issues which increased investors demand for similar issues in anticipation of additional redemptions. Most bank rate reset issues trading below par had strong gains of more than 5% in March. During the month, all issue types had positive returns, with rate reset issues experiencing the largest gains. The S&P/TSX Preferred Share index ended the month with a gain of 3.47%.
For the second consecutive month, inflation in Canada was lower than expected. Prices rose only 0.3% in February compared with forecasts of 0.6% increases. As a result, the annual rate of inflation declined to 2.8% from 2.9%. The news caused bond yields to drop that day but had limited impact over the balance of the month. The lack of lasting impact may have been due to better than expected performance in the Canadian economy, which reduced the need for monetary easing by the Bank of Canada. Growth in Canadian GDP during January was reported at 0.6% and the initial estimate for February was an additional 0.4% improvement. Those increases implied growth in the first quarter at an annual rate of 3.5%, much better than the Bank of Canada’s 0.5% forecast. Housing starts were stronger than expected at 253,000 units, although still inadequate for the rise in Canada’s population. The rapid increase in population accounted for the unemployment rate edging up to 5.8% despite job creation that was twice as strong as forecasts.
While a bank’s after-tax cost of capital will continue to be considered in redemption decisions, there are clearly other considerations when a bank decides to redeem an issue. Notwithstanding the reset spread level, it appears that the Office of the Superintendent of Financial Institutions continues to encourage banks to replace traditional $25.00 par preferred shares with LRCNs or institutional preferred shares. As noted above, CIBC issued its second series of institutional preferred shares in March. The bank raised $500 million with shares having a dividend rate of 7.337% and a reset spread of 390 basis points. Given the issue’s high dividend rate and reset spread, there was strong institutional investor demand and it performed well after issuance. Later in the month, CIBC announced the redemption of its $325 million CM.PR.T series with a reset spread of 331 basis points.
Over the last three years, banks have been using the proceeds from the issuance of LRCNs and institutional preferred shares to fund redemptions of $25.00 par preferred shares, with most redemptions reducing their after-tax cost of capital. However, replacing the CM.PR.T series with the higher cost institutional preferred share was not economically beneficial. The CM.PR.T shares would have reset their dividend approximately 60 basis points lower than the institutional shares, plus the bank had to pay significant expenses regarding the new issue. We note that issuing a LRCN would have been a cheaper alternative, but CIBC had reached its regulatory limit for LRCNs and needed to issue institutional preferred shares instead.
Also, as noted above, TD Bank announced the redemption of the $350 million TD.PF.L series with a reset spread of 327 basis points. TD Bank currently has much higher regulatory capital than necessary following the termination of its acquisition of First Horizon in May 2023. Consequently, TD Bank is currently trying to reduce its level of capital, so redeeming its issue made sense.
In addition, during the month, Brookfield Renewable Partners announced the redemption of the $175 million BEP.PR.O preferred units, which have different tax treatment than preferred shares. It will use the proceeds from a US$150 million perpetual subordinated note issuance for the redemption. The company estimated that BEP.PR.O would have reset approximately 70 basis points higher than the rate on the subordinated note, thereby making the redemption economically advantageous.
During the month, five series of preferred shares reset their dividends. Dividend rates continued to reset significantly higher because the 5-year Canada bond yield remained substantially higher than five years ago. Details of the resetting issues were as follows:
For several months, the holders of resetting fixed rate preferred shares have been reluctant to choose the floating rate option when available. In March, though, Aimia announced that enough AIM.PR.C investors had opted for the floating rate option and a new floating rate AIM.PR.D series would be issued. As a result, on April 1, 2024, Aimia will have both series outstanding. The other four resetting series had an insufficient number of holders wanting to make the switch into the floating rate series and all shares will remain fixed rate ones. On balance, despite floating rate yields remaining substantially higher than fixed rate ones and interest rates potentially staying higher for longer, preferred share investors continue to appear concerned that interest rates will fall in the next year and take floating rate dividends below fixed rate levels.
In other issuer news, Canadian Western Bank announced that it will not redeem either its CWB.PR.B or CWB.PR.D series on April 30th. The new dividend rates for the fixed and floating rate options will be announced in early April.
In aggregate, the seven largest preferred share ETFs had an outflow of $20 million during March. Given the strong market performance during the month and year-to-date, a third consecutive month of outflows was surprising.
J. Zechner Associates Preferred Share Pooled Fund
The fund returned 2.37% in March, which significantly underperformed the S&P/TSX Preferred Share index. The shortfall was largely a function of security selection. As noted above, most bank reset issues that were trading below par moved sharply higher in the month. The fund held only a few of those shares, which hurt its relative performance. In addition, the fund held relatively more perpetual type preferred shares that lagged the performance of rate reset issues.
Portfolio activity during the month included switching PWF.PR.T into MFC.PR.K for a pickup of approximately 60 basis points. Also, we switched PPL.PR.Q into PPL.PR.A and ENB.PR.B into ENB.PR.N for a pickup of approximately 20 basis points in both cases. Other activity included adding positions in TD.PF.C which trades below par, and TRP.PR.D which will reset in early April at an estimated yield greater than 7.50%. We did not participate in the new CIBC institutional preferred share issue as the fund already held the bank’s earlier institutional issue that has both a higher yield and a higher reset spread.
Outlook and Strategy
Notwithstanding the strong start to the year, we believe the preferred share market continues to offer attractive opportunities. Many perpetual and rate reset issues can be purchased with yields greater than 6.25% and 7.00%, respectively. In addition, the 5-year bond yield continues to be substantially higher than five years ago resulting in substantial increases in dividend rates on resetting issues, which is reflected in the more than 1.50% lift in dividend rates on each of the resetting issues in March.
As the third anniversary of inflation breaking out of Canada’s 1% to 3% target band approaches, we note that investors are having to again revise their expectations for the timing of the first rate cut by the Bank of Canada. Inflation remains sticky and we think more and more Canadians are adapting to both the current levels of interest rates and inflation. We believe Canada’s inflation rate may accelerate above 3.0% in the coming months as the recent 10% rise in oil prices, ongoing housing rent increases, and various tax increases, including the April 1st federal carbon tax increase and the 9.5% increase in Toronto property taxes, are accounted for. If this happens, the Bank may not cut interest rates before autumn, which will put upward pressure on bond yields until then. We also believe the Bank will be cautious about lowering interest rates because it will want to avoid creating another housing frenzy.
We continue to be sceptical about how much monetary easing is built into Canada’s negatively sloped yield curve. For several years, the Bank has been estimating the “neutral” rate, which is neither stimulative nor restrictive, to be between 2.00% and 3.00%. More recently, though, the Bank has indicated that the neutral rate has probably increased. Our view is that the Canadian economy can sustain significantly higher interest rates than prevailed in the 2009 to 2022 period.
Equity markets are reflecting more optimism about economic growth than we believe is warranted. Stock market indices have recently hit all-time records, while corporate yield spreads, which are an indication of perceived credit risk, have narrowed to below average levels. A significant factor behind the optimism is expectations of rate cuts by the Bank of Canada. Given our view that inflation is not yet vanquished and that rate cuts will not occur as soon as expected, we are cautious that equity markets may correct and cause a correction in preferred share prices.
Notwithstanding the possible slowing of the economy, we continue to remain confident in the creditworthiness of the issuers in the portfolio, as these companies have successfully weathered previous economic downturns without impacting their ability to pay the dividends on their preferred shares.