The Canadian preferred share market started 2017 with a bang, outperforming investment grade bonds, common stocks, and even junk bonds by a significant margin. Unlike other securities, preferred shares were immune from the volatility arising from the changeover in U.S. administrations. In part, the strong performance of preferred shares reflected investors’ ongoing search for attractive yield combined with limited new issue supply. In addition to investors purchasing outstanding, individual issues, preferred share ETF trading volumes hit an all-time record in January. We believe, though, that much of the ETF activity did not reflect simple buying of the asset class; rather, it was hedging of structured notes linked to the preferred share market. The S&P/TSX Preferred Share index returned 4.05% in January.Preferred Share Performance | January 2017

The structured notes were created by a number of banks and sold primarily through their respective wealth management divisions, although some institutions may also have participated. (There is no centralised reporting on structured notes, so it is difficult to estimate the total size of the market.) Many of the notes were autocallable, principal-at-risk products linked to the performance of the BMO Laddered ETF, ZPR. The notes will be automatically called and a variable return is paid if, on any set valuation date, the level of ZPR is above a predetermined value. However, if the notes are not called prior to the final valuation date, and the value of ZPR has declined, the investor stands to lose a portion of their original investment. Another, less obvious aspect of these structured notes is that they are based only on the price performance of ZPR and the investor does not participate in the dividend yield of the ETF, which could mean forgoing roughly 5% return a year. The structure is essentially a package of bank debt combined with a series of digital call options on ZPR. When a bank sells one of these notes it is short the options and hedges that exposure with purchases of ZPR. If new units of ZPR must be created (during January, $148 million of new ZPR units were created), that will result in buying of each of the component series of preferred shares held in the ETF. If ZPR subsequently increases in value, the bank will need to buy additional units in order to maintain its hedge.

In recent months, the volume sold of this style of structured notes appears to have made an increase in the value of ZPR a self-fulfilling prophesy; when the notes are sold, the bank has to buy ZPR to hedge its exposure, putting upward pressure on the price of ZPR, which forces the bank to buy even more of the ETF. As additional series of these structured notes are sold, that creates even more upward pressure on the ETF. The risk, of course, is what happens if and when ZPR falls in value. Such a decline might be triggered by some of these notes being auto-called, triggering the unwinding of underlying hedges (i.e. selling of ZPR), or perhaps simply by a correction in the preferred share market. Either way, the structured notes have added a layer of potential volatility and risk to the market.

With the substantial interest in ZPR during January, it is not surprising that the return on rate reset preferred shares was higher than the overall market; the Solactive Laddered Rate Reset Index gained 4.76% in the month. Floating rate issues, which make up 6.0% of the market but only 2.6% of the index, surged an estimated 9.3% in the month, perhaps making up some of the ground lost versus rate reset issues in the last four months. Perpetual issues trailed both rate reset and floating rate preferreds, earning only 2.2% on average.

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