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In the first week of November, preferred shares extended their negative trend from October. However, the market turned around and ended the month with solid positive returns. In particular, performance in the last week of the month was strong, contributing approximately two-thirds of the gains, as investors looked to reinvest the $300 million received from the redemption of BMO.PR.W, and two additional redemptions totaling $500 million were announced. All preferred share types had positive average returns in the month, with rate reset issues returning 3.1%, floating rate issues returning 3.5%, while perpetuals lagged with a return of 0.3%. The S&P/TSX Preferred Share index ended the month with a gain of 2.29%.
Canadian economic data received in November showed the economy was performing somewhat below its potential, but not as poorly as some observers had believed. Estimated GDP growth in the third quarter was slightly below expectations at an annual rate of 1.0%. However, the underlying details gave some reason for optimism as domestic demand grew at a 2.4% pace, household consumption rose 3.5%, and the savings rate was at a 3-year high of 7.1%. Weakness in the GDP release came from a drop in the volatile business investment category as well as net trade and inventories. Of note, the GDP release also included large upward revisions to GDP growth over the last three years that meant the Canadian economy was bigger than previously thought and that there is currently less economic slack than previously estimated.
Fairfax Financial Holdings issued $700 million of bonds in November, saying the proceeds were to be used to redeem some of the company’s preferred shares. Initially, Fairfax did not specify which series of shares it was targeting, which led to a rally in all its series of preferred shares. Subsequently, the company announced its intention to redeem the $250 million FFH.PR.C series and the related floating FFH.PR.D series, that had reset spreads of 315 basis points. Given the lack of clarity regarding which additional series will be called in the future, investors are speculating on which series are most likely to be redeemed. Some of its issues resetting in 2025 have low reset spreads, but the FFH.PR.M series, with a reset spread of 398 basis points, would seem to be a likely possibility. For the month, Fairfax Financial preferred shares were the best performing issues with average gains of 14.0%.
In addition, Cenovus Energy Inc announced it will redeem the $250 million CVE.PR.C series that has a reset spread of 313 basis points. The issue had been trading close to par before the announcement and consequently had a small 1.8% increase in price on the news. However, other Cenovus issues moved higher in price and had average gains of 7.0% in the month.
During November, Aimia Inc announced a substantial issuer bid for all its preferred shares, AIM.PR.A, AIM.PR.C and AIM.PR.D at values per share of $17.00, $17.50, and $18.4375, respectively. In exchange for their shares, investors will receive a 5-year senior unsecured note with a coupon of 9.75% and a par value of $100. As a result of the discounted prices on the preferred shares, Aimia hopes to book a gain of approximately $65 million. In addition, the difference between the preferred share dividends and the interest on the proposed note will save Aimia approximately $8 million per year. The exchange has the support of Phillips Hager and North Investment Management, whose clients own approximately 76% of the preferred shares. Because the shares are being exchanged for the interest bearing note, the transaction should not result in substantial reinvestment flows back into the preferred share market.
There were no new issues of preferred shares in November. During the month, four series of preferred shares reset their dividends. Dividend rates continue to reset significantly higher because the 5-year Canada bond yield is substantially higher than five years ago. Details of the resetting issues were as follows:
Enbridge Inc, Fortis Inc and Pembina Pipeline Corp each announced insufficient investor interest in making the switch to the respective floating rate series and all their respective shares will remain fixed rate ones for the next five years. While floating rate yields remain higher than fixed rate ones, the differential has been reduced by approximately 100 basis points since the start of the year due to the Bank of Canada’s interest rate cuts. This combined with the prospect of additional rate cuts by the Bank of Canada has reduced the appeal of the floating rate option.
In other issuer news, National Bank of Canada announced that holders of Canadian Western Bank’s two preferred share series, CWB.PR.B and CWB.PR.D, had approved the switch into new National Bank preferred shares with the same dividend rates, reset spreads and reset dates. Both CWB.PR.B and CWB.PR.D holders approved the switch with the affirmative vote greater than 90% of votes cast at the special meeting.
In addition, as this is being written, BIP Investment Corporation, a subsidiary of Brookfield Infrastructure Partners L.P., announced that the resolution to permit the redemption of the BIK.PR.A series at a price of $26.75 per share has passed with the affirmative vote of 80% of votes cast at the special meeting. All outstanding BIK.PR.A shares will be redeemed on December 5th along with the final quarterly dividend payment.
In November, the seven largest preferred share ETFs had an aggregate outflow of $18 million. Only one of the ETFs experienced a net inflow in the month.
J. Zechner Associates Preferred Share Pooled Fund
In November, the fund returned 1.74%, which underperformed the S&P/TSX Preferred Share index. The shortfall was largely a function of two factors. Firstly, the fund held relatively more perpetual type preferred shares, which had the lowest returns for the month. Secondly, the portfolio held relatively fewer Fairfax preferred shares that on average increased 14% on the month.
Portfolio activity during the month was limited.
Outlook and Strategy
The Bank of Canada is scheduled to make its final interest rate announcement of the year on December 11th. While some observers are forecasting another 50 basis point reduction, we believe the Bank will lower rates by only 25 basis points. The economy does not appear to need urgent stimulative action and the decline of the exchange rate to one of the weakest levels in the last 20 years suggests the Bank should be cautious about larger rate cuts. We also note that the announced GST rebate from the federal government and the partial HST holiday in some provinces will provide short lived economic stimulus that may reduce the need for the Bank to lower rates faster.
We continue to believe that the pace of the Bank of Canada’s rate reductions is less important than the level at which it stops. The Bank’s most recent estimate of the neutral rate, which is neither restrictive nor stimulative, is 2.75%, or 100 basis points lower than the current rate. That seems like a reasonable point for the Bank of Canada to at least pause, given the economy is not in a recession, the scale and pace of easing from the 5.00% rate peak, and the lag with which the economy responds to rate changes. While some observers are forecasting a terminal rate as low as 2.00%, we are not convinced that is the most likely outcome. With the yields of Canada bonds of terms ranging from 2 years to 30 years clustered close to 3.00%, we don’t believe there is a lot of potential for bond yields to decline much further.
Despite the Bank of Canada cutting its interest rate 125 basis points since June, the 5-year bond yield continues to be substantially higher than five years ago as reflected in the resetting issues in November increasing their dividend rates more than 1.50%. Also, since the four resetting issues all trade below par, the increase in dividend yields was even greater. November’s resetting issues are good examples of the continued value we see in the preferred share market. The issues are from four investment grade issuers, and all provided attractive dividend yields greater than 6.25% when their dividend rate was reset. Given our view that bond yields are unlikely to decline much further, we believe that preferred share yields should continue to be significantly better than corporate bond yields. In addition, as evident by the return this month, the preferred share market continues to benefit from the ongoing redemption trend as investors reinvest the proceeds among fewer outstanding issues.