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June began with preferred share investors taking profits after the very strong start to the year. The preferred share market moved lower by more than 5% in just over two weeks, but this was reversed by month end due to three new Limited Recourse Capital Note (LRCN) issues and the announcements of six preferred share redemptions totalling $2.25 billion. While some of these announcements appeared to be anticipated by the market, the market was boosted by expectations of even more redemptions and potential reinvestment related buying activity in July. Over the entire month, rate reset and perpetual issues had small positive returns, while floating rate issues generated a negative return. The S&P/TSX Preferred Share index ended the month with a -0.02% return.
During the month, the most significant economic event in Canada occurred on June 5th, when after four consecutive months of better than expected inflation news, the Bank of Canada lowered its target overnight interest rate from 5.00% to 4.75%. The subsequent CPI release, however, showed a monthly increase in prices of 0.6% that pushed the annual rate to 2.9% versus the month earlier 2.7% rate and the expected 2.6% pace. The worse than expected inflation news means investors will be focused on the next CPI release on July 16th, which will come eight days before the Bank’s next interest rate announcement. Another negative surprise will likely mean the Bank will not lower its rates. Other economic data received in June tended to be stronger than expected and did not increase the urgency with which the Bank of Canada needed to ease monetary policy. For example, growth in Canadian GDP during April was estimated to be 0.3%, rebounding from weaker growth in February and March. On a year-over-year basis, GDP grew 1.1%, not robust but also not close to a recession. In addition, both retail sales and housing start data in June were better than expected.
In April, Royal Bank issued a US$1.0 billion LRCN with an initial coupon rate of 7.50% and a reset spread of 289 basis points and subsequently redeemed the $500 million RY.PR.Z that had a reset spread of 221 basis points. In June, Royal Bank used more of the LRCN proceeds to redeem its $500 million RY.PR.H series, which has a reset spread of 226 basis points. After the US$ LRCN was converted to a Canadian dollar equivalent security, the redemptions made sense. It was estimated that the bank was reducing its after-tax cost of capital by approximately 60 basis points with the RY.PR.H redemption.
After the Royal Bank’s announcement, iA Financial Group issued a $350 million LRCN with an initial coupon rate of 6.92% and a reset spread of 360 basis points. With news of the LRCN, the $125 million IAF.PR.B 4.60% perpetual series jumped almost 18% in price and late in the month, the company confirmed that it would be redeeming the shares. The market had not anticipated the issuance of a LRCN to redeem the IAF.PR.B shares given the relatively low dividend rate on the series versus the higher cost of the LRCN, even with the tax advantage of LRCN interest deductibility. However, it was iA Financial’s only remaining series of $25.00 par preferred shares, so it appears that it is simplifying its capital structure.
Next up, CIBC issued a $500 million LRCN with an initial coupon rate of 6.99% and a reset spread of 370 basis points. This LRCN had largely been anticipated by the market, given that in March, CIBC issued an institutional preferred share to increase its regulatory limit for LRCNs. A week after the LRCN issue, CIBC announced the redemption of the $400 million CM.PR.O series and $250 million CM.PR.Y series that had reset spreads of 232 and 362 basis points, respectively. These decisions appear to be based on a combination of favourable economics and a desire to redeem traditional $25.00 par preferred share.
Lastly, TD issued a US$750 million LRCN with an initial coupon rate of 7.25% and a reset spread of 298 basis points. Subsequently, in the last week of the month TD announced the redemption of the $500 million TD.PF.B series and $450 million TD.PF.M series that have reset spreads of 227 and 356 basis points, respectively. The economics of redeeming the high reset spread TD.PF.M series are clear. In addition, much like the Royal Bank case, after converting the US$ LRCN to a Canadian dollar equivalent security it was estimated that redeeming the TD.PF.B would reduce the bank’s after-tax cost of capital by approximately 60 basis points.
Also, during the month, National Bank of Canada announced an agreement to acquire Canadian Western Bank. On the day of the announcement, CWB preferred shares traded higher, with the CWB.PR.B series increasing approximately 7% and CWB.PR.D, which was already trading above par, increasing almost 2%. The transaction is expected to close by the end of 2025.
In June, there were no new issues of either traditional $25.00 par preferred shares or institutional preferred shares. Also, no series of preferred shares reset their dividends. However, Manulife Financial and Laurentian Bank announced that an insufficient number of investors in their series that reset in May wanted to make the switch into the respective floating rate series, and all recently reset shares will remain fixed rate ones. Despite floating rate yields that are substantially higher than fixed rate ones, preferred share investors remain concerned that interest rates will fall significantly in the next year and take floating rate dividends below fixed rate levels.
In aggregate, the seven largest preferred share ETFs had a net outflow of $87 million in June. The three largest ETFs, ZPR, HPR and CPD, continued to experience significant outflows, with each having net withdrawals of more than $20 million.
J. Zechner Associates Preferred Share Pooled Fund
In June, the fund had a return of -0.30%, somewhat lagging the S&P/TSX Preferred Share index. The shortfall was due to the fund holding relatively few of the bank preferred shares that were being redeemed.
Portfolio activity during the month included switching the EMA.PR.L perpetual series into the EMA.PR.C rate reset series for a pickup of approximately 100 basis points in yield.
Outlook and Strategy
As noted above, the month was dominated by financial institutions issuing LRCNs to fund preferred share redemptions. Year to date, all issuer announced redemptions total $4.7 billion, approximately 10% of the total market at the start of the year. This trend continues to be supportive of the preferred share market’s performance.
We remain positive on preferred shares because they continue to offer investment grade quality with significantly better yields than corporate bonds, making them an attractive fixed income alternative, especially for taxable investors. The 5-year bond yield remains substantially higher than five years ago, and we expect that this will continue for the rest of the year. As a result, preferred shares resetting their dividend rates this year should continue to see substantial increases in those rates.
While Bank of Canada Governor Tiff Macklem said following the June rate reduction “it is reasonable to expect further cuts to our policy interest rate”, the disappointing increase in inflation made a follow up cut at the Bank’s July 24th meeting less certain and dependent on whether the CPI release on July 16th shows a reversion to the downward trend in inflation. We are not sufficiently optimistic that inflation has indeed been brought under control, as we note that rent and mortgage service costs, the two factors keeping CPI elevated, are unlikely to slow soon and we wonder if food costs will continue to decline or start to rise again.
Indeed, we believe the Bank of Canada will not lower interest rates as much as the market expects. For several years, the Bank estimated the “neutral” interest rate, which is neither stimulative nor restrictive, to be between 2.00% and 3.00%. More recently, though, the Bank 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. Notwithstanding the current economic uncertainty, we 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.