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In April, the preferred share market traded in a narrow range. Trading volumes were fairly low, with the exception of days surrounding the quarterly preferred share index rebalance. Volumes spiked as a result of the rebalancing because the index related ETF, CPD, had to sell preferred shares that were deleted from the index and reinvest the proceeds with additions to numerous other holdings. The S&P/TSX Preferred Share index ended the month with a return of 0.27%.
Canadian economic data released in April was mixed. On the positive side, unemployment held steady at the low rate of 5.0% and job creation remained very good. Also, retail sales fell less than expected in February following an upwardly revised surge in January. On the negative side, late in the month it was revealed that Canadian GDP grew by only 0.1% in February, following the 0.6% expansion in January. In addition, StatsCan’s advance estimate for March showed the economy contracting 0.1%. For the first quarter the pace of growth was roughly 2.5% per annum, but there appeared to be little momentum going into the second quarter. As expected, the 12-month increase in CPI fell to 4.3% from 5.2% a month ago as large price increases from early in 2022 fell out of the calculation. However, the monthly increase in March was 0.5% and that followed 0.5% in January and 0.4% in February. So, inflationary pressures remain.
At its April rate setting meeting, the Bank of Canada left its trendsetting interest rates unchanged. It was subsequently revealed that at that meeting the Governing Council considered raising rates again because inflation was not slowing enough. However, it chose to wait until the next meeting in June to decide on additional rate increases. Yields of 5-year Canada bonds edged slightly lower in the month.
During the month, there were no new issues of traditional $25.00 par preferred shares or of institutional preferred shares. It has now been more than one year since the last issuance of a $25.00 par preferred share. However, over that period there have been four institutional preferred share issues by banks. In April, two series of preferred shares reset their dividends. As has been the case for the last year, the dividend rates increased significantly because the 5-year Canada bond yield was substantially higher than five years ago. Details of the resetting issues were as follows:
During the month, TD Bank announced that an insufficient number of holders of TD.PF.J wanted to make the switch into the floating rate series and all shares will be fixed rate ones, with a dividend rate of 5.747% for the next five years. Likewise, Artis REIT and Brookfield Renewable Partners announced the same results from the holders of AX.PR.I and BEP.PR.M respectively, and all shares will be fixed rate ones, with dividend rates for the next five years of 6.993% and 6.05% respectively. Although floating rate yields are at present substantially higher than fixed rate ones, investors are clearly worried that interest rates will fall in the next year and take floating rate dividends below fixed rate levels.
In April, Canadian General Investments Limited announced that it will redeem its $75 million CGI.PR.D retractable series on June 12th, the shares’ first retraction date. Also in the month, Manulife Financial Corporation announced that it will not be redeeming its MFC.PR.Q shares. The new dividend rate will be announced on May 23rd and investors must make their decision on converting into the floating rate series by June 5th.
Despite the resilience of the Canadian and U.S. economies following substantial interest rate increases, financial strain has shown up in some interest sensitive parts of the economy. Commercial real estate is one of these areas, particularly office buildings, with several projects in the United States defaulting. The pandemic-induced move to hybrid work has led to a sharp fall in demand for office space and a resultant jump in vacancy rates. In the preferred market, investors’ concern about the value of commercial real estate has been reflected in the more than 20% year to date decline in the price of Brookfield Office Properties’ preferred shares. The default by a Brookfield affiliate on more than US$750 million of mortgages on office properties in Los Angeles in March was followed in April by another Brookfield Fund defaulting on a US$161 million mortgage for a dozen office properties mostly in the Washington DC area. Also in April, investor concern seemed to increase over Artis REIT’s ability to execute its deleveraging initiatives with assets sales. The company’s preferred shares experienced sharp declines in April, with AX.PR.E falling more than 20% and AX.PR.I more than 10%.
The quarterly S&P/TSX Preferred Share Index rebalance occurred in April, with eight deletions (all rate reset issues) and no additions. The event created liquidity in the market, resulting in the trading volume on that day being almost twice the daily average. Buying pressure moved the market higher, but in the following few days these gains were reversed.
The seven largest preferred share ETFs experienced net outflows of $16 million in April with only CPD having net inflows. Given that CPD is a passive index fund, it likely benefited from the closure this month of Invesco’s Canadian Preferred Share Index ETF, PPS.
J. Zechner Associates Preferred Share Pooled Fund
The fund returned 0.35% in April, which was slightly better than the S&P/TSX Preferred Share index return. During the month, rate reset issues had positive returns and outperformed both perpetual and floating rate type issues, which had negative returns.
In April, portfolio activity included adding a new position in BN.PR.Z with a yield greater than 7.50% and switching positions in ENB.PR.D into ENB.PR.B and NA.PR.E into NA.PR.C to pick up additional yield. Also, we started to make some switches from rate reset issues that are resetting more than year in the future into recently reset issues of the same issuer. Given the uncertain path of interest rates over the next few months, we chose the certainty of the high dividend rates on the recently reset issues.
Outlook and Strategy
As noted above, during the month there was little change in bond yields. The yield of the 5-year Canada bond continues to be substantially higher than five years ago resulting in substantial increases in dividend rates on resetting issues, which continues a trend dating back to the middle of last year. Since last June, the bond market has been essentially treading water, waiting to see the outcome of the monetary tightening cycle. One school of thought has held that inflation will quickly fall back to the 2% target so that the Bank of Canada will be able to lower interest rates before significant economic pain occurs. The so-called soft-landing scenario was initially embraced by central bankers who wanted to avoid being blamed for causing a recession. Over time, though, the stickiness of inflation and the resilience of the economy has led central banks and many investors to realise that interest rates will need to stay high for an extended period. Therefore, we believe rate reset issues, particularly those with reset dates in the next few months, will continue to benefit from sharply higher dividend rates when they reset.
Slower economic growth may yet result from the rate increases to date, but the key question is whether inflation will fall sufficiently and sustainably enough for the Bank of Canada to begin lowering interest rates. We remain cautious in our outlook for inflation because the experience of the 1980’s suggests that once inflation is embedded it is difficult to eradicate. In addition, fiscal policy in Canada and other countries is currently quite expansionary and at odds with restrictive monetary policy. We anticipate that the annual rate of inflation will fall further in the next couple of months as large increases from a year ago fall out of the calculation (prices jumped 1.4% in May 2022 for example), but recent monthly increases remain problematic.
The resilience of the Canadian economy following very substantial interest rate increases has surprised many. Last summer, many economic forecasts called for a slowdown by the end of the year, but economic activity has continued to be positive. Labour markets are historically tight, with very low unemployment and large numbers of unfilled positions. Spending on goods has declined following the pandemic disruptions, but there remains significant pent-up demand for services such as travel. Higher interest rates don’t seem to have diminished consumer demand. In large part because the massive government transfers during the pandemic allowed personal savings to build up, and those extra savings are slowing the reaction to higher rates and high inflation. In addition, even interest rate sensitive sectors such as housing appear to be stabilizing, with home prices no longer falling, and sales have begun picking up.
However, with interest rates expected to remain at or above current levels until 2024, we believe the risk of a hard recession is increasing. Notwithstanding, 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.