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In June, the preferred share market experienced a downturn that effectively reversed all the positive performance that was generated in May. The negative performance was driven by volatility in equity and other risk markets due to persistently higher inflation and more aggressive monetary policy responses from the Bank of Canada and the U.S. Federal Reserve. The Bank of Canada raised its overnight rate by 50 basis points for a second consecutive time, bringing it to 1.50%. The Fed surprised the market with a 75 basis-point increase, the first time it has increased rates by that amount since November 1994. In addition, several Fed officials hinted that it was likely to raise rates by a similar amount at its July meeting. The 5-year Canada bond yield increased by 36 basis-points to end the month at 3.10%, a level not seen since 2010. Despite this increase in yield leading to higher dividends on resetting rate reset preferred shares, investors seemed to focus on the growing risk of a recession and the potential negative impact on preferred share issuers. The June 30th redemption of the EFN.PR.I and IAF.PR.G shares for a total of $400 million had negligible impact on the market. The S&P/TSX Preferred Share index returned -5.27% in June.
Canadian economic data released in June showed continued strength. April’s GDP showed year-over-year growth of 5.0% and May’s unemployment rate fell to 5.1%, the lowest level in the history of that statistic. Canadian inflation continued to climb higher, reaching an annual rate of 7.7% in May, the highest level since 1983. This level will keep the Bank of Canada actively raising interest rates in order to return inflation to the Bank’s 2% target.
There were three Limited Recourse Capital Note (LRCN) issues in June. CIBC issued an $800 million LRCN with the proceeds designated for the redemption of its CM.PR.R shares on July 29th. The initial coupon rate of 7.15% on the LRCN was greater than the approximate new dividend rate of 6.45% that would have been required on the preferred shares due to their +338 basis point reset spread. However, since the interest payments on LRCNs are tax deductible, while the preferred share dividends are not, the after-tax cost of the LRCN to CIBC was lower than leaving the CM.PR.R shares outstanding. Manulife Financial and Bank of Nova Scotia also issued LRCNs in June, raising $1 billion and 1.5 billion, respectively. While neither issuer subsequently announced preferred share redemptions, we note that the MFC.PR.I shares, which have a reset spread of +286 basis points, may be redeemed in September. There were no new preferred shares issued in June.
In June, four series of fixed rate preferred shares reset their dividend rates and each reset share saw the new rate reset substantially higher. Details of the resetting issues were as follows:
For each of the resetting series of preferred shares, there was insufficient interest in switching into the floating rate alternative and, as a result, holders of these issues will receive fixed rate dividends for the next five years. In contrast, TransAlta announced that there was sufficient interest in the floating rate alternative to TA.PR.F, which announced its new dividend rates on May 31st. Going forward, there will be 9,955,701 TA.PR.F shares paying a fixed rate of 5.854% and 1,044,299 TA.PR.G floating rate shares with an initial dividend rate of 4.584%. The TransAlta shares have a reset spread of +310 basis points.
The seven largest preferred share ETFs experienced total net withdrawals of $155 million in June. This was the fifth consecutive month that aggregate flows were negative. Only TPRF, which holds common shares in addition to preferred shares, and CPD enjoyed net deposits during the period. Investment dealers reported ongoing selling by retail investors of both individual preferred shares and ETFs. Institutional investors, in contrast, were more disposed to be buyers but were waiting for greater stability in prices.
Preferred Share Pooled Fund
The fund returned -4.90% in June, which was somewhat better than the S&P/TSX Preferred Share index return. Given the volatility during the month activity was light, but we did add to our position of FFH.PR.D, which was one of the top performing holdings. This is a floating rate issue which offers good value and allows the fund to benefit from increasing interest rates as the Bank of Canada continues to tighten monetary policy.
Outlook and Strategy
The Bank of Canada and the Fed have stated their intensions to return inflation to their respective 2% target levels. Consequently, we believe the Bank of Canada will increase its interest rates by 75 basis points at its July 13th announcement date. Notwithstanding the more aggressive moves by the central bank, inflation may prove stickier than investors currently anticipate, leading to more rate increases than expected. Of note, we believe the Bank of Canada will not stop tightening monetary conditions if a recession develops but inflation does not fall back towards its 2% target. The pace and scale of the rate increases may decline, but tighter monetary conditions will continue until inflation is under control. In addition, the Bank has begun Quantitative Tightening (reducing its holdings of bonds), which will over time put upward pressure on bond yields. In this environment, we believe that higher bond yields are likely.
Rate reset preferred shares will benefit from increased dividends driven by higher bond yields. With bond yields already at their highest levels in a decade, every series of reset preferred shares will be increasing its dividend rate, if it is not redeemed. However, in the current uncertain economic environment, retail investors appear leery of taking advantage of this opportunity. We think this is a good time to apply a contrarian view. Preferred shares continue to be an attractive alternative for fixed income investors, offering historically attractive yields and low long-term correlation versus bonds.
While we maintain a positive outlook, we are holding some cash and being patient in looking for the best yielding opportunities while being mindful of the risk of potential redemptions. We also note that, while the potential for a recession is increasing, the issuers in the portfolio are large, well-known companies with strong balance sheets that have successfully weathered previous economic downturns without impacting their preferred shares. Accordingly, we are confident about the creditworthiness of the portfolio’s holdings.