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The preferred share market declined somewhat in February. The decline appeared to be correlated to the stock market volatility in the period, and investment dealers reported that retail investors rather than institutional ones were the primary sellers of preferred shares in the month. We have noted a correlation between preferred shares and equities in the past, and this latest example confirms that the correlation tends to be higher in times of equity market weakness. The equity volatility was driven by rising geopolitical concerns, as well as the prospect of central banks beginning to reduce their extraordinary monetary stimulus by raising interest rates. The invasion of Ukraine by Russia, when it finally occurred, had little discernable impact on preferred share prices. Preferred shares did receive some support from redemptions that totaled $750 million in February. The S&P/TSX Preferred Share index returned -2.25% in the month.
Given that both Ontario and Quebec were in lockdown in January due to increased Covid-19 outbreaks, it was not surprising that Canadian economic data received in February for that period showed weakness. Notably, employment contracted by 200,100 jobs, which caused the unemployment rate to jump to 6.5% from 5.9% the previous month. Retail sales fell during January, but Canadian inflation continued to increase, reaching 5.1%, its highest level in 30 years. However, a more positive piece of economic news received as this is being written showed that during the fourth quarter of last year Canada’s economy grew at a 6.7% pace, which was faster than both the market and the Bank of Canada expected. For all of 2021, Canadian gross domestic product expanded 4.6%, the largest increase in two decades. This gain in activity brought Canadian output back to pre-pandemic levels and should encourage the Bank of Canada to start reducing its monetary stimulus by raising interest rates. Higher interest rates should result in bond yields moving higher, which will be positive for rate reset issues. The strong economic environment is also a positive for the continued creditworthiness of preferred share issuers.
As we saw throughout 2021, share redemptions have continued this year. In February, two Canadian banks called outstanding series of preferred shares: Royal Bank redeemed its RY.PR.P shares on February 24th and Bank of Montreal redeemed the BMO.PR.B shares on February 25th. The two redemptions totaled $750 million, or about 1.2% of the market. Unusually, the perpetual RY.PR.P shares were redeemed above par, at a price of $25.75. Royal Bank chose to pay the premium to redeem the shares early, rather than wait until 2025 when they could be redeemed at par, because the shares paid a relatively high dividend rate of 5.25%.
The trend of redemptions will continue in March as six series of preferred shares totaling $2.2 billion have been called by their respective issuers. Details of the issues to be redeemed are as follows:
Only the BCE.PR.O redemption was a surprise because BCE rarely redeems its preferred shares. The series, which BCE assumed when it took over Bell Aliant several years ago, was one of the smallest ones the issuer has outstanding, and its redemption may have been to slightly simplify the company’s sources of capital.
In February, no preferred shares reset their dividend rates and there were no new issues of preferred shares in the month.
In issuer news, Brookfield Asset Management announced that it is considering spinning off its asset management business. Brookfield suggested that a standalone asset management business would be simpler to understand for newer investors, yield a higher valuation multiple for the entity and attract more global interest. We are monitoring the situation as the company has not yet provided enough detail about the possible transaction to evaluate the impact on Brookfield’s preferred shares.
In other issuer news, TD Bank announced it was buying First Horizon National, a regional U.S. bank, while Bank of Nova Scotia increased its stake in Scotiabank Chile. Brookfield Renewable Partners announced that it is part of a consortium that is proposing the privatization offer for Australian power-generator, AGL Energy Ltd. Equitable Bank will be acquiring a majority interest in Concentra, which will make it Canada’s seventh largest bank. And as this is being written, Pembina and KKR have agreed to combine their natural gas processing assets in Western Canada in a new joint venture. The new entity will also acquire interests held by Energy Transfer LP. with a total value of the transaction reaching C$11.4 billion. We do not at this time believe any of these transactions will have a material impact on the creditworthiness of the respective companies’ preferred shares.
During February, the six largest preferred share ETFs experienced total net withdrawals of $4.5 million. This was the first time in over a year that aggregate flows were negative. Only the actively managed DXP and TPRF enjoyed net deposits in the month
Zechner Associates Preferred Share Pooled Fund
The fund returned -1.65% in February, which was somewhat better than the S&P/TSX Preferred Share index return. The relatively good result reflected broad based performance by a variety of holdings.
During the month, we added a new position of IFC.PR.E, which is a perpetual preferred share. We also added to our holdings of the PWF.PR.L and GWO.PR.G perpetual shares. With the market consolidating moderately throughout the month, we were comfortable being patient about investing new cash from dividends and deposits, waiting for attractive opportunities.
Outlook and Strategy
Given the strong performance that preferred shares garnered in 2021, we have not been surprised to see some slowing in recent months. However, despite geopolitical concerns and central banks tightening monetary policy, we remain confident that future performance will be supported by continued redemptions and attractive yields. Additionally, as inflationary pressures continue to climb and the Bank of Canada initiates a series of interest rate hikes, we will likely see upward pressure on bond yields. Rate reset preferred shares will have their dividends reset higher with higher bond yields. In addition, rising yields on bonds will cause their prices to fall, which should encourage investors to search for alternative quality investments such as preferred shares that benefit in a rising rate environment.
Given our positive outlook, we are keeping cash levels relatively low. However, as noted above, we are being patient in looking for the best yielding opportunities while being mindful of the risk of potential redemptions. With perpetual issues having lagged the performance of rate reset issues for several quarters, they have become relatively more attractive. As a result, we are considering a shift back toward perpetual issues.
As this is being written, the Bank of Canada has raised its administered rates 0.25%, thereby commencing what is expected to be a series of several interest rate increases. The Bank’s move was expected and, as a result, does not change our strategic outlook.