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In July, the preferred share market moved sharply higher. The market was boosted by the expectation of continued redemptions by banks and related reinvestment buying as $1.725 billion was redeemed at the end of the month. In addition, a decline in Canada bond yields contributed to strong perpetual share price performance during the month. Investors became more confident that interest rates would move lower over the balance of this year and next as better than expected inflation data combined with some weakening of labour markets led the Bank of Canada to sound dovish following its rate setting meeting in July. All preferred share types had positive returns in the month, with perpetual issues gaining 5.1% and rate reset issues returning 2.2% on average. The S&P/TSX Preferred Share index ended the month with a gain of 2.25%.
The key piece of Canadian economic data released in July was lower than expected CPI inflation. We learned that prices unexpectedly declined 0.1% in June, and the annual rate decelerated to 2.7% from 2.9%. The unemployment rate rose to 6.4% from 6.2% despite a drop in the participation rate. Higher unemployment reflected ongoing population growth while job creation stalled. In addition, weaker than expected retail sales suggested consumers were struggling to manage higher interest rates and past inflationary pressures. On a slightly more positive note, the Canadian economy continued to grow at a pace slightly above 1.0% per annum. Hardly a robust pace, but not a recession either. The Bank of Canada followed up its June 5th interest rate reduction with a second 25 basis point cut on July 25th. The Bank’s next rate setting meeting will be on September 4th.
In July, Royal Bank issued a $600 million institutional preferred share with an initial coupon rate of 6.698% and a reset spread of 340 basis points. From the bank’s perspective this compared favourably to its January issue which had a dividend rate of 7.408% and a reset spread of 390 basis points. With the closing its acquisition of HSBC Bank Canada, Royal Bank has been an active in managing its capital ratios this year. In addition to the two institutional preferred shares, it has issued a US$1.0 billion Limited Recourse Capital Note (LRCN) and redeemed $1.0 billion of traditional $25.00 par preferred shares.
Also during the month, EQB Inc., the parent of Equitable Bank, issued a $150 million LRCN with an initial coupon rate of 8.00% and a reset spread of 455 basis points. The issuer has only one preferred share, the 5.969% EQB.PR.C series, with $72.8 million outstanding, a reset spread of 478 basis points and a reset date of September 30, 2024. Given the issue’s high reset spread, it had been trading close to par for a few months, however the LRCN issuance increased speculation that the issue could be redeemed.
In addition, Bank of Montreal announced the redemption of the $400 million BMO.PR.T series with a reset spread of 224 basis points. The market had largely anticipated this redemption given the issuer’s May redemption of the BMO.PR.S series with a similar reset spread. The BMO.PR.T redemption combined with the previously announced Royal Bank redemption of the $500 million RY.PR.H series will result in investors receiving $900 million in the last week of August.
In July, only one series of preferred shares reset its dividend rate. The new rate was a significant increase because the 5-year Canada bond yield is substantially higher than five years ago. Details of the resetting issue were as follows:
During the month, Brookfield Renewable Power announced that an insufficient number of BRF.PR.C investors wanted to make the switch into the floating rate series and all shares will remain fixed rate ones. Despite floating rate yields 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 an outflow of $60 million in July. The three largest, ZPR, HPR and CPD, continued their trend of monthly outflows, with a combined total of $68 million.
J. Zechner Associates Preferred Share Pooled Fund
In July, the fund returned 2.70%, well ahead the S&P/TSX Preferred Share index result. The fund’s outperformance was largely a function of the fund holding relatively more perpetual type preferred shares which had the highest returns for the month.
Portfolio activity during the month was mainly focused on increasing the allocation to perpetual type shares. This included adding to the MIC.PR.A position at an attractive 6.65% yield, and partial switching of rate reset issue CU.PR.C into perpetual issue CU.PR.H and rate reset issue BN.PR.Z into perpetual issue BN.PF.D.
Outlook and Strategy
We believe the Bank of Canada will lower its interest rates at its next meeting in September, barring an unexpected rebound in inflation. Canadian growth has been struggling for close to a year and, as a result, the economy is no longer operating at full capacity. The interest rate reductions to date by the Bank of Canada and the future ones expected mean that shorter term yields will move lower than longer term yields. However, we are uncertain about the future level of longer term yields. In past market cycles, longer term bond yields have fallen as the Bank of Canada has lowered interest rates, but in this cycle those yields are already much lower than the Bank’s overnight target rate. We believe the market may be anticipating more rate cuts than will occur, which means longer term yields may not decline much from current levels.
Notwithstanding another month of strong positive performance, we believe the preferred share market continues to offer attractive yields, significantly better than corporate bonds, making them an appealing fixed income alternative. The fund’s portfolio, for example, has a current yield of 6.72%. In addition, the ongoing redemption trend will be supportive of the preferred share market’s performance as investors seek to reinvest the proceeds.
We like perpetual issues because they have potential for significant gains as their yields fall and because their dividends are fixed. With regard to rate reset type shares, even with its recent decline, the 5-year bond yield continues to be substantially higher than five years ago resulting in substantial increases in dividend rates. That was reflected in the BRF.PR.C series increasing its dividend rate more than 2.00% in July and, because it was trading at a discount to par, its running yield jumped from 5.08% to 7.61%.
Despite Canadian economic uncertainty, 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.