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In August, the preferred share market moved sharply higher. The market traded down early in the month as global equity market volatility sparked a flight-to-safety bid for bonds. The volatility was led by Japan’s Nikkei index which plunged almost 20% in the first three days of the month, but other stock markets also experienced sharp declines. However, as stocks began recovering bond investors began refocusing on the potential for interest rate cuts in September and subsequent months. With fixed income yields in general falling, preferred share investors seemed to focus on locking in the current attractive dividend yields and the market finished the month strongly. As we anticipated last month, the preferred share market benefitted from reinvestment related buying activity late in August as investors received $900 million from the redemption of the BMO.PR.T and RY.PR.H series. All preferred share types had positive returns in the month, with perpetual issues gaining 4.0% and rate reset issues returning 2.5% on average. The S&P/TSX Preferred Share index ended the month with a gain of 2.71%.
Canadian economic data received during August supported the belief that the Bank of Canada would continue to gradually lower interest rates. GDP grew at an annual pace of 2.1% in the second quarter, but StatsCan estimated that the economy stopped growing at the end of the quarter (June) and the start of the third quarter (July). The unemployment rate held steady at 6.4%, but that was due solely to a sharp drop in the participation rate as job creation faltered. In addition, retail sales declined for the fifth month in the last six as consumers struggled to deal with high interest rates and inflation. Importantly, the inflation rate slowed to 2.5% from 2.7% the previous month. The Bank of Canada did not hold a rate-setting meeting in August. Minutes of the Bank’s July 24th meeting focussed on the downside risks to inflation, suggesting the Bank’s Governing Council was concerned about the increasing slack in the economy.
During the month, three issuers announced the redemption of preferred shares, which will occur on September 30th. EQB Inc, the parent of Equitable Bank, announced that it would redeem its only preferred share, the $72.8 million EQB.PR.C series. The issue has a reset spread of 478 basis points. Given the issue’s high reset spread, it had been trading close to par for a few months, and with the issuance of a LRCN in July, the redemption announcement was expected. In addition, Element Fleet Management announced the redemption of the remaining $133 million EFN.PR.E series. The market had also anticipated this redemption given it was the issuer’s only remaining issue and its reset spread of 472 basis points. Also, Dundee Corporation announced the redemption of the remaining $29 million DC.PR.B series and $18 million DC.PR.D series. The market was surprised by this announcement, despite the reset spread of 410 basis points, as these small issues did not receive much market attention and traded infrequently prior to the announcement.
In August, 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:
For a few months, the holders of resetting fixed rate preferred shares have been reluctant to choose the floating rate option when available. In August, though, Enbridge Inc announced that enough ENB.PR.Y investors had opted for the floating rate option and a new floating rate series would be issued. As a result, on September 1st, Enbridge will have both series outstanding.
Also, in August, TransAlta Corporation announced that it does not intend to redeem the TA.PR.J shares. As this is being written, the new fixed and floating dividend rates have been reset to 6.773% and 8.005% respectively. Investors must make their decision on converting into the floating rate series by September 16th.
On the last day of the month, AltaGas Ltd announced that it will not be redeeming the ALA.PR.G series and ALA.PR.H series (the outstanding corresponding floating rate series). This somewhat surprised the market as the company had redeemed its ALA.PR.E series with similar reset spread in December 2023. As this is being written, the new fixed and floating dividend rates have been reset to 6.017% and 7.265% respectively. Investors in both series have until September 13th to make their decision to remain in their current series or switch into the other.
In August, monthly ETF flows continued the negative trend of 2024. In aggregate the seven largest preferred share ETFs had an outflow of $107 million.
J. Zechner Associates Preferred Share Pooled Fund
In August, the fund returned 3.23%, well ahead the S&P/TSX Preferred Share index. The fund’s outperformance was largely a function of security selection, particularly in two areas. Firstly, the fund held relatively more perpetual type preferred shares which had the highest returns for the month. Secondly, investor interest in locking in the current attractive dividend yields produced returns greater than 5% on several rate reset positions with their next reset dates in 2028 and 2029.
During the month, we sold the BMO 7.373% institutional preferred share position at a price level from which we saw limited upside appreciation going forward. We continued to increase the allocation to perpetual type shares, which included increasing the ELF.PR.F position from 1% to 2% at an attractive yield of 6%, and small additions to CU.PR.H and PWF.PR.L.
Outlook and Strategy
As this is being written, the Bank of Canada has lowered its interest rates by 25 basis points, the third consecutive reduction. The Bank also indicated “If inflation continues to ease broadly in line with our July forecast, it is reasonable to expect further cuts in our policy rate.” Interestingly, the Bank noted that the recent increase in the unemployment rate was due to recent immigrants and youth having more difficulty securing jobs. So far, the rise in the unemployment rate has not been caused by layoffs, as has been the case in some previous cycles, which suggests the economy remains resilient. The Bank also suggested the higher numbers of recent immigrants and youth looking for jobs would help slow wage gains from the current inflationary pace. We have our doubts about the impact of immigrants and youth on average wages because of the potential mismatch of skills.
The Bank’s overnight target rate is now 4.25%, still well above the yields of Canada bonds that range from 2.85% to 3.15% and are clearly discounting several further rate cuts in the coming quarters. Many observers believe that the Bank will make additional 25 basis point cuts at its meetings on October 23rd and December 11th. Barring a significant reversal in inflation’s downward trend, we concur with that outlook. The key question, though, is the level at which the Bank stops. We believe the Bank is unlikely to lower its overnight rate to less than 2.50%, and may well stop at 3.00%, given that the economy is not in recession and the need to allow for the lagged effect of any monetary easing. In addition, the Bank’s estimate of the neutral rate of interest, that is neither stimulative nor restrictive, has increased from its previous 2.00% to 3.00% range, which suggests 2.50% may not be reached.
Notwithstanding another month of strong positive performance, we believe the preferred share market continues to offer attractive yields and potential for gains. Next year, resetting preferred shares will see substantial dividend increases because the 5-year Canada bond yield should be much higher than the pandemic lows, when the yield fell below 0.50%. As noted above, we have also been adding to perpetual issues because they offer attractive yields with potential for price gains as we anticipate that investors will continue to focus on locking in the current attractive dividend yields. In addition, the ongoing redemption trend should be supportive of the preferred share market’s performance as investors seek to reinvest the proceeds.
Despite a slowing Canadian economy, 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.