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In October, the preferred share, common equity, and bond markets all experienced volatility. Investors had to deal with an array of competing factors, including a war in Israel that initially produced a flight to safety and lower bond yields. Economic data suggested the Canadian economy was slowing in response to Bank of Canada’s series of interest rate increases, and inflation unexpectedly declined. Conversely, the U.S. economy continued to show strength and U.S. bond yields, which often lead Canadian ones, moved sharply higher. Despite the already attractive yields available in the preferred share market, retail selling continued with the redemption of ETFs and perhaps the start of tax-loss selling of individual issues. The S&P/TSX Preferred Share index ended the month with a return of -2.80%.
In Canada, the annual rate of inflation declined to 3.8% from 4.0%, and the monthly change in prices showed an unexpected decline of -0.1%. That prompted a rally in shorter term bonds as investors anticipated the Bank of Canada would not need to raise interest rates again this cycle. The rally was reinforced by subsequent data that showed Canadian GDP growth stalled in August. In addition, StatsCan’s flash estimate of growth for September was also flat, raising the possibility that Canada had slipped into a technical recession of two consecutive quarters of shrinking rather than growing. More positively, housing starts were much stronger than expectations and unemployment held steady at the relatively low rate of 5.5%. Job creation was strong, and the participation rate edged higher. As expected, the Bank of Canada left its interest rates unchanged as it wanted additional data before adjusting monetary conditions.
In October, there were no new issues of traditional $25.00 par preferred shares or institutional preferred shares. Also, the previously announced redemption of the $400,000,000 TD.PR.K series occurred on October 31st. During the month, two series of preferred shares reset their dividends. Dividend rates continue to reset significantly higher because the 5-year Canada bond yield continues to be substantially higher than five years ago. Details of the resetting issues were as follows:
On the last day of the month, National Bank announced that an insufficient number of holders of NA.PR.G wanted to make the switch into the floating rate series and all shares will be fixed rate ones, with a dividend rate of 7.056% for the next five years. Investors in BMO.PR.E must make their decision on converting into the floating rate series by November 10thth.
In other issuer news, DBRS Morningstar upgraded the credit rating of Intact Financial Corporation, including its preferred share rating from Pfd-2 to Pfd-2(high). DBRS notes the company’s strong financial performance and improved market position with recent acquisitions that have increased its product and revenue diversification.
In October, the quarterly preferred share Index rebalance occurred with three deletions and three additions. The fund held only one of the affected issues, EFN.PR.E, which was added back to the index. As usual, the rebalancing resulted in robust trading volumes on that day but had little discernable impact on prices.
In aggregate, the seven largest preferred share ETFs had an outflow of $104 million in October, with all days but one having aggregate outflows. As noted above, retail selling continued in ETFs. ZPR accounted for approximately one half of the aggregate outflow for the month. As we have noted in the previous couple of months, it appears that the closure and liquidation of a preferred share fund has contributed meaningfully to the inflows and outflows for ZPR.
J. Zechner Associates Preferred Share Pooled Fund
The fund returned -2.34% in October, which was better than the S&P/TSX Preferred Share index result. The fund’s outperformance was largely a function of security selection including its exposure to the Brookfield corporate family. While the fund’s positions in Brookfield Corporation (BN) preferred shares underperformed, the preferred shares of BN’s operating subsidiaries, in particular Brookfield Office Properties and Brookfield Renewable Partners, significantly underperformed the market. Most of those two issuers’ preferred shares had price declines of more than 10%, with Brookfield Office Properties having several issues declining more than 20%. The fund had deliberately avoided the issues of both companies which helped its performance relative to the index.
In October, portfolio activity included selling two rate reset issues, TRP.PR.A and TRP.PR.E, which are scheduled to reset in late 2024, and adding to several perpetual issues to lock in yields greater than 7.00%.
Outlook and Strategy
During the month, while longer term bond yields rose a few basis points, there was a slight decline in the yield of the 5-year Canada bond as investors anticipated that the Bank of Canada was finished raising interest rates this cycle. Despite this, the 5-year bond yield remains substantially higher than five years ago resulting in substantial increases in dividend rates on resetting issues, which is reflected in the approximately 2% increase in the dividend rate of the two resetting issues in October.
While the decline in the inflation rate was good news, we believe caution is warranted before declaring the fight against inflation complete. Wage increases to compensate for past inflation are putting substantial pressure on employers to raise prices further. In addition, the recent slowing in Canadian economic activity is only partially due to higher interest rates. Adverse weather, wildfires, and labour union strikes have temporarily dampened activity in recent months, and some rebound from those events seems likely.
We also believe the risk of a recession remains elevated given the need for rates to stay higher for longer and the less than robust pace of recent growth. Notwithstanding the growing risk of a recession, 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.