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In September, the preferred share market traded down for most of the month as increasing bond yields put pressure on both common and preferred share markets. Bond investors seemed to abandon the hope that central banks would cut interest rates this year and pared expectations for rate reductions in 2024. Catalysts for the shift in expectations included a reacceleration in inflation, an extension of the rally in oil prices to above $90 per barrel and continued resilient economic activity despite the sharp rise in interest rates in the last 18 months. However, in the last week of the month, the preferred share market was taken by surprise when TD Bank redeemed a rate reset issue and preferred shares rallied, particularly bank rate reset issues. The S&P/TSX Preferred Share index ended the month with a return of 1.44%.
In Canada, the economic data released in September suggested activity was decelerating, but still growing. However, to some extent, interpreting the underlying strength of the economy was made more difficult by the record wildfire season, labour strikes, and harsh weather events. The key data point in the month was CPI inflation that rose to 4.0% from 3.3%, on strength in gasoline prices, mortgage interest costs and rents. Additionally, core measures of inflation that are closely followed by the Bank of Canada rose for the first time in almost a year. The jump in inflation was larger than expected and reinforced the view that the Bank of Canada was not finished with its struggles to bring inflation back to 2%. In other news, the unemployment held steady at 5.5%, but the increase in average hourly wages accelerated to 5.2% from 5.0%, reiterating the need for monetary policy to stay restrictive. Canadian GDP was estimated to have contracted at an annual rate of 0.2% in the second quarter rather than the forecast growth rate of 1.2%, but the market reaction to the news was muted by the hard to quantify impact of wildfires et cetera. Shortly after the GDP data release, the Bank of Canada chose to leave its interest rates unchanged as it wanted more time to assess the impact of prior rate increases.
As mentioned above, the most significant news in September was TD Bank taking the market by surprise when it announced, after the market closed on September 22nd, that it would redeem the TD.PF.K issue which had closed that day at a price of $21.79. TD.PF.K has a reset spread of 259 bps and the company had not redeemed its previous two resetting issues, TD.PF.I and TD.PF.J, with reset spreads of 301 and 270 basis points respectively. This appeared to not make economic sense; however circumstances had changed since those higher spread issues were not redeemed. As we have pointed out previously, following the termination of its proposed acquisition of First Horizon in May, TD Bank has had much higher regulatory capital than required. As a result, it is trying to reduce its capital, including with a significant common share buy-back program. Thus, redeeming the TD.PF.K shares made sense.
In contrast, prior to TD Bank’s announcement, National Bank chose to extend its NA.PR.G issue with a reset spread of 277 basis points. The new dividend rate will be announced on October 17th. Market participants are keenly looking at the possible redemption of Bank of Montreal’s BMO.PR.E issue, which is due to reset on November 25th with a spread of 268 basis points. However, current market pricing suggests that it will not be redeemed because Bank of Montreal does not have capital levels as high as TD Bank.
In September, there were no new issues of traditional $25.00 par preferred shares or institutional preferred shares. During the month, one series of preferred shares, BN.PF.A, reset its dividend. The dividend rate for the issue was reset significantly higher because the 5-year Canada bond yield continues to be substantially higher than five years ago. Details of the resetting issue were as follows:
After the September 15th deadline for investors to make their decision on converting into the floating rate series, Brookfield Corp. announced an insufficient number of holders wanted to make the switch into the floating rate series. All shares will remain fixed rate ones, with a dividend rate of 6.744% for the next five years. In similar fashion, Manulife, Artis REI, and BCE announced that their respective series of preferred shares that reset in August had not garnered enough interest in the floating rate alternative and would remain with fixed rates for the next five years. Despite floating rate yields remaining substantially higher than fixed rate ones and bond investors anticipating interest rates staying higher for longer, preferred share investors continue to appear to believe that interest rates will fall in the next year and take floating rate dividends below fixed rate levels.
In other news, DBRS Morningstar placed the credit rating of Brookfield Corporation under review with positive implications. This includes the company’s Pfd-2(low) preferred share credit rating. DBRS has identified an error in the application of certain methodologies used in the determination of the company’s credit rating, and it will conduct a review of the company and the applicable methodological approach in the next few weeks.
Also, Enbridge Inc. announced the acquisition of three U.S. based utilities for $19 billion (including the assumption of approximately $6 billion of debt) which will make it the largest natural gas utility operator in North America. After this announcement, DBRS Morningstar placed Enbridge’s credit rating “under review with developing implications” and S&P affirmed its rating but revised its outlook from stable to negative. Despite the positive influence on the business risk profile with the addition of more regulated assets, the rating agencies are uncertain of the impact on the company’s financial metrics at this time since the financing plan has not been finalized. Clarity will occur after the financing plan is finalized, and regulatory approvals have been obtained.
In aggregate the seven largest preferred share ETFs had an outflow of $86 million in September. This was driven largely by a $66 million net outflow from ZPR which followed an inflow of $106 million in August. As we noted last month, the timing of the inflows last month suggested they may have been related to the closure of the NBI Canadian Preferred Equity Private Portfolio Fund and the fund’s manager possibly deciding that the liquidity in ZPR was better than the portfolio in the NBI fund.
J. Zechner Associates Preferred Share Pooled Fund
The fund earned 1.10% in September, which was somewhat less than the S&P/TSX Preferred Share index return. After the TD Bank redemption announcement, the best performing issues in the market were bank rate reset issues. Fund performance was hurt by its underweight in these types of issues, and the approximate 13% allocation to bank institutional preferred shares and LRCNs that are not in the S&P/TSX Preferred Share index and which underperformed traditional $25 par value issues in the month.
In September, portfolio activity in the fund was minimal.
Outlook and Strategy
As noted above, bond investors pushed yields higher in September and the yield of the 5-year Canada bond continues to be substantially higher than five years ago resulting in substantial increases in dividend rates on resetting issues. With bond investors seemingly anticipating rates staying higher for longer, reset issues will continue to benefit from sharply higher dividend rates when they reset, particularly those with reset dates in the next few months and potentially further in the future.
Some months ago, we noted that the fight against inflation resembled the carnival game of Whack-a-Mole. No sooner have price increases in one area of the economy subsided then another sector experiences sharply higher prices. For example, recall the surge in goods prices early in the pandemic, the shift to services such as travel once the economy reopened, and now labour strikes resolved with large wage gains. For a central bank, such as the Bank of Canada, trying to rein in inflation, the problem is that it only has one lever to pull, interest rates. Because different sectors of the economy respond differently in terms of speed and magnitude to higher interest rates, the Bank of Canada will need to keep interest rates at a restrictive level for an extended period to bring inflation back to the desired 2% pace.
Only a widespread slowing of the economy is likely to result in the Bank achieving its objective. While a so-called soft landing might be sufficient, we believe a recession is much more likely to occur because of the difficulty assessing economic activity and inflationary pressures in real time. The Bank will want to avoid tightening to a degree that halts economic growth but does not control inflation, also known as stagflation. Instead, the Bank will need to ensure that inflation is well and truly under control before it can consider easing monetary policy. At this point, it is not clear that the Bank has raised interest rates high enough to accomplish its goal. While some observers are describing the current level of rates as “high”, that is true only if your perspective is limited to the period since the Great Financial Crisis. If we look at the period from 1992 to 2007, when inflation was fluctuating around 2%, it was not uncommon to see the Bank’s interest rates and bond yields at or above current levels while economic growth remained satisfactory. We believe the recent adjustment of the bond market to rates staying higher for longer may extend somewhat further.
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.