In February, the preferred share market, like common equity and bond markets, gave back some of January’s strong performance.  January’s optimism regarding interest rate cuts later this year switched to a realization that rates were likely to stay higher for longer. The shift in investor expectations was fueled by data that showed economic activity was holding up and inflation was not slowing as quickly as hoped, despite the past year’s monetary tightening. The prospect of interest rates remaining relatively high increased the risk of a serious recession, which led to risk assets retracing some of the gains enjoyed in January. The S&P/TSX Preferred Share index ended the month with a return of -0.96%, which meant it outperformed both common equities and bonds.

In Canada, labour market data continued to show considerable strength. Early in the month, job creation of 150,000 new positions in January was announced, 10 times the expected amount. The unemployment rate held at the low rate of 5.0%, rather than declining, because the participation rate jumped to 65.7% from 65.4% the previous month. The increase in the participation rate left it essentially in line with pre-pandemic levels. The strong labour market encouraged consumers, and retail sales accelerated. The only sector of the economy that struggled was the housing sector, with housing starts and sales of existing homes even weaker than forecasts. Late in the month, it was announced that Canadian GDP growth stalled in the fourth quarter of 2022. The lack of growth was linked to a large drop in inventories following outsized gains the previous two quarters. Other details in the GDP release were more positive, showing household consumption grew at a 2.0% pace, while the savings rate increased from 5% to 6%. As well, the lack of growth in the fourth quarter was offset somewhat by StatsCan’s preliminary estimate that showed growth rebounding in January.

The Bank of Canada did not have a rate setting meeting in February but was likely pleased with a larger than expected drop in year-over-year inflation. Canadian CPI decelerated from 6.3% to 5.9%, although several measures of core inflation showed much less improvement. Also, the one month increase in prices of 0.5% indicated that inflation was not yet under control. The Bank’s next rate announcement is scheduled for March 8th, and it is widely expected that there will be no change at that time.

Activity in the preferred share market was light in February. There was no new issues of either traditional $25.00 par preferred shares or institutional preferred shares during the month.

However, on the last day of the month, Industrial Alliance announced that on March 31st it will redeem the $150 million IAF.PR.I series, which has a reset spread of 275 basis points. This redemption was somewhat unexpected by the market, as the shares closed the day before the announcement at more than $1 below the $25 par value. This was the first issue from a financial institution to be redeemed in over six months, since both TD Bank and National Bank unexpectedly extended rate reset issues with larger reset spreads, in October. As well, in January, Manulife Financial Corporation decided to extend its MFC.PR.J series which had a reset spread of 261 basis points. Industrial Alliance’s decision to redeem, rather than extend, its IAF.PR.I shares may have reflected an excess capital position. Alternatively, unlike the banks and other life insurance companies, which are regulated by the federal Office of the Superintendent of Financial Institutions (OSFI), Industrial Alliance is regulated by the Quebec provincial regulator, which may have provided different instructions regarding redemptions.

In February, there were no announcements of rate reset issue extensions. Manulife, which previously announced the extension of the MFC.PR.J, set the dividend rates on the fixed and floating options. Investors have until March 6th to decide. Details are as follows:

Although floating rate yields have been increasing since last March when the Bank of Canada began its monetary tightening, there has not been much interest in floating rate preferred shares. The lack of interest continued even as yields on 3-month Treasury Bills and bank prime rate moved above the yield of 5-year Canada bonds, which meant floating rate dividends rose above fixed rate ones. In February, that changed. Pembina Pipeline announced that holders of 1,028,130 PPL.PF.A series had opted for the floating rate series PPL.PF.B, so both PPL.PF.A and PPL.PF.B will be listed going forward. In addition, BCE Inc announced that 3,635,351 of its BCE.PR.C fixed rate series were tendered for conversion into the floating rate BCE.PR.D series. At the same time, 351,634 of the BCE.PR.D series were tendered for conversion into the BCE.PR.C series. Consequently, going forward, BCE Inc will have 6,716,274 BCE.PR.C and 13,148,226 BCE.PR.D shares outstanding. The BCE.PR.D shares will continue to pay a monthly floating rate dividend set at 100% of the prime interest rate. At current prices, the floating rate BCE.PR.D shares yield about 2.00% more than the BCE.PR.C shares.

Not everyone was convinced of the value of floating rate shares, however. Enbridge announced that insufficient numbers of ENB.PR.D and ENB.PF.K holders wanted to make the switch into the floating rate series, therefore all shares will receive fixed rate dividends for the next five years. Pembina Pipeline announced a similar result from holders of its PPL.PF.E series.

The seven largest preferred share ETFs experienced net outflows of $ 43 million in February, however, the experience of each fund varied.  

J. Zechner Associates Preferred Share Pooled Fund

The fund returned -0.42% in February, which was better than the S&P/TSX Preferred Share index return. During the month, perpetual issues significantly underperformed rate reset issues, and the fund’s performance benefited from the portfolio’s slight underweight in perpetual issues. In addition, performance benefited from a small position in the IAF.PR.I issue, which as noted above was unexpectedly redeemed and appreciated in price more than a $1 on the last day of the month. Activity in the fund was fairly light during the month.

Outlook and Strategy

As noted above, investor’s expectations of falling rates later this year switched to a realization that rates were likely to stay higher for longer as inflation was not slowing as quickly as hoped.  This resulted in the yield of 5-year bonds rising 48 basis points during the month. The benefit to resetting rate reset issues can be seen in the more than 150 basis point increase in the dividend rate on the MFC.PR.J issue. Given this issue trades at a discount to par, the resultant increase in yield was even larger than the change in the dividend rate.

The direction of interest rates over the next several months will be determined by the path of inflation and whether it falls back close to the 2% target rate. The year-over-year rate of inflation is likely to decline further in the next few months as the very large increases in CPI in early 2022 fall out of the calculations. However, the key question is whether monthly increases going forward will be sufficiently constrained. We believe the Bank of Canada is unlikely to ease monetary policy and lower interest rates until inflation has subsided for several months to avoid a resurgence that would require even higher interest rates.  Unfortunately, we are not optimistic that inflation can be reined in in the next few months. It is our belief that it has become entrenched, and the complexity of the economy makes controlling it using only interest rate increases a very challenging exercise for the Bank of Canada. Recently, inflation has transitioned from goods to services, highlighting this challenge.

We also see several factors that should add to the inflationary pressures over the next year. Among these is the reopening of China’s economy with the lifting of its Zero-Covid policy this past December. A resurgence in the world’s second largest economy will result in increased demand for imports that will lead to higher global commodity prices. Another concern is that Canadian fiscal policies are not being coordinated with monetary policy but are instead diluting the fight against inflation. Examples include payments by some provincial governments to taxpayers to offset price increases (particularly for energy), and the federal government’s drive to increase immigration when affordable housing is in very short supply (leading to higher rents). In addition, the Bank of Canada’s decision to pause rate increases while the U.S. Federal Reserve continues to raise them may result in our exchange rate weakening, which will cause import prices to move higher.

We believe rate reset issues, particularly those with reset dates in the next few months, will continue to benefit from sharply higher dividend rates when they reset. Despite the increased the risk of a serious recession with the prospect of interest rates remaining higher for longer, we continue to remain confident in the creditworthiness of the issuers in the portfolio. These companies have successfully weathered previous economic downturns without impacting their ability to pay the dividends on their preferred shares.