In July, the preferred share market performance was essentially flat until a couple of days before the quarterly preferred share index rebalancing when investor positioning prior to and during the rebalance elevated trading volumes and pushed prices higher. Trading volumes on the index rebalancing day were very strong at more than three times the average daily volume and passive index ETFs experienced inflows. The market was able to hold on to most of these gains and the S&P/TSX Preferred Share index ended the month with a return of 1.45%. During the month, there was divergence in performance across issue types, with both rate reset and floating rate issues outperforming perpetual issues by more than 1%.

Canadian economic data released in July was generally positive. The labour market remained strong; while the unemployment rate increased to 5.4% from 5.2%, the change was due solely to a rise in the participation rate as more Canadians were encouraged to look for work. Job creation was robust with 59,900 net new positions created in the month, with 109,600 new full-time positions more than offsetting a decline of 49,800 part time jobs. Monthly GDP growth accelerated to 0.3% in May, although StatsCan’s flash estimate for June showed a small contraction. Housing starts rebounded sharply, beating all forecasts. Inflation fell more than expected with the 12-month rate dropping to 2.8% from 3.4% the previous month. However, the core measures of inflation that the Bank of Canada focuses upon showed only marginal improvement and remained too high for the Bank’s comfort. In July, the Bank increased its interest rates 25 basis points, following up a similar sized increase in June. Subsequent statements from Bank officials indicated that further increases were possible this year if economic conditions warranted.

In July, there were no new issues of traditional $25.00 par preferred shares or institutional preferred shares. 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:

Investors in EMA.PR.C and EMA.PR.H had to make their decision on converting into the floating rate series by July 31st. In July, Manulife Financial Corporation announced that it will not be redeeming the MFC.PR.K series on September 19, 2023. The new dividend rate will be announced on August 21st and investors will have to make their decision on converting into the floating rate series by September 4th.

In issuer news, DBRS Morningstar downgraded TC Energy preferred shares to Pfd-3 (high) from Pfd-2 (low) after the company announced its intention to sell a 40% interest in its Columbia Gas Transmission, LLC and Columbia Gulf Transmission, LLC systems for $5.2 billion in cash. While this will help the company fund its capital expenditures, the rating agency is concerned about structural subordination with additional debt at this new joint venture and the potential execution risks with the company’s elevated capital expenditure program planned for 2023 and 2024. However, the agency noted that the company’s business continues to be strong, with the majority of it regulated and under contract, and with healthy fundamentals at its natural gas pipelines and power assets. Later the same week, the company also  announced a plan to spin off its liquids pipelines business, resulting in two separate, independent, publicly listed companies. This plan is subject to a shareholder vote in mid-2024 as well as regulatory approval. While there are still several unknowns and moving parts to this spin-off, the current market expectation is that the preferred shares will remain the obligation of the existing company. The rating agencies did not take any additional action on this news.

Also in the month, Laurentian Bank announced that it is undertaking a strategic review of its business and it has been in discussions with potential buyers. Investors viewed this as potentially positive news as a buyer would likely be a higher rated Canadian financial institution. Subsequently, the company’s preferred share series, LB.PR.H, closed almost 9% higher on the first trading day after the announcement.

As noted above, the quarterly S&P/TSX Preferred Share Index rebalancing occurred in July with thirteen deletions and two additions. As usual, this resulted in robust trading volumes on that day, which moved the market higher. Unlike many previous rebalancing gains which were reversed in the following few days, this time the market was able to hold on to most of the gains through the end of the month as some new money seemed to come into the market.

The seven largest preferred share ETFs experienced net inflows of $6 million in July, with the passive index ETFs CPD and ZPR accounting for all the inflows. In particular, CPD enjoyed a $33 million net inflow in the month.  Interestingly, these inflows were concentrated in the two days bracketing the rebalancing, with all other days experiencing net withdrawals. 

J. Zechner Associates Preferred Share Pooled Fund

The fund returned 1.20% in July, which was lower than the S&P/TSX Preferred Share index return. We believe the underperformance was largely a function of volatility during illiquid summer market conditions.

In July, portfolio activity included switching of positions in CPX.PR.C into CPX.PR.E and concluding the switch of MFC.PR.I into MFC.PR.Q to pick up yield. We also took advantage of price speculation on the day of the Laurentian Bank announcement and sold the LB.PR.H position at a very attractive price. In addition, we executed two switches between Fortis and Intact Financial issues. We switched FTS.PR.J into IFC.PR.K, and IFC.PR.G into FTS.PR.G, and in both cases increased the yield meaningfully.

Outlook and Strategy

Bond yields moved higher in July as the economy continued to show resilience and investors were forced to reevaluate their expectations for an imminent slowdown that would lead to monetary easing and lower interest rates. As noted above, 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.

The recent decline in the inflation rate is welcome news, but not unexpected, given the very large increases in prices that occurred in the first half of last year. Unfortunately, we believe the improving trend is finished and inflation is likely to start rising again. Some of the factors underlying our outlook include the resilience of the economy, elevated core inflation measures, recent price increases in food and energy, and small monthly increases in the second half of last year. In addition, wage pressures (and strikes) are increasing as workers seek to offset the impact of inflation that has already occurred.

If we are correct, the Bank of Canada may choose to increase interest rates again at either its September or October meetings. Even if it does not increase rates further, it is unlikely to lower rates for several quarters. Consequently, we believe the risk of a recession beginning in the next few quarters is significant. Indeed, a recession may be required to bring inflation back to the 2% target on a lasting basis. Importantly, we believe the Bank of Canada is willing to permit a recession as it struggles to control inflation.

We remain concerned that a recession may begin later this year or early in 2024. The resilience of the Canadian economy to date following substantial interest rate increases shows that even tighter monetary policy is required to bring inflation sustainably down to the 2% target. That raises the likelihood of the economy reaching a breaking point with a sudden sharp retrenchment, rather than achieving a so-called “soft landing”. The experience of the 1980’s, when inflation had become entrenched as it is currently becoming, suggests that inflation can only be curbed with a significant economic contraction that results from a substantial reduction in aggregate demand. Despite this increased risk, 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.