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In July, the preferred share market rebounded from a weak June with a strong month that outperformed Canadian equity and bond markets. Despite a lack of redemptions and new issuance, investors continued to seek attractive tax advantaged dividend income. During July, the most noteworthy trend in financial markets was a move to higher bond yields, primarily due to a resumption of hostilities in the Middle East. Tit-for-tat attacks by Iran and the United States left the June Memorandum of Understanding ceasefire in tatters and the Strait of Hormuz was once again closed to oil and gas tanker traffic. Bond yields climbed as oil prices rose because investors were concerned about the impact on broader inflation. More positive economic data in Canada also played a role in pushing yields higher.
In the preferred share universe, all types had similar strong positive average returns in the month, with perpetual and rate reset issues having returns of 2.3% and 2.4% respectively. The S&P/TSX Preferred Share Index ended the month with a return of 2.35%.
Canadian economic data received during July suggested the economy was beginning to recover from the U.S. initiated trade war. Canadian GDP grew faster than economists’ estimates in May and the year-over-year growth rate accelerated to 1.7% from 1.1%. In addition, the advance estimate of June’s GDP, if achieved, meant the economy grew at a robust pace greater than 3.0% in the second quarter. Concerns about a possible recession following weak growth in the previous two quarters evaporated, thereby reducing pressure on the Bank of Canada to lower interest rates. In addition, Canada had a significant trade surplus for the fourth consecutive month. Inflation dipped in June to 2.8% from 3.2% on lower energy prices, but the news was mostly ignored as oil prices had begun climbing again. The Bank of Canada left its interest rates unchanged at its meeting in mid-July.
In corporate news, Brookfield Infrastructure Partners and Brookfield Renewable Partners both announced plans to simplify their corporate structures by converting their limited partnership units on a one-for-one basis into newly issued shares of two new corporate entities, BIP Inc. and BEP Inc., respectively. Both transactions are expected to close by year end following unitholder meetings on October 14th. Notwithstanding, the preferred units of both entities will remain outstanding and unaffected by these plans.
During the month, two series of preferred shares reset their dividends. The dividend rates reset significantly higher because the 5-year Canada bond yield is substantially higher than the pandemic levels of five years ago. Details of the resetting issues were as follows:
| Issue | Existing Fixed Dividend Pricing Date | Existing Dividend Rate | New Fixed Dividend Rate | New Floating Dividend Rate |
|---|---|---|---|---|
| BCE.PR.I | July 2021 | 3.390% | 5.100% | Adj. Prime rate |
| CSE.PR.A | July 2021 | 3.702% | 5.788% | 4.994% |
Given that fixed rate dividend rates are higher than floating rate ones, investor interest in floating rate issues continues to be limited. During the month, BCE Inc. announced an insufficient number of investors wanted to remain in or switch to the currently outstanding related BCE.PR.J floating adjusted prime rate series to keep it outstanding. Therefore, all BCE.PR.J shares will be delisted and all investors will hold BCE.PR.I shares with a fixed rate dividend for the next five years. In addition, Capstone Infrastructure announced insufficient investor interest in making the switch to the related floating rate series and all CSE.PR.A shares will remain fixed rate ones for the next five years.
In July, the quarterly S&P/TSX Preferred Share Index rebalancing featured three additions, AQN.PR.D, BEP.PR.S and GWO.PF.A, and four deletions, BCE.PR.B, BCE.PR.C, BCE.PR.Y and CU.PR.J. Also, during the month, the seven largest preferred share ETFs had an aggregate inflow totaling $82 million. Only the actively managed HPR had an outflow that amounted to $2 million.
J. Zechner Associates Preferred Share Pooled Fund
In July, the fund had a return of 1.84%, thus under performing the S&P/TSX Preferred Share index. The shortfall was largely a function of security selection, particularly the fund’s approximate 11% allocation to Limited Recourse Capital Notes (LRCN) and institutional preferred shares which collectively had a flat return on the month.
Portfolio activity during the month included selling the CM.PR.S position at a yield to call below 3.50% and some of the MFC.PR.K position at a yield to call below 4.00%. These proceeds and funds from accumulated dividends were used to add a new position in the Sun Life Financial 5.614% LRCN with a yield to call of 6.12%.
Outlook and Strategy
The war between the United States and Iran remains a wildcard for financial markets. The complete lack of trust between the two countries and the absence of any common interests suggest it may drag on for several more months. While U.S. President Trump would like to end the unpopular conflict well before the mid-term elections in early November, the Iranians are also aware of the elections and may be content to stall negotiations until later in November. Consequently, war may continue to be a source of considerable volatility.
The improvement in Canadian economic growth was a pleasant surprise in July, but we believe the trade war remains a significant risk. The U.S. president’s mercurial, unpredictable, and unreliable policies on tariffs and his desire to dominate all the United States’ trading relationships suggest he may try to implement even more extreme measures. His July threat of 50% tariffs on some imports from Canada may or may not be implemented, but until the CUSMA treaty is finally renegotiated, we should anticipate some economic pain. Consequently, we believe there is little likelihood of rate increases by the Bank of Canada for the balance of this year. Only a significant unexpected economic slowdown is likely to cause the Bank to change its rates this year.
In July, the 5-year bond yield remained well above the extremely low level of five years ago resulting in the two resetting issues increasing their dividend rates more than 170 basis points. Given that the two issues trade below par, the increases in yields were even greater. We expect the 5-year Canada bond yield to remain in a trading range near current levels. Therefore, we continue to anticipate large increases in resetting dividend rates in the coming months.
Despite the slowdown in the redemption trend, given that corporate bond yield spreads remain at historically low levels, we believe corporations will continue to look for opportunities to issue LRCNs and hybrid bonds at attractive coupons and reset spreads that will enable them to reduce their after-tax cost of capital by redeeming high reset spread series.