In June, a strong performance, particularly in the first half of the month, helped the preferred share market recover some of the losses from May. During the month, there was divergence in performance across issue types, both rate reset and floating rate issues had strong positive returns while perpetual issues had negative returns. Rate reset shares, especially some issues that had significantly underperformed year-to-date, led the market higher as increases in bond yields seemed to have investors anticipating higher dividend rates. The rise in bond yields came as the Bank of Canada resumed raising its overnight interest rate to fight inflation. The S&P/TSX Preferred Share index returned 1.28% in the month.

Canadian economic data received in the month was somewhat mixed. GDP growth stalled in April, partly due to the federal employees’ strike, but StatsCan’s flash estimate for May indicated a rebound to 0.4% growth. The unemployment rate rose to 5.2% from 5.0% as 17,300 net jobs disappeared. The details of the labour market report were not as negative, however, as all the weakness was in the seasonally volatile youth segment (ages 15-24) which saw job losses of 77,000. In contrast, the prime segment (25-54) had robust job gains of 63,000 positions. As expected, the annual inflation rate dropped to 3.4% from 4.4% as the outsized increase in May 2022 was dropped from the calculation. Core measures of inflation did not improve as much and remained well above the 2% target.

The Bank of Canada resumed its monetary tightening on June 7th, raising its overnight rate by 25 basis points to 4.75%. It was the Bank’s first increase since January. The Bank cited concerns that inflation might get stuck materially higher than the 2% target as consumption and interest sensitive areas of the economy were stronger than expected and the labour market remained very tight. Bond yields, particularly for shorter terms, rose sharply following the Bank’s rate decision and investors began to consider the potential for additional tightening at the Bank’s upcoming meetings in July and September.

Also, the Office of the Superintendent of Financial Institutions announced that it would require the six largest banks to increase the minimum regulatory capital they hold by November 1, 2023, thereby making preferred share redemptions less likely. However, it is noteworthy that TD Bank currently has higher regulatory capital than this new minimum level following the termination of its acquisition of First Horizon in the US.

In June, there were no new issues of preferred shares, and no preferred share series reset their dividend rates. The previously announced redemption of the $75 million CGI.PR.D series by Canadian General Investments Limited occurred on June 12th.

During the month, Manulife Financial announced an insufficient number of holders of MFC.PR.Q wanted to make the switch into the floating rate series and all shares will remain fixed rate ones, with a dividend rate of 5.942% for the next five years. Likewise, Intact Financial and Capital Power announced the same results from the holders of IFC.PR.G and CPX.PR.E respectively, and all shares will be fixed rate ones, with dividend rates for the next five years of 6.012% and 6.631% respectively. Despite floating rate yields remaining substantially higher than fixed rate ones, investors continue to appear worried that interest rates will fall in the next year and take floating rate dividends below fixed rate levels.

In other news, Northland Power issued a $500 million hybrid bond with a 9.25% coupon and reset spread of 584 basis points.  This came after the company’s redemption in December of the $120 million NPI.PR.C series, which would have reset at that time with a new dividend rate of approximately 6.60%. Given the significant increase in financing cost, even with adjusting for the after-tax benefit of interest payments rather than dividend payments, it seemed to be an economic mistake. However, Northland Power was able to raise a larger amount than it would have been able to in the preferred share market.

Also in June, Brompton Group brought a new preferred share ETF to market. The Brompton Split Corp. Preferred Share ETF, symbol SPLT, will hold a basket of preferred shares issued by split corporations. Split corporations hold portfolios of dividend paying common stocks and distribute most of the dividends to their preferred shareholders while their common shareholders receive the benefit of any capital gains in the portfolio. In an unfortunate coincidence, DBRS downgraded the preferred shares of a Brompton-managed split corporation, Dividend Growth Split Corp., from P-3 to P-3(low) citing reduced downside protection because the underlying portfolio had declined in value.

The seven largest preferred share ETFs experienced net outflows of $39 million in June, with HPR accounting for $36 million of the outflow. 

J. Zechner Associates Preferred Share Pooled Fund

The fund returned 0.45% in June, which was significantly lower than the S&P/TSX Preferred Share index return and gives back some of the significantly better performance in May. Security selection was a factor in the underperformance. Several issues not in the portfolio that had had declines of 20% or more in the first five months of the year experienced gains of 5% or more in June. In addition, some of the perpetual share holdings experienced sharp price declines on low trading volume.

In June, portfolio activity included continuing the switching of positions in FFH.PR.C into FFH.PR.K, and MFC.PR.I into MFC.PR.Q to pick up additional yield. In addition, we added a new position in CU.PR.C, a rate reset issue, with a yield greater than 7%.

Outlook and Strategy

Preferred shares are offering historically high yields and we believe that rate reset issues, particularly those with reset dates in the next few months, will continue to benefit from sharply higher dividend rates as interest rates stay higher for longer with inflation not declining to the Bank of Canada’s 2% target for several months.

Since peaking in June 2022 at 8.1%, Canadian inflation has fallen quickly back to 3.4% as of May. We believe the rate is likely to decline again in the next month as the 0.7% monthly increase in June 2022 falls out of the calculation. However, after that, our expectation is that the inflation rate will accelerate again. We note that the average monthly increase in prices in the first five months of this year has been 0.5%, far greater than the pace consistent with an annual rate of 2%. In addition, the Bank of Canada’s preferred measures of core inflation are only slightly less than 4%, indicating the fight against inflation is not nearly over. The Bank of Canada’s next two rate setting announcements are scheduled for July 12th and September 6th, and we expect the Bank will raise rates 25 basis points on one of those dates.

We are 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 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.