November was a good month for financial markets, with Canadian bond, common equity, and preferred share indices sharply higher. A large decline in bond yields was the catalyst, which seemed to be an extension of moves begun in October and fueled by lower inflation, slightly weaker economic data, and less hawkish comments from central bankers. However, preferred shares were the standout asset class with returns markedly better than both bonds and common equities. The market started the month strongly as investors seemed to awaken to the attractive yields available in preferred shares, then later in the month the Federal government cleared up the confusion regarding the taxation of preferred shares held by financial institutions which prompted additional gains. The S&P/TSX Preferred Share index ended the month with a return of 9.47%.

There was substantial variation in the performance of similar issues during the month. As a group, the fixed rate reset sector had the strongest returns in November, gaining 10.2%. Investors were clearly trying to lock in very attractive current yields as they ignored a 50 basis point plunge in 5-year Canada bond yields that will mean lower resetting dividend rates going forward. Perpetual issues, which were yielding roughly 1% less than rate reset issues, returned an average 7.9% in the month as investors saw long term value in them. Floating rate issues earned only 7.0%, even though they offered markedly better yields than either rate reset or perpetual issues.

Canadian economic data received in November was mixed but on balance slightly negative. Canadian GDP was estimated to have shrunk at a 1.1% annual rate in the third quarter, much worse than expected. However, the second quarter GDP estimate was revised substantially higher from -0.2% to +1.4%, and StatsCan’s initial estimate for October was a relatively strong +0.2%. The unemployment rate rose to 5.7% from 5.5% as rapid population growth from immigration more than offset strong job creation. In the housing sector, existing home sales were weak, but starts of new homes were strong. Importantly, the annual inflation rate in October dropped to 3.1% from 3.8% as strong price gains in October 2022 were dropped from the calculation. Bonds rallied on the inflation news as investors knew the Bank of Canada would not begin lowering interest rates until inflation was back under control and close to the Bank’s 2% target.

The Bank of Canada did not have a rate setting meeting in the month, but the federal government released its Fall Economic Statement (FES) on November 21st. In it, the government projected higher deficits for the next few years that will require significantly more borrowing in the form of both bonds and Treasury Bills. The bond market did not immediately react to the projection of higher deficits, but the increased supply may become a headwind to lower yields in the coming months and quarters.

In the FES, the government cleared up the confusion created in the Budget last March regarding the taxation of preferred shares held by financial institutions. The Budget had proposed that preferred share dividends received by banks and insurance companies would be taxed as regular income, but the FES reversed this, stating that the dividends would continue to receive preferential tax treatment. This led to additional strong gains in preferred shares that were already recovering from being deeply oversold.

In November, two issuers announced the redemption of a preferred share series. Element Fleet Management announced that it would redeem the EFN.PR.A series. This was not particularly surprising given the series had a reset spread of 471 basis points and the shares were trading only slightly below $25 prior to the announcement. The company also announced it anticipates redeeming its two other series, EFN.PR.C in June 2024 and EFN.PR.E in September 2024. Also during the month, AltaGas Ltd announced that proceeds from the issuance of a $200 million hybrid bond, with an interest rate of 8.90% and reset spread of 509 basis points, would be used to redeem its ALA.PR.E series. This took the market by surprise given the high cost of the hybrid and the relatively low reset spread of 317 basis points on the ALA.PR.E series. The shares, as well as other series of Altagas preferred shares, moved sharply higher on the news.

There were no new issues of traditional $25.00 par preferred shares or institutional preferred shares in November. However, the split share fund Canadian Banc Corp. issued $85 million of the BK.PR.A preferred share series with a yield of 8.16%. Coincidentally, DBRS downgraded BK.PR.A from P-3 to P-3(low) because of a reduction in downside coverage.

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 remains substantially higher than five years ago. Details of the resetting issues were as follows:

Late in the month, both Pembina Pipeline Corporation and Enbridge Inc announced insufficient interest in making the switch to the floating rate series and all shares will remain fixed rate ones. Also, during the month, Bank of Montreal announced a similar outcome for BMO.PR.E, which reset in October. Despite floating rate yields remaining substantially higher than fixed rate ones, preferred share investors continue to worry that interest rates will fall in the next year and take floating rate dividends below fixed rate levels. At the end of November 3-month Treasury Bills were yielding 5.04%, while 5-year Canada bonds yielded 3.63%.

In November, Algonquin Power announced that it does not intend to redeem its AQN.PR.A series on January 2, 2024. The new fixed and floating dividend rates will be announced on December 4th and investors must make their decision on converting into the floating rate series by December 18th.

In other issuer news, DBRS Morningstar put the credit rating of Laurentian Bank of Canada, including its preferred share rating of Pfd-3, “under review with negative implications”. DBRS notes recent negative events, including the departures of the company’s CEO and Chair of the Board, and a computer mainframe outage that disrupted online access to retail and business accounts for four days which could make it more difficult to improve a personal banking segment that is lagging its peers.  In addition, BCE Inc renewed its normal course issuer bid (NCIB) to purchase up to 10% of the public float of each series of its outstanding preferred shares. The period of the NCIB will extend from November 9, 2023, to November 8, 2024.

In aggregate the seven largest preferred share ETFs had an inflow of $6 million in November. Given the strong market performance during the month, it is surprising that there was not a larger inflow.

J. Zechner Associates Preferred Share Pooled Fund

The fund had a return of 8.74% in November, which was lower than the S&P/TSX Preferred Share index return. While strong performance was seen across all structures and most issuers, fund under performance was largely a function of security selection. On the positive side, the announced redemption of the fund’s small position in ALA.PR.E benefited performance, as did its holding of ALA.PR.H that surged over 20% in the period. However, some of the worst performing issues in the market during October were the best performing ones in November. In particular, Brookfield Office Properties significantly outperformed the market with several issues having price returns of more than 20%. Having previously deliberately avoided some of the weakest issues, the fund trailed the market slightly as some of the laggards rebounded. Year-to-date performance of the fund remains well ahead of the index.

In November, portfolio activity included switching NA.PR.C into NA.PR.G and National Bank LRCN to pick up more than 40 basis points in additional yield. We also switched some AQN.PR.D, which resets in March 2024, into AQN.PR.A, which resets in December 2023. Given the uncertain path of interest rates over the next few months, we chose the higher degree of certainty of a near term reset versus one in several months. We also took profits in a portion of the ALA.PR.H position as it moved sharply higher. In addition, we sold some low yielding bank rate reset issues to add to several existing positions in both rate reset and perpetual issues with higher yields.

Outlook and Strategy

Despite the decline in bond yields and strong preferred share performance during the month, we believe the market continues to offer attractive yields. Many perpetual and rate reset issues can be purchased with yields greater than 6.5% and 7.5% respectively. As a result, the yield of the fund’s portfolio was 6.97% at the end of November. In addition, the 5-year bond yield continues to be substantially higher than five years ago, which will result in substantial increases in dividend rates for upcoming resetting issues.

It is possible that the November bond rally may have gone too far. We are not convinced that inflation will continue to quickly fall towards the 2% target, in part because the comparison with price moves last year will be more challenging in November and December. As well, the recent sharp drop in bond yields has loosened financial conditions markedly, which means there is less pressure on the Bank of Canada to reduce interest rates. We also believe investors have not yet focused on how much the Bank will lower rates when it does begin to loosen monetary conditions. The Bank has suggested that its estimate of the neutral rate, which is neither stimulative nor restrictive, may be revised higher. While we believe the rally may have gone too far too soon, we do not believe it is likely to fully reverse and the high yields seen in October may indeed prove to be the peak ones for this cycle. As a result, we are focussed on issues that have recently reset their dividend rates for the next five years as well as issues that will be resetting in the very near future. We are also increasing the holdings of perpetual issues to lock in yields that are historically very attractive.

A possible widespread slowing of the economy because of the need for interest rates to remain high for several more months remains a concern. We are particularly cautious regarding the real estate sector given its elevated leverage and the need to adjust cap rates to reflect current interest rates and bond yields. Also, there is a concentration of returns in equity markets, particularly in the U.S. S&P500 where seven massive tech stocks are dominating the price performance of the other 493 index constituents. We believe any correction in equities could cause a correction in preferred share prices.

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.