Preferred shares began October by drifting modestly lower in price, thereby extending the weakness that began in September. In the second week of the month, though, there was a sharp selloff in the market caused by two banks deciding to extend rather than redeem two series of their preferred shares. For more than two years, banks had consistently redeemed every issue due to reset its dividend rate, so the decisions to extend caught investors very much by surprise. Other bank preferred shares quickly sold off as investors revised their expectations of whether those shares would be redeemed, and the weakness spread to non-bank issues as well. The selloff ended a few days later when a non-bank issuer announced it would redeem one series of its preferred shares. Over the balance of the month, the preferred share market recovered most but not all its losses. The S&P/TSX Preferred Share index ended the month with a return of -0.88%.

Canadian economic data released in October was somewhat mixed. GDP in August increased by only 0.1% versus the prior month, but that was enough to register growth of 4.0% versus a year ago.  September employment increased by 21,100, the first jobs increase in four months. The increase recovered less than 20% of the jobs lost over the previous three months and was largely driven by an expected rebound in education employment. The positive jobs number combined with a modest decline in labour force participation helped push the unemployment rate down to 5.2% from 5.4%. Less positively, Canadian home sales declined for the seventh consecutive month as higher interest rates further slowed activity in that sector. Inflation in September slowed slightly to an annual rate of 6.9%, which was higher than expected and only marginally lower than the 7.0% level of the previous month, despite the aggressive interest rate increases by the Bank of Canada so far this year.

In early October, the Bank of Canada Governor made several comments that the Bank would continue to fight inflation aggressively. As a result, the market consensus expectation for the Bank’s increase in its interest rate in late October shifted from 50 basis points to 75 basis points. Government benchmark bond yields ranging from 2 to 30 years in maturity rose by more than 50 basis points in the first three weeks of October. However, at its October 26th announcement, the Bank chose to raise its rates by only 50 basis points, which led to a fall in bond yields as investors expected that the Bank might soon stop raising rates and start lowering them. Over the month, the yield of 5-year Canada bonds rose 12 basis points, further bolstering prospects of dividend increases for rate reset preferred shares.

Over the last two years, Canadian banks have issued Limited Recourse Capital Notes (LRCNs) and institutional preferred shares with the proceeds often used to redeem traditional $25 preferred shares. However, as mentioned above, the market was shaken by the unexpected extension of two series of rate reset preferred shares by two banks. In early October, TD Bank announced that it will not be redeeming its $350 million TD.PF.I series of shares in November. Instead, the shares, which have a reset spread of 301 basis points, will have a dividend rate of 6.301% for the next five years. TD did this despite having issued a $1.5 billion LRCN with an initial coupon rate of 7.283% and a reset spread of 410 basis points in September. The market believed the decision to extend the TD.PF.I shares may have been due to TD’s need to fund, during these uncertain financial markets, the upcoming US$13.4 billion takeover of First Horizon Bank. As a result, there was no immediate broad-based reaction to TD’s announcement.

A week later, however, National Bank announced that it will not be redeeming its $400 million NA.PR.C shares in November. These shares, which have a reset spread of 343 basis points, will have a dividend rate of 7.027% for the next five years. This was done despite National Bank having issued a LRCN in August in the amount of $500 million with an initial coupon rate of 7.50% and a reset spread of 428 basis points. At the time, the redemption of the NA.PR.C looked like the possible use of the proceeds. Unlike TD Bank, National Bank had no obvious need for additional capital, so its extension decision suggested banks were no longer being encouraged by OSFI to redeem all their traditional $25 par value preferred shares. That created uncertainty about whether bank preferred shares with redemption dates in the next three years would be extended or redeemed, particularly since those issues have much lower reset spreads than the issues that have been called in the last two years. With redemptions at par appearing less likely, investors sold bank preferred shares leading to the sharp selloff in mid-month.

The market quickly stabilized and began to recover when Pembina Pipeline announced three days later that that it will redeem the $300 million PPL.PF.C series, which has a reset spread of 365 basis points. In addition, while both TD.PF.I and NA.PR.C traded down to 52-week lows on the extension news, once investors realized the attractive dividend rates they would be receiving for the next 5 years (combined with their high reset spreads) relative to other bank issues, demand for them increased and the shares closed the month at prices close to those just before the extensions were announced.

The TD Bank and National Bank issues raised their dividend rates substantially as a result of the resetting process. Details of the resetting issues are below:

TD Bank subsequently announced that an insufficient number of TD.PF.I holders wanted to make the switch into the floating rate series, therefore all shares will be fixed rate ones for the next five years. National Bank has yet to announce whether there was sufficient interest in switching into the floating rate alternative to NA.PR.C. With yields expected to peak within the next year or so, investors are choosing the certainty of a relatively high fixed rate dividend rather than the floating rate alternative that might suffer once yields begin to recede.

In issuer news, DBRS upgraded the preferred shares of Co-operators General Insurance Company to Pfd-2 from Pfd-2 (low). The rating agency notes the company has generated strong and consistent growth and improved underwriting profitability, while maintaining prudent liquidity, leverage and capital levels.

In addition, the S&P/TSX Preferred Share index rebalanced in October with sixteen deletions and only one addition. Also during October, there were no redemptions of preferred shares and no new issues.

The seven largest preferred share ETFs continued to experience net withdrawals in October, with total outflows of $73.5 million. A smaller preferred share ETF, the Evolve Dividend Stability Preferred Share Index ETF, was closed and de-listed in October. It had only $12 million in assets as of August.

J. Zechner Associates Preferred Share Pooled Fund

The fund returned -1.36% in October, which underperformed the S&P/TSX Preferred Share index return. Some of the portfolio holdings that were removed from the S&P/TSX Preferred Share index in the month experienced particularly large declines during the illiquid trading conditions experienced in October. We anticipate that they will rebound in the coming weeks.

During the month, we added additional rate reset shares, NPI.PR.C, NA.PR.E and ENB.PR.D, which have reset dates in the next few months and that will benefit from higher dividend rates when they reset. We reduced positions in EMA.PR.F, NA.PR.S and BAM.PF.B, which have reset dates further in the future. In perpetual issues, we switched the BCE.PR.T position into additional BCE.PR.A (with a small pickup in yield), added to the existing RY.PR.N position, and sold some lower yielding issues.

Outlook and Strategy

The increase in 5-year bond yields so far this year continues to result in substantially higher dividend rates on resetting rate reset preferred shares, as can be seen above in the large increases in the dividend rates of the resetting TD Bank and National Bank issues. With most preferred shares trading at discounts to par value, the increases in yields are magnified. To date, however, we do not believe the market has fully recognized the large increases in yields that are likely from issues resetting in the next year or so. Once that occurs, demand for those preferred shares should increase which may lead to potential price gains.

Both the Bank of Canada and the U.S. Federal Reserve have signaled that they will be continuing to raise interest rates through the remainder of the year, and it is important to remember that influencing aggregate demand and inflationary pressures with changes in monetary policy can involve a lag of six months to a year. We believe, though, that 5-year bond yields are more likely to rise from the current levels than fall substantially in the next twelve months.

The risk of a recession has increased substantially because of the sharp increase in interest rates by the Bank of Canada this year. Should a recession occur, we anticipate that each of the issuers held in the portfolio will continue to pay their dividends because of their current financial strength and their track record in successfully navigating past economic downturns.

Preferred shares are offering historically high yields, and given the advantageous tax treatment of dividends, they look very attractive versus alternative fixed income instruments. We are being patient in looking for the best yielding opportunities, hence the relatively high 8% cash balance in the portfolio.  We are focused particularly on rate reset issues which we believe the market does not yet fully appreciate the expected dividend increases, while being mindful of the risk of potential redemptions. We are especially interested in opportunities to lock in yields greater than 7% for periods approaching five years with rate reset issues, or longer in the case of perpetual preferred shares.