In October, the preferred share market had positive performance until the middle of the month. However, over the balance of the month both preferred and common equity markets turned lower, precipitated by an increase in bond yields, despite a greater than expected decline in inflation and a larger than normal interest rate reduction by the Bank of Canada. The catalyst for the sell off was a very weak U.S. bond market that experienced large increases in yields as investors scaled back expectations of future rate cuts by the U.S. Federal Reserve. Preferred share investors appeared to seize the opportunity to take profits. Over the month, unsurprisingly given the increase in bond yields, perpetual issues were the worst performing type with an average loss of 2.8% and floating rate issues were the best performing type with an average gain of 0.7%. Rate reset issues on average lost 0.5% over the month. The S&P/TSX Preferred Share index ended the month with a loss of 1.38%.

Canadian economic data received in October was mixed. On the positive side, the unemployment rate declined to 6.5% from 6.6%. Job creation was strong with 46,700 net new positions created, including 112,000 new full-time jobs that more than offset a 65,300 decline in part-time ones. A drop in the participation rate to 64.9% from 65.1% also contributed to the decline in the unemployment rate. Less positively, Canadian GDP experienced little growth in August, although StatsCan’s flash estimate for September showed a more robust 0.3% increase. Inflation slowed more quickly than expected, dropping to 1.6% from 2.0% the previous month. A 7% decline in gasoline prices was the main driver of the better than expected inflation rate, leaving core measures of inflation unchanged at 2.4%.

Following three consecutive interest rate cuts of 25 basis points, the Bank of Canada lowered rates by 50 basis points on October 23rd. The larger size of the reduction had little impact on Canada bond yields as it matched what had become the consensus expectation. The Bank cited the lower inflation rate and slack in the economy as reasons for the larger move. We note that one often mentioned measure of that slack is the unemployment rate, but in a subsequent discussion with a Deputy Governor, he acknowledged there has been little change in the unemployment rate for Canadians other than newcomers and youth. The last two years’ surge in immigration is the cause of the rising unemployment rate, rather than economic weakness.

In October, Bank of Montreal announced that it will be redeeming the $300 million BMO.PR.W series, with a reset spread of 222 basis points. The market had been anticipating this redemption since BMO redeemed an issue in April with a similar reset spread. However, as noted last month, after TD Bank announced that it would not be redeeming the TD.PF.A series, with a similar reset spread, the market started reevaluating the potential for other redemptions of resetting bank issues and several series of shares traded down in price, including BMO.PR.W. Consequently, on the redemption news BMO.PR.W traded up 5.0%. Investors will receive the $300 million on November 25th.

There were no new issues of preferred shares in October. Of note, though, Royal Bank and CIBC issued USD $1 billion and USD $500 million, respectively, of Limited Recourse Capital Notes (LRCNs). The proceeds of the CIBC LRCN may be used to redeem its CM.PR.P series next January. Royal Bank does not have a preferred share series resetting before next May, but it does have two small perpetual series that may be redeemed at any time.

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

TD Bank announced insufficient investor interest in making the switch to the floating rate series and all TD.PF.A shares will remain fixed rate ones for the next five years. In contrast,TC Energy announced there was sufficient investor interest in making the switch into the related floating rate series. The new floating rate series, TRP.PR.L, will have 1.3 million shares outstanding, while TRP.PR.E will have 16.7 million shares outstanding. The TRP.PR.L series was listed for trading on October 30th.

Also during the month, Manulife Financial announced that it will not be redeeming the $350 million MFC.PR.M series, with a reset spread of 236 basis points. Given that the issuer had not redeemed previous similar resetting issues, the market had anticipated this and the price was unaffected. The company will announce the new dividend rates for the fixed and floating rate options on November 20th.

In other issuer news, National Bank of Canada announced, that as part of its acquisition of Canadian Western Bank, it would be seeking investor permission to exchange Canadian Western Bank’s two preferred share series, CWB.PR.B and CWB.PR.D, into new National Bank preferred shares with the same dividend rates, reset spreads and reset dates. Investors in these two series, as of the October 24th record date, will be voting on the exchanges at a meeting to be held on November 28th. The exchanges require approval by at least two-thirds of each series’ votes cast at the meeting. A consent fee of $0.50 per share will be payable to the holders who vote regardless of whether they vote for or against the exchanges.

In addition, BIP Investment Corporation, a subsidiary of Brookfield Infrastructure Partners L.P., announced that due to potential Canadian tax rules changes which could result in additional costs beginning in 2025, it intends to complete a reorganization to maintain the economic benefits of its business structure. On November 27th, the issuer will hold a special meeting of the BIK.PR.A series investors, as of the close of business on October 25th, at which it will be seeking approval from investors to pass a special resolution to permit the redemption of the BIK.PR.A series at a price of $26.75 per share. The special resolution must be passed by the affirmative vote of at least two-thirds of votes cast at the meeting.

During the month, the quarterly S&P/TSX Preferred Share index rebalancing featured no deletions and three additions, with GWO.PR.R, LB.PR.H and PWF.PF.A shares returning to the index. Also in October, the seven largest preferred share ETFs had an aggregate outflow of $107 million. Only one of the ETFs experienced a net inflow in the month. 

J. Zechner Associates Preferred Share Pooled Fund

In October, the fund returned -1.76%, which underperformed the S&P/TSX Preferred Share index. The fund’s underperformance was largely a function of the fund holding relatively more perpetual type preferred shares, which had the lowest returns for the month.

As noted last month, AltaGas announced that with the resetting of the fixed rate ALA.PR.G series’ dividend rate there was insufficient interest to keep the floating rate ALA.PR.H series outstanding and all shares will be the ALA.PR.G series for the next five years. Consequently, the fund’s holding of ALA.PR.H shares was switched into the ALA.PR.G series. Other portfolio activity during the month also included adding the Royal Bank 4.20% institutional preferred share at a price of $87.90, a substantial discount to par. We believe this issue offers good potential for price appreciation.

Outlook and Strategy

The Bank of Canada’s next rate announcement is scheduled for December 11, and we expect it will lower rates by 25 basis points although another 50 basis point move is clearly possible. As noted above, we believe the rise in the unemployment rate does not reflect economic weakness. Rather, it has been caused by the federal government’s immigration policy. We also believe that concerns that economic growth will suffer significantly in 2025 and 2026 from the burden of increased mortgage payments with renewals are overblown. While interest rates are higher than in 2020 and 2021, they have dropped significantly from their peaks of last year. For floating rate borrowers, we expect the Bank of Canada will continue lowering rates into the first half of next year, thus further reducing the potential shock of increased mortgage payments. We also note that the higher wage inflation of the last few years has resulted in increased employment incomes for most borrowers, making mortgage payments more affordable.

As we noted last month, the pace of the Bank of Canada’s rate reductions is less important than the level at which it stops. The Bank’s most recent estimate of the neutral rate, which is neither restrictive nor stimulative, is 2.75%, or 100 basis points lower than the current rate. That seems like a reasonable point for the Bank of Canada to at least pause, given the economy is not in a recession, the scale and pace of easing from the 5.00% rate peak, and the lag with which the economy responds to rate changes. While some observers are forecasting a terminal rate as low as 2.00%, we are not convinced that is the most likely outcome. If we are correct that the Bank will pause at 2.75%, the yields of Canada bonds are unlikely to decline substantially from current levels.

We believe the preferred share market continues to offer attractive yields and potential for price gains. The 5-year bond yield continues to be substantially higher than five years ago as reflected in the resetting issues in October increasing their dividend rates more than 1.25%. If bond yields don’t decline substantially from current levels, then resetting issues in 2025 will benefit from substantial increases in their dividend rates because bond yields should be much higher than in 2020. Preferred share yields should continue to be significantly better than corporate bond yields, making them an appealing fixed income alternative. In addition, the ongoing redemption trend should benefit all types of preferred shares as investors reinvest the proceeds among fewer outstanding issues.