Despite preferred shares offering yields that were very competitive with other fixed income alternatives, particularly on an after-tax basis, investors continued to pull money out of the market in September. Extending a trend that began in March, preferred share ETFs again experienced large net withdrawals in September. The seven largest preferred share ETFs had $87 million of net outflows in the period, bringing the 7-month total to just under $950 million. Preferred share trading conditions remained quite illiquid in September, with lower than normal volumes.

J.Zechner Associates Preferred Share Pooled Fund

The fund returned -5.43% in September, which was markedly better than the S&P/TSX Preferred Share index return of -6.88%, but still disappointing. Contributing to the relatively better performance was relatively high levels of cash equivalents (7.9% at month end), and the holdings of institutional preferred shares and the LRCN which did not suffer the same magnitude of losses as traditional preferred shares in the period.

During the month, we participated in the new CIBC institutional preferred share issue and made some small additions to holdings that had recently cheapened. However, we primarily let cash levels accumulate from deposits, dividends, and the sale of a portion of the BMO.PR.E holding. With the market trending lower, we preferred to be patient about redeploying the growing cash position.

Outlook and Strategy

With both the Bank of Canada and the U.S. Federal Reserve expected to continue their interest rate increases in the coming months, the potential for a recession by the end of this year or the beginning of 2023 is increasing. However, we are confident in the creditworthiness of the issuers in the portfolio, as these companies have successfully weathered previous economic downturns without impacting their preferred shares.

The potential for a recession means there is a significant risk that equity markets decline further, and preferred shares weaken as a result. The recent correlation between preferred shares and common shares, though, has been higher than normal. In the past, we have observed preferred shares are more correlated with equities in down markets than in market rallies. Historically, the correlation in weak markets has been about 45%, but recently the correlation has been closer to 70%. We think that the correlation should return to more typical levels as income-focused investors look to take advantage of the highest yields available in many years. Since the financial crisis of 2008-2009, preferred share yields of 5.00% or more have indicated good value. Currently, institutional preferred share issues have been coming to market with yields in excess of 7.20% and some traditional preferred shares are yielding over 7.00%. In our opinion, that suggests preferred shares are cheap and are offering a buying opportunity.

Strategically, we are monitoring the market for indications that it has stabilized and then we will look to redeploy the elevated cash position. With yields at very attractive levels, and dividend rates resetting substantially higher as a result of higher bond yields, we are looking for issues that are not priced properly to reflect the expected jump in dividend rates. We note that the fund is already well positioned to take advantage of the expected dividend increases with over 28% of the fund scheduled to reset their respective dividend rates before the end of next year. Excluding cash, the average yield of the fund holdings (before expenses) is currently slightly above 6.00%. We believe that will move higher as dividends  rates continue to be increased.

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