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Jeff Herold
March 22, 2024
The preferred share market drifted lower for most of February. However, on the final day of the month, Bank of Montreal issued a U.S. dollar Limited Recourse Capital Note (LRCN) which led to speculation regarding further preferred share redemptions by banks. As a result, the prices of several banks’ rate reset issues scheduled to reset in the next few months moved sharply higher. Over the entire month, rate reset and floating rate issues had positive returns, while perpetual issues had negative returns. The S&P/TSX Preferred Share index ended the month with a gain of 0.13%.
The most noteworthy piece of Canadian economic data received in February was the Consumer Price Index. Prices were forecast to have risen 0.4% in January but were, in fact, unchanged. As a result, the annual rate of inflation fell to 2.9% from 3.4% the previous month. The core measures of inflation showed a more modest improvement and remained above 3.0%. The better than expected inflation news caused a brief rally in bonds, but investors appeared to want confirmation that the improving trend would last. In other news, the unemployment rate declined to 5.7% from 5.8% due to good job creation and a slightly lower participation rate. Growth in average hourly wages decelerated but, at 5.3%, remained inconsistent with the 2% inflation target. In addition, Canadian economic growth in the final quarter of 2023 was estimated at an annual rate of 1.0%, slightly better than expected, while the third quarter contraction was revised upward from -1.1% to a slightly less worrisome -0.5% pace. On balance, the economic data showed the Canadian economy was performing below potential, but not so poorly that immediate monetary easing was required. The Bank of Canada did not have a rate setting announcement in February. Its next meeting is scheduled for March 6th, when it is expected to leave its trendsetting interest rates unchanged. [As this is being written, the Bank of Canada has left its overnight target rate unchanged at 5.00%]
In February, there were no new issues of preferred shares. However, as noted above, Bank of Montreal issued a U.S. $1.0 billion LRCN with an initial coupon rate of 7.70% and a reset spread of 345 basis points. The size of the issue was larger than some market participants thought the bank needed. This led to speculation that, in the next few months, there would be redemptions of bank rate reset issues with reset spreads between 200 and 300 basis points, despite similar issues not being redeemed recently. Investors appeared hopeful that, notwithstanding the reset spread, the Office of the Superintendent of Financial Institutions will continue to encourage banks to replace traditional $25.00 par preferred shares with LRCNs or institutional preferred shares.
In February, no series of preferred shares reset their dividends. However, during the month, investors in six series of preferred shares that reset their dividends in January had the choice of switching into the floating rate option. Despite floating rate yields remaining substantially higher than fixed rate ones and interest rates potentially staying higher for longer, insufficient numbers of holders in all six series wanted to make the switch into the floating rate series and all shares will remain fixed rate ones. Preferred share investors continue to appear concerned that interest rates will fall in the next year and take floating rate dividends below fixed rate levels.
Also, during the month, Aimia Inc. and Algonquin Power and Utilities Corp. announced that they do not intend to redeem their respective preferred share series AIM.PR.C and AQN.PR.D. The new dividend rates will be announced in early March and investors in both series will have to make their decision to switch into the floating rate series by March 18th.
In rating news, Morningstar DBRS downgraded Financial 15 Split Corp.’s preferred shares from Pfd-3 to Pfd-4 (high). The rating agency cited reduced downside protection, a decline in the dividend coverage ratio, and unhedged foreign exchange risk for the downgrade. Morningstar DBRS also downgraded North American 15 Split Corp.’s preferred shares from Pfd-4 (high) to Pfd-4 citing similar reasons.
In aggregate, the seven largest preferred share ETFs had net outflows of $46 million in February. ZPR saw the largest withdrawals, but HPR and RPF also experienced significant outflows.
J. Zechner Associates Preferred Share Pooled Fund
The fund had a return of -0.41% in February, which significantly underperformed the S&P/TSX Preferred Share index. The fund’s underperformance was largely a function of security selection. As noted above, several banks’ reset issues trading below par moved sharply higher in the last couple of days of the month. The fund held only a few of those shares, which hurt performance. In addition, the fund held relatively more perpetual type preferred shares that lagged other types of preferred shares.
Portfolio activity during the month included selling some IFC.PR.G to buy CU.PR.C that had recently cheapened. Also, we switched PPL.PR.O into PPL.PR.A for a pickup of approximately 40 basis points.
Outlook and Strategy
We believe the preferred share market continues to offer attractive yields, significantly better than corporate bonds, making them an appealing fixed income alternative. In addition, rate reset shares are enjoying substantial increases in their dividend rates because the 5-year Canada bond yield remains substantially above its level five years ago.
We remain cautious about interest rates declining significantly because we believe investors are too optimistic about inflation slowing and because of the potential for fewer interest rate cuts by the Bank of Canada than many investors are anticipating. While the January inflation data was a pleasant surprise, we are not confident that it is the start of a trend. The first six or seven months of each year is when Canada tends to experience the greatest inflationary pressures and 2024 is likely to be no different. Given the complexity of the economy and the potential for a second round of price increases well above the Bank of Canada target rate, we prefer to be patient about anticipating a return to the 2% target.
As we noted last month, if and when the Bank of Canada begins lowering interest rates, a key consideration will be how low rates might go. For several years, the Bank has been estimating the “neutral” rate, which is neither stimulative nor restrictive, to be between 2.00% and 3.00%. More recently, though, the Bank has indicated that the neutral rate has probably increased. Given the recent bout with inflation, we believe the Bank will be reluctant to lower its target interest rate below 3.00%. We suspect that level differs from the expectations of investors who started their careers in the last fifteen years, a period when the Bank of Canada kept its interest rate well below 2.00%. We believe that period was an aberration, rather than the new normal, and the Bank will be reluctant to return interest rates to such low levels, given the negative consequences that included a housing bubble. Prior to the Great Financial Crisis, the Bank’s overnight target rates never went below 2.00% and yet the Canadian economy performed reasonably well. Our view is that the Canadian economy can sustain significantly higher interest rates than prevailed in the 2009 to 2022 period.
The next couple of quarters may also determine whether the Canadian economy falls into a period of stagflation. Stagflation refers to an economy characterized by high inflation, low economic growth and high unemployment. At present, inflation is too high and economic growth is sputtering, but unemployment cannot be characterised as high. Should unemployment rise substantially from current levels, the Bank of Canada will have a dilemma because its actions to lower inflation may hurt the labour market.
At this time of economic uncertainty, 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. However, we are particularly cautious regarding real estate issuers given their elevated leverage and the need to adjust cap rates to reflect current interest rates and bond yields. In addition, there is a concentration in equity market gains, particularly in the U.S. S&P500 where seven massive tech stocks are dominating the price performance of the other 493 index constituents. Any correction in equities will likely cause at least a temporary correction in preferred share prices.
Our investment management team is made up of engaged thought leaders. Get their latest commentary and stay informed of their frequent media interviews, all delivered to your inbox.