A Look at Preferred Shares

Preferred shares were battered in 2015 and early 2016, and the considerable decline they suffered is worth a closer look. From the outset, it should be noted that this weakness is due to rate reset preferred shares.

In recent years, the Canadian preferred share market has evolved. Before 2008, most of these shares were "perpetual", that is to say that they had no predetermined maturity and paid a fixed dividend. In 2008, a new type of preferred shares emerged: rate reset preferred shares. This category has grown significantly and now represents 70% of all preferred shares. These pay a dividend rate that is reviewed every five years. At the time of the review, the new dividend rate corresponds to the prevailing yield of five-year Canada bonds plus a predetermined premium. The price of rate reset preferred shares is therefore closely correlated to the five-year Canada bond: it drops when interest rates decrease and rises when rates increase. Since January 2015, the five-year rate dropped to a historic low of 0.49%. Some preferred shares whose rates were reset in 2015 and 2016 saw their dividends fall, in some cases by over 40% compared to the initial dividend level. Securities prices were therefore adjusted downwards. However, decreases in dividends are now accounted for in securities prices.

In addition to the drop in Canadian bond yields, credit spreads widened, amplifying the decline in the price of securities. Until recently, yields required by investors were rising. For example, in January 2015, investors subscribed heavily to the issuance of a bank preferred share (Royal Bank) with a dividend of 3.6% (a premium of 262 basis points over the five-year rate) while in February 2016, the dividend required to achieve a similar success was 5.5% (a premium of 453 basis points over the five-year rate). We must return to the 2008-2009 financial crisis to observe premium resets of this magnitude. It is therefore very likely that issuers redeem their securities (with a very high premium) at the next reset date. Consequently, the short estimated term should limit volatility. Moreover, the potential gain from a rate hike is limited compared to other rate reset preferred shares which are trading at a deep discount (compared to the issue price of $25).

After a 29% drop in the S&P/TSX Preferred Shares Index from the top in November 2014 to the bottom in January 2016, we are seeing a rebound in the index. Concerns about the possibility of negative rates have faded since January. Volatility in the preferred shares market declined and is at levels below that of the last six months. In addition, we see a greater investor interest in this asset class, which supports stock prices.

We believe that the current price levels of rate reset preferred shares offers an attractive entry point. Downside risk is limited and in an environment of rising rates, equity returns should far exceed those of traditional fixed income. The reset mechanism will provide some protection, and increased five-year Canada bond rates will lead to a rebound in prices.