Atlantic Power announced today that it would be resetting the dividend rate on its $100,000,000 AZP.PR.B issue effective December 31, 2014. The reset spread is 418 basis points. The announcement was not a surprise as the company has been struggling in recent years, as the P-5 rating and $12.55 price of the preferred shares suggest.
Two other issuers have to reset their dividend rates or redeem the issues on December 31st. The $550,000,000 TRP.PR.A issue has a relatively low reset spread of 192 basis points, which makes it relatively cheap for TransCanada to leave it outstanding. Thus, we think the issue will reset rather than being redeemed. We also believe that that Fairfax Financial will reset the dividend rate of its FFH.PR.C issue rather than redeeming it. The reset spread is 315 basis points, which is close to what we estimate Fairfax would have to pay if it brought a new issue. Given the costs associated with new issues, we think Fairfax will choose to leave the current issue outstanding rather trying to refinance it.
The Canadian preferred share market was an oasis of relative calm in October as many other financial markets experienced significant volatility. Canadian common shares, for example, returned -2.07% in the month, having been down more than 7.0% at mid-month. U.S. equities lost more than 5.5% by mid-month, but finished +2.44%. Canadian bonds returned +0.57% in the month, having been up more than 1.5% earlier in the period. Intraday volatility, particularly on October 15th, was extraordinary in both equity and bond markets. In contrast, at its lowest point in the month the S&P/TSX Preferred Share Total Return index was -0.72%, but finished the month at its highest level, +0.51%. For investors seeking to reduce volatility in their portfolios, preferred shares offer significant diversification benefits.
The fund’s emphasis on perpetual issues again served it well in October. Perpetual preferred share prices gained an average of 0.50% compared with rate reset share prices that fell 0.74% and floating rate share prices that plunged an average 2.18%. The fund also benefitted from favourable security selection as a number of issuers that we had been avoiding experienced subpar financial results. TransAlta, for example, reported disappointing quarterly earnings because of weak Alberta power prices and all of its preferred share issues dropped by more than 5% in price. The TA.PR.J issue that came to market in August finished October at $22.65, re-emphasising the need for careful analysis before purchasing new issues. Other preferred shares that suffered large losses in the month included Talisman Energy (down more than 8%), Bombardier (down about 4%), and Atlantic Power (down more than 11%).
New issue activity was relatively light in October, with only two deals totalling $600,000,000. The volatility occurring in other markets may have been the reason for the lighter than expected new issue volume. Details of the new issues were as follows:
Redemption announcements were made for two issues during October. The details of the issues to be redeemed are as follows:
The S&P/TSX Preferred Share index had its quarterly rebalancing in October. Three of the fund’s holdings, ALA.PR.G, AQN.PR.D, and PPL.PR.G, were added to the index, and benefitted from buying from index-linked Exchange Traded Funds. Two of the fund’s holdings, CCS.PR.C and EMA.PR.E, were dropped from the index because of low trading volume. We opportunistically bought more of these issues as index-linked ETF’s were obliged to sell.
We remain positive about the long term prospects for preferred shares, but we think there is the possibility that the market may continue to consolidate at current levels over the near term. The fund holds approximately 11% in cash equivalents that provide both a measure of defense and the capacity to add attractive new issues if they become available.
Financial markets experienced considerable volatility in October. The bond market rally that began in mid-September continued in the first half of the month. Risky assets, such as equities, fell sharply as investors worried about slowing economic growth and potential over-valuations, while less risky assets, including bonds, rallied significantly as investors sought to protect their capital. Indications of stronger economic growth, including good news regarding Canadian and U.S. labour markets, were generally ignored.
On October 15th, however, following substantial intraday volatility, the markets reversed course, with equities rallying over the balance of the month and bond prices falling. The S&P 500 U.S. equity index initially fell 7.7% from the previous month’s close and then surged to an all-time record by the end of October. Canadian stocks did not fare as well; the S&P/TSX initially fell 7.2%, but was unable to recover the losses by the end of the month. The FTSE TMX Canada Universe Bond index earned 0.57% in October, having been up as much as 1.46% earlier in the period.
For several months, we have been projecting Canadian economic growth to be tepid; in other words, positive but uninspiring. Economic data received during October confirmed that outlook. Unemployment fell to 6.8%, the lowest level since December 2008, on robust but suspiciously volatile job creation. Less positively, manufacturing and retail sales were both weaker than expected and Canada’s trade balance swung into deficit as exports faltered. Canadian GDP in the most recent month (August) was also weaker than forecast at -0.1%. Inflation held steady at 2.0%. The Bank of Canada released its quarterly Monetary Policy Report and acknowledged higher than expected inflation, but indicated concern about the pace of Canadian economic growth and the potential impact of weaker energy prices. The Bank also dropped its reference to being neutral and, in doing so, became the first major central bank to move away from providing forward guidance regarding rates.
U.S. economic activity was somewhat stronger than that in Canada. Unemployment fell to 5.9% from 6.1% on good job creation. In addition, higher numbers of unfilled job openings suggests that the labour market will continue to be favourable. Third quarter GDP grew faster than expected at +3.5% and industrial production grew robustly on a surge in utility production as well as a rebound in manufacturing. Less positively, even though consumer confidence surveys indicated increased optimism, that did not translate into actual spending as consumers actually reduced their expenditures. The U.S. Federal Reserve as expected ended its bond purchase programme known as quantitative easing. In its accompanying statement, the Fed avoided mentioning global growth as a concern, which encouraged some observers to conclude that the Fed would raise interest rates next year even if European growth remained problematic.
October 15th was one of those remarkable days that occur every few years in which markets experience extraordinary volatility and observers struggle for explanations. The catalyst for the volatility appeared to be some moderately weaker U.S. economic data that caused a sharp selloff in equity markets. As well, concerns about the Ebola virus and European economies possibly falling back into recessions helped produce a flight to safety bid for bonds. Rumours also circulated that continued large withdrawals from PIMCO were causing unwinds of their positions in illiquid market conditions. The US Treasury market experienced what appeared to be panic type buying in the morning. A very sharp run up in prices saw 30-year Treasuries trade 5 points higher than the previous day’s close. The trading pattern suggested one very large investor had to get out of a losing position, whatever the cost. Much of the buying occurred through the futures market, as dealers reported relatively light trades in the cash market. The jump in Treasury prices, though, caused global government bond prices, including those of Canada, to move sharply higher too. Over the balance of the day, bond prices retreated, giving up most of the mornings gains.
If there is a single global benchmark bond, it would be the 10-year U.S. Treasury, due to the size and depth of the U.S. bond market and the status of the United States as the world’s largest economy. Virtually every sovereign issuer in the world issues bonds with 10-year maturities and the yields of each of these are invariably compared to that of the U.S. Treasury. The Canadian bond market is no exception, with the spread between 10-year Canada’s and U.S. Treasuries followed closely by many investors and investment dealers. The Treasury doesn’t always have the lowest yield, but its movement tends to have broad influence on global bond markets. So the fluctuations in the 10-year Treasury yield during October were noteworthy. At one point, the benchmark yield had fallen by roughly a quarter over a two week period that did not include major disasters or economic collapses. Other bond markets, including Canada’s, moved in sympathy with U.S. Treasuries, although the magnitude of the moves was often more muted. The magnitude of the U.S. move provided an indication of the uncertainty in investors’ minds regarding growth and monetary policy, but also suggested significant speculative activity.
The Canadian yield curve shifted downward in a nearly parallel fashion in October. Yields of benchmark Canada bonds maturing from 2 to 30 years declined 8 to 11 basis points in the month. The decline in yields powered the federal sector, which returned 0.65% in the period. The provincial sector also returned 0.65%, as the benefits of longer durations was offset by provincial yield spreads widening by 4 basis points in the month. Corporate bonds gained only 0.38%, because their yield spreads widened an average of 7 basis points thereby offsetting most of the yield decline on benchmark Canada’s. New issue supply was subdued at only $5.8 billion, of which $5.0 billion was raised by Bank of Nova Scotia, CIBC, National Bank, and TD. In part, the reduced issuance reflected the nervousness of the markets. However, the banks’ October 31st yearends also played a part, because they were reluctant to add to positions that might have required additional capital. Real Return Bonds earned only 0.45%, as economic uncertainty dampened investor demand for inflation protection. Non-investment grade corporates fell 0.72% in the month, as investors sought to reduce risk within their portfolios. As a result of the October loss, high yield returns for the first ten months of 2014 trail those of investment grade corporates.
NexGen Canadian Bond Fund
The NexGen Canadian Bond Funds earned somewhat less than the benchmark in October. Interest rate anticipation was the primary reason for the shortfall. The duration of the portfolio was shorter than the benchmark, and that reduced returns as yields fell and prices rose. The sector allocation, which had over-weighted corporate bonds, reduced returns in the month as that sector’s results trailed those of government bonds. Security selection was also a small negative factor in the month. Yield curve positioning was a small positive.
Noteworthy transactions included a switch out of long term Canada bonds and into a long term Quebec issue to improve yield. We switched out of long term Canada bonds and into a long term Quebec issue to improve yield. We also switched out of the ultra-long Canada issue, because it was not trading as well as we had expected. The bond had been issued via syndication rather the auction process used for other Canada bonds, and as a result it had experienced reduced liquidity. In addition, we took advantage of the steep yield curve and switched out of June 2019 Canada Housing bonds and into a March 2022 issue to pick up 46 basis points in yield.
Outlook and Strategy
Looking ahead, we think October’s volatility will be followed by a period of consolidation as investors try to discern the path of economic growth and central bank policies. With quantitative easing finally finished, the focus for U.S. monetary policy will be the timing of the first interest rate increases. Fed officials are concerned about the durability of the U.S. expansion, but given that unemployment is below 6% and GDP growth has been averaging better than 3%, it makes little sense to leave interest rates close to 0%. We think the Fed will most likely wait until next June before starting a series of increases. An earlier start is possible, but unlikely unless U.S. growth accelerates significantly. The bond market, though, will anticipate the Fed’s first move by a few months. When that occurs, we would expect mid-term bond yields to be most affected.
The Bank of Canada is unlikely to raise Canadian interest rates until the Fed has raised its rates two or three times. Canadian growth is so slow that it is barely reducing the output gap that exists in this country. As well, the Bank wants to encourage exports, so it wants to avoid causing the exchange rate to strengthen. Rate increases in Canada are unlikely for at least twelve months.
Current yield levels offer little protection from a bond market selloff. Even though, the Bank of Canada is unlikely to raise rates for at least a year, we believe it is prudent to keep portfolio durations shorter than their benchmarks. A number of factors have driven yields to these levels including geopolitical concerns, fears of Ebola, equity market jitters, and pension fund rebalancing. As these factors fade in importance over time, previously ignored economic fundamentals may become more prominent. Should that occur, yields may drift higher well in advance of central bank moves.
The widening of corporate yield spreads in October had more to do with the impending fiscal year end of most investment dealers than a deterioration in creditworthiness. Most corporations are enjoying robust earnings and credit quality remains strong. That said, corporate yield spreads have narrowed substantially in the last few years and the risk/reward trade-off is no longer as compelling. Accordingly, we are being very selective about additions to the portfolios and looking for opportunities to take profits where appropriate.
Industrial Alliance announced today that it would be redeeming its Series E perpetual preferred shares, effective December 31, 2014. The $100,000,000 IAG.PR.E issue paid a 6.00% dividend rate, which made it expensive for the issuer. The redemption price will be $26.00 per share.
As always, holders of the shares being redeemed should talk with their advisors to determine whether it makes more sense to wait for the redemption or to sell now and reinvest.
Donald Nesbitt & Mikhail Alkhazov – Ziegler Capital Management
“October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.” – Mark Twain’s “Pudd’nhead Wilson”
American author and humorist Mark Twain’s witty assessment of the stock market cautions us that the opportunity provided by investing in stocks does not come without risk. The volatility exhibited by financial markets in October reminds us of the risk that lies beneath the advancement of the economy and its underlying investments. The recent market correction was ostensibly triggered by concerns over global economic growth and the specter of deflation, which are particularly acute in Europe. In the U.S., a disappointing decline in September retail sales combined with weakening readings of consumer and small business confidence as well as a drop in the Empire State manufacturing index fanned fears of falling economic growth. In addition, investors worried about the implications of the U.S. Federal Reserve’s cessation of government bond purchases (QE), which at one point was pumping $85 billion a month into financial markets and the economy.
We are mindful that as this recovery moves into its sixth year of expansion, it has been subject to “fits and starts”, characterized by fluctuating data and ambiguous signals. This uncertain environment should not come as a surprise, since the weak, protracted nature of this expansion is consistent with recoveries following recessions induced by financial crises, which require lower interest rate levels for longer periods to assist economic entities with deleveraging. We view the market’s recent weakness as just another “fit” along its course toward a higher path, supported by what we see as sustainable fundamentals. The economy would have to move into a recession, producing a decline in corporate earnings, for us to become “bearish” on the market.
Despite some softening in recent economic data, we see several positives such as improving employment figures, continued expansion in U.S. and global industrial production and rebounding business and consumer sentiment. Corporate earnings continue to grow, with Standard & Poor’s (S&P) reporting that 2Q’14 EPS for the S&P 500 Index (SPX) grew at 9% (year-over-year). Third quarter earnings reporting began in October, with S&P indicating that consensus estimates call for 11% (year-over-year) growth for third quarter S&P 500 earnings.
The NexGen US Dividend Plus Fund benefits from a U.S. dollar that appreciates relative to the Canadian dollar. Strong U.S. dollar appreciation provided a strong tailwind to the Fund’s performance during September, but that effect was essentially flat in October, as the U.S. currency appreciating by only 0.6% against the Canadian dollar.
U.S. equities began the month of October in steep retreat, but recovered in the latter half to end the month with reasonable gains. The Large-cap S&P 500 Index gained 2.4% in October. Value-oriented equity management approaches generally underperformed growth-tilted strategies during October, as investors sought out companies displaying stronger prospects for future earnings growth. The Russell 1000 Value Index increased 2.2% in October, led higher by the defensive Health Care (+4.0%) and Utilities (+8.0%) sectors, while the cyclically sensitive Energy (-2.9%) and Materials sectors (-2.0%) experienced losses on back of weaker energy and commodity prices.
The NexGen US Dividend Plus Fund carries an over-weight to the cyclically sensitive Industrials and Financial sectors, relative to the Russell 1000 Value Index. The Fund holds a moderate under-representation to Materials and Utilities stocks and a considerable underweight of Consumer Staples holdings; the latter two sectors being more defensive in nature. These sector allocation differences, which favor the more cyclically sensitive areas of the economy over the defensive segments, reflect our belief that the market will likely favor companies that benefit from an improving economy and exhibit relatively stronger earnings and dividend growth.
Although the Fund was underweight to Utilities stocks, relative to its benchmark, its holdings in the sector performed well, led by positions in Southwest Gas Corp. (SWX) that appreciated 19.6% and a holding of Edison International (EIX) that returned 11.9% in October. Financial stocks generally did well in October, with holdings in the Real Estate Investment Trust (REIT) industry doing exceptionally well on the back of lower interest rates. The Fund’s holding of retail REIT Weingarten Realty Investors (WRI) returned 15.1% and a position in Apartment Investment and Management Co. (AIV) appreciated 12.5% in October. The Fund’s holdings in the insurance industry also performed well, led by positions in The Travelers Co. (TRV) and The Chubb Corp. (CB) that appreciated 7.3% and 9.1%, respectively in October.
The Fund carried a relatively large holding in global energy exploration and producer ConocoPhillips (COP), which declined 4.8% in October with the fall in energy prices. A position in LyondellBasell Industries (LYB), an industry leader in plastics manufacturing, fell 15.7% in October as falling oil prices undermine its advantage from using natural gas as an input for its products.
We remain optimistic about the outlook for U.S. equities. The low interest rate environment appears to be in place for a “considerable period”, bolstered by a strong dollar to stave off inflation. The prospect of continued earnings growth discounted at low rates provides an ideal backdrop for further gains in U.S equities. However, we are also mindful that the idyllic conditions supporting current market valuation are about as good as they can get, with current market valuation reflecting expectations that profits will continue to expand while interest rates will remain low. October’s volatility was a reminder that any threats, real or perceived, to these supportive conditions could produce near-term turbulence in the equity markets.
Mark Twain’s recognition of the risks associated with investing are as relevant today as they were 120 years ago. We recognize that the best way to weather periods of equity market instability is to construct and manage a well-diversified portfolio of stocks with attractive fundamentals supported by strong cash flows generated from sound business practices.
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