The preferred share market was fairly quiet in November. Prices generally drifted upward because there was little new issue supply to satisfy investor demand. There was also an absence of redemptions during the period, although there were some rate reset issues that were extended. The S&P/TSX Preferred Share Total Return Index returned 0.73% in November.
Perpetual preferred shares enjoyed good performance in the month, gaining an average 0.89% in price and 1.17% in total return. By comparison, floating rate issues had an average total return 0.41%, and rate reset issues earned 0.34%. A number of rate reset issues with low reset spreads fell sharply in price during November as investors realized that the issues were not likely to be redeemed or trade back at par in the foreseeable future. We have been avoiding most issues with low reset spreads because we believed them to be overvalued. It also seemed that investors became more conscious of credit quality during November, as higher quality issues performed well but lower quality issues were under pressure.
The weakness in rate reset issues with low spreads appeared to be the result of three issuers announcing that they would be rolling over their respective issuers. Atlantic Power, which has fallen to speculative quality as a result of poor financial results, announced it would be resetting the dividend rate on the AZP.PR.B issue at a spread of 418 basis points over 5-year Canada bonds. The announcement was not a surprise because the company would have a difficult time refinancing the issue and the market expected that because the shares were trading for little more than half their issue price. TransCanada announced that it would not redeem the TRP.PR.A issue, and would reset the dividend rate at 192 basis points over Canada bonds. If TransCanada had tried to issue new preferred shares during the month, we estimate that the dividend rate would have been about 50 basis points higher, so it made sense that the issuer was extended. The third issuer that extended a preferred share issue in November was Fairfax Financial. The company decided to reset its FFH.PR.C issue at 315 basis points over Canada bonds, presumably because it was unclear that it could refinance at a lower cost. The Funds hold the FFH.PR.C issue and we were indifferent to whether it was redeemed or extended. We will be converting the holding into a floating rate issue that will pay dividends equivalent to the yield on 3-month Canada Treasury Bills plus 3.15%.
The banks were noticeably absent from the new issue market in November, primarily because they were in “blackout” prior to their year-end financial results being released during the month. They are expected to be back in the market during December, but some dealers have reported that clients are concerned that NVCC Bank preferred issues are expensive at current levels. We agree.
Last year, the preferred share market came under pressure when there was a substantial amount of tax-loss selling in November and December. We expect there will be considerably less this year, because price action in 2014 has been much better and there are not a lot of issues that have declined significantly in value. As we noted last month, we remain positive about the long term prospects for preferred shares, but we think there is the possibility that the market may consolidate over the near term. The Funds hold approximately 15% in cash equivalents that provide both a measure of defense and the capacity to add attractive new issues if they become available. The cash level increased both as a result of new deposits to the Funds, due to our purchase discipline, and the sale of the PPL.PR.E holding. The Pembina issue had appreciated since purchase, and with the issuer coming to market regularly, we believed it was time to take profits.
The Canadian bond market enjoyed healthy gains in November as bond prices rose and yields fell. Good
economic news in Canada and the United States, and there was a lot of it, was generally ignored; investors focused instead on disappointing economic growth in Europe and China.
In Europe, speculation continued about potential quantitative easing by the European Central Bank to counter moribund growth and that prompted European bond yields to fall to record lows, with Canadian and U.S. bond yields following in sympathy. In China, the central bank cut interest rates as growth appeared to have slowed below the country’s +7.5% target growth rate. Canadian and U.S. bond prices were also pushed higher by speculators positioning for bond index durations lengthening in early December. The FTSE TMX Canada Bond Universe gained 1.55% in the month.
Canadian economic news in November was generally better than expected. For example, third quarter GDP grew at a +2.8% pace that beat expectations of +2.1%. The unemployment rate plunged to a 6-year low of 6.5% from 6.8% a month earlier, as job growth remained robust. Retail sales were stronger than forecasts, and wholesale sales grew by 1.8% in the month, more than double expectations. In addition, Canada’s trade balance unexpectedly moved back into surplus, as exports rose and imports declined. The only really negative news in November was that inflation surged to 2.4% from 2.0% a month earlier. Notwithstanding four consecutive months of dropping gasoline prices, higher prices for food and clothing, among other items, led overall prices higher.
In the United States, the economic news was also good, although not as uniformly so as in Canada. On the positive side, the estimated pace of U.S. GDP growth in the third quarter was revised up to +3.9% from an earlier estimate of +3.5%. Combined with the +4.6% pace of the second quarter, the two most recent quarters experienced the fastest growth since 2003. Unemployment declined to 5.8% from 5.9% even as the participation rate increased slightly. Manufacturing surveys improved and retail sales were slightly better than forecasts. Less positively, industrial production unexpectedly fell due to weaker utility and mining output. As well, personal income and spending were weaker than expectations. Inflation held steady at 1.7%, rather than falling as forecast, and core inflation accelerated slightly.
Perhaps the most important development in November was the plunge in the price of oil. Oil prices had been declining since they hit the year’s highs ($107.73 per barrel for WTI) in late June, but the decline accelerated in November. News late in the month that OPEC would not cut production to stem the decline resulted in a further sharp drop in prices. By month end, oil had fallen to $66.15 per barrel, down 18% in the month and more than 38% from the June high.
Determining the impact of the fall in the price of oil is like the question of whether a glass is half full or half empty; it depends on your perspective. For the Canadian energy sector, it is clearly a negative development, although with oil prices set in U.S. dollars, the drop in the Canadian exchange rate is offsetting some of the pain. As well, the differential between Canadian oil prices (Western Canadian Select) and U.S. oil prices (West Texas Intermediate) is currently fairly small, which is also beneficial for Canadian producers. If prices stay low for very long, though, there may be reduced spending on drilling and major capital projects such the oil sands. Outside of the energy sector, the drop in oil prices is like a large, broadly based tax cut. Consumers will have more money to spend on other things, and businesses that use a lot of oil, such as airlines, will have improved profitability. Governments, though, will have less royalty and tax revenue as a result of the lower oil price. The impact on inflation is positive, of course, but as we have seen in the Canadian data, it can be offset by other factors. Overall, the drop in oil prices should be stimulative for the global economy.
In recent years, the longstanding correlation between the price of oil and the Canadian exchange rate appeared to weaken. This year, though, the correlation has again become very apparent. The weakness in the exchange rate has not been a Canadian phenomenon, as the U.S. dollar has gained in value against almost every other currency in recent months. Since mid-year, as the Loonie has fallen 6.5%, the Pound has fallen 8.5%, the Euro 9.1%, and the Yen 14.6%. Only the Chinese Renminbi has gained versus the U.S. unit. It seems the currency markets are paying more attention to relative economic strength than the bond markets.
The Canadian yield curve flattened in November as 2-year Canada bond yields declined 4 basis points while the yields of bonds maturing in 5 years and longer dropped 17 to 20 basis points. Remarkably, the monthly changes in Canadian bond yields were greater than the declines in U.S. bond yields, an event which rarely occurs. The decline in yields propelled federal bonds to a monthly return of 1.18%. Provincial bonds, which have significantly longer durations on average, gained 2.28%. Provincial returns were also helped by their yield spreads narrowing 2 basis points versus benchmark Canada bonds. Corporate bonds fared little better than federal issues, returning 1.22%. On average, corporate yield spreads widened marginally versus Canada bonds, led by bank subordinated debt spreads that increased by up to 10 basis points as investors re-evaluated the relative risks of that class of bank capital. New corporate issuance in November was fairly active at $9.0 billion. Non-investment grade bonds markedly underperformed investment grade issues, returning -0.73% in the month. The decline in Canadian high yield bond prices closely followed the drop in U.S. high yield bonds. Real Return Bonds earned only 1.66% in November, thereby lagging nominal bonds with similar durations. Apparently, investors focused less on actual inflation than the potential impact of falling oil prices on future inflation.
NexGen Canadian Bond Funds
The portfolio slightly underperformed the benchmark in November. Interest rate anticipation lowered returns because portfolio duration was shorter than that of the benchmark as the market rallied. Sector allocation was reduced results by a small amount due to the overweight allocation to corporate bonds and slightly underweight positioning in long term provincial issues. Yield curve positioning was also a small negative factor in the month. On the positive side, security selection added to returns. A number of corporate holdings enjoyed narrower yield spreads, with the NVCC issues of CIBC and Bank of Montreal leading the way as they tightened by 8 basis points each.
New investments included an amortizing asset backed security, Silver Arrow Leasing Corporation (SALC), (supported by Mercedes Benz car leases), a 10-year Powerstream bond, a 7-year new issue from Thomson Reuters, and a 20-year bond from Metro Inc. The Cominar REIT floating rate note was sold.
Outlook and Strategy
There is an axiom in the investment business that “the market is never wrong”. That may be true, but it appeared that global bond markets were at least defying gravity in November. While Eurozone economies continue to stagnate and Japan struggles to break free of deflation, growth in countries such as the United States, Great Britain and Canada has been satisfactory. The need for extraordinarily low interest rates has long past, and cautious central bankers will finally start raising rates in 2015. The bond market does not appear to recognize that likelihood, however. In Canada, every Government of Canada bond maturing in the next 20 years yields less than inflation, which begs the question “Why would anyone buy those bonds?” With the economy performing reasonably well and a relatively stable stock market, there hasn’t been a flight-to-safety bid for bonds that could account for the low yields. Instead, there simply seems to be too much money chasing too few bonds. Given the amount of bonds issued by all levels of governments to fund their respective budget deficits since the crisis, that really reflects the incredible amount of monetary stimulus that has been provided. While consumer inflation has been relatively contained so far, there clearly has been inflation in the prices of financial assets such as bonds, stocks, and even real estate.
We believe that current yields are not attractive and prefer to keep portfolio durations below benchmark levels to protect from potential increases in yields. However, we recognize that the current bond market rally may extend a little further, and with liquidity declining during the holiday season, we are cautious about potential volatility. With regard to the different market sectors, we continue to emphasise corporate bonds. At this stage of the economic cycle, corporate profitability remains good and the additional yield available on corporate bonds is appealing. With regard to individual issuers, we maintain our longstanding aversion to commodity exposure, so we continue to hold no oil & gas companies.
We would like to thank you for your continued support and we extend our best wishes to you for happy and healthy holidays.
WPT Industrial REIT (WIR-U)
WPT owns warehouses and distribution centres in the US, and is benefiting from the growing e-commerce trend. They are a smaller and more nimble player than some of their peers, which allows them to pick up overlooked assets at accretive prices. WPT has a 6.6% dividend yield and the ability to grow this over time.
Keyera is a midstream energy infrastructure company with exposure to oil, gas, and NGL processing, transportation, storage, logistics, and marketing. The company has a 3.4% dividend yield and has a pipeline of projects that will help deliver increasingly better financial results in the coming years, which should ensure ongoing dividend growth. We view this recent pullback as an entry opportunity for a company with a secular growth story.
Gildan Activewear (GIL)
Gildan is a manufacturer and marketer of wholesale and branded activewear in North America. The company has major competitive advantages and will benefit from the slide in cotton and energy prices throughout 2015. Although their recent quarter was a slight disappointment, the company raised the dividend by approximately 20% and initiated a share buyback. The company has a 1% dividend yield, but this is offset by significant earnings and dividend growth in the years ahead. Jeff Young is the Lead Manager of the NexGen Canadian Dividend Funds, Canadian Diversified Income Funds, and North American Large Cap Funds.
Donald Nesbitt & Mikhail Alkhazov – Ziegler Capital Management
The specter of disinflation made itself known in November, as many of the major central banks stepped up their efforts to provide liquidity – even while the U.S. Federal Reserve was ending its Qualitative Easing program. China made a surprise announcement that it was cutting its interest rates for the first time in two years and European Central Bank (ECB) president Mario Draghi signaled that the ECB would be expanding its stimulus program. The Bank of Japan has pursued further monetary policy ease, as the second quarter increase in the VAT tax increase pushed the economy back into recession and Canada’s central bank succeeded in taking policy rates up to 1%, before economic conditions caused them to refrain from further tightening.
Lower inflation expectations are reflected in the low sovereign bond yields across the globe. The U.S. has been showing decent economic growth relative to other developed nations, yet the yield on the 10-year U.S. Treasury is back below 2.2% (started the year at 3%), and long-term inflation expectations priced into the TIPS market are again below 2% (was 2.4% last summer).
Oil prices plummeted by almost 18% in November after OPEC declined to cut production in response to increasing supply. Lower energy prices should initially lessen headline inflation, while energy companies’ profits will come under pressure and lead to cutbacks in capital investment for the sector. However, the expansionary effects of lower oil prices should eventually stimulate overall consumer demand and help boost employment and assist the global recovery.
The NexGen US Dividend Plus Funds’ benefit from a U.S. dollar that appreciates relative to the Canadian dollar. The U.S. dollar appreciated about 1.3% against the Canadian dollar in November, helping the Funds’ relative performance.
U.S. equities moved steadily higher in November and ended the month with reasonable gains. The Large-cap S&P 500 Index gained 2.7% in November, while smaller issues did not fare as well; the S&P 600 Small-cap Index lost 0.3% and the S&P 400 Midcap Index gained only 1.8% for the month. Value-oriented equity management approaches generally underperformed growth-tilted strategies during November, as investors sought out companies displaying stronger prospects for future earnings growth. The Russell 1000 Value Index increased 2.05% in November, led higher by the cyclically sensitive Consumer Discretionary (+7.8%) and Information Technology (+7.1%) sectors, while the more defensive, and higher yielding Telecommunication (+1.2%) and Utilities (+1.0%) sectors lagged. Energy stocks fell along with lower oil prices, leaving Energy (-8.0%) as the only sector to post a loss in the month of November.
The NexGen US Dividend Plus Funds carry an over-weight to the cyclically sensitive Industrials and Information Technology sectors, relative to the Russell 1000 Value Index. The Funds hold 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.
Financial stocks generally performed in line with the market during November, but many of the Funds’ financial stock holdings performed relatively well. Several of the Funds’ holdings in the Real Estate Investment Trust (REIT) industry did exceptionally well on the back of lower interest rates. The Funds’ holding of retail REIT The Macerich Company (MAC) returned 13.2%, the mortgage REIT Chimera Investment Corp. (CIM) returned 8.3% and a position in Apartment Investment and Management Co. (AIV) appreciated 4.8% in November. The Funds’ holdings in the insurance industry also performed well, led by positions in The Allstate Corp. (ALL) and ACE Limited (ACE) that appreciated 5.5% and 4.6%, respectively in November.
The Funds carried a relatively large holding in global energy exploration and producer ConocoPhillips (COP), which declined 8.4% in November with the fall in energy prices. A position in LyondellBasell Industries (LYB), an industry leader in plastics manufacturing, fell 13.3% in November as falling oil prices undermined its advantage from using natural gas as an input for its products.
The Funds were rebalanced in November to better position its risk and return attributes. Our stock positions in the Financials sector were reduced to reflect a near neutral allocation relative to the benchmark Russell 1000 Value Index and we increased our exposure to the cyclically sensitive Information Technology, Industrials and Materials sectors.
Equity valuations appeared reasonably in-line with historic multiples at the end of November. We see little or no additional return potential from further profit margin expansion, as margins are at historically high levels. Earnings growth will depend upon increases in revenue and, in the absence of further multiple expansion, equity price returns will track moderate growth in global GDP. The low interest rate environment in place for a considerable period may have been extended, bolstered by a strong dollar. A muted inflation outlook enhances the relative attraction of equities as an attractively priced alternative to fixed income investments.
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