Canadian preferred share prices continued to move upward in a seesaw pattern during March. An absence of new issues and occasional ETF flows were contributing factors behind the market strength. Interestingly, increased purchases of preferred share ETFs had a delayed reaction to underlying preferred share prices. As well, when ETF volumes declined, it led to preferred share prices retracing their gains. The S&P/TSX Preferred Share index returned 1.81% in the month. The Solactive Laddered Rate Reset index gained 2.13%, as rate reset issues outperformed other types of preferred shares.
During March, five issues (BAM.PR.T, BCE.PR.O, BPO.PR.P, FFH.PR.K, and MFC.PR.C) reset their dividend rates. In each case, there was insufficient interest in the floating rate option and all holders will continue to receive fixed rate dividends for the next five years. In contrast with most of 2016, when the floating rate option was often selected by investors, very few have tried to switch to floating rate dividends in recent months. The likely explanation for the change is the significant widening of the yield spread between 5-year Canada bonds and 3-month Treasury Bills following Donald Trump’s election as U.S. president. As a result, the floating rate option yielded 50 to 75 basis points less than the fixed rate alternative and few investors were willing to forego that much income.
The pickup in new issue supply that occurred in February proved short lived; there were no new issues in March. As a result, any buying interest had to be satisfied in secondary trading, which was supportive of preferred share prices during the month.
The supply of perpetual preferred shares continued to shrink. Last month, we noted that the proceeds of the new Bank of Montreal issue were likely to be applied to the redemption of two perpetual issues. As this is being written, the bank has announced that it will be calling both the BMO.PR.K and BMO.PR.L perpetual issues on May 25th. As well, Bank of Nova Scotia announced the redemption of its BNS.PR.O issue effective April 26th. In total, the three bank perpetual issues accounted for $730,000,000, which will presumably need to be reinvested by the respective holders in April and May.
In addition, Brookfield Office Properties announced the full redemption of its BPO.PR.K shares and the partial redemption of its BPO.PR.J shares effective March 31st. Both series were relatively small retractable issues.
NexGen Canadian Preferred Share Fund
Fund performance in March trailed the benchmark slightly. Security selection was generally favourable, but relatively high cash levels and a somewhat elevated allocation to straight preferred shares negatively impacted performance.
Notwithstanding relatively illiquid conditions and a lack of new issue supply, we chose to profit from some series of preferred shares that we felt had little room for further appreciation. The BMO.PR.B holding was sold. While additions were made to several other holdings, the cash position rose from 3.2% to 6.4%. New issues coming to market will allow the cash to be deployed quickly and at more attractive yields than currently available in the secondary market.
Market Outlook and Strategy
On April 12th, the Bank of Canada (BOC) will release its quarterly Monetary Policy Report and announce its next decision regarding interest rates. We believe the BOC is unlikely to change rates at that time, but it will be very interesting to learn how the BOC reacts to the recent string of stronger than expected economic data. Non-energy exports, one economic sector which the BOC has been focusing on, has remained disappointingly weak. While the balance of the economy has been performing much better than the BOC had anticipated. The amount of economic slack in the Canadian economy, known as the output gap, will have been substantially reduced in the last three quarters. With the Canadian inflation rate already at the 2% target, the BOC will be hard pressed to stay as dovish as it has been on the direction of interest rates for the next few quarters.
Should the BOC acknowledge the improvement in the Canadian economy, it may adjust its forecast for the closing of the output gap (i.e. when the economy will return to full employment). That, in turn, will have implications for the timing of raising interest rates. Any indication that they’re more likely to raise rates in the next year will lead to a reaction in the bond market. Shorter-term bond yields will probably adjust upward. However, if the BOC does not give any indication that it is changing its outlook, the bond market may start to discount future monetary tightening on its own if the economic data remains strong. If our analysis is correct, floating rate preferred shares should strengthen and rate reset issues may also rally as bond yields rise.
From a long-term perspective, preferred shares have moved slightly below their historical average yield of 5.00%, but alternative fixed income investments such as bonds continue to yield near record lows. This suggests that the recent growth in institutional demand will remain a significant factor in the preferred share market in 2017. New issue supply, however, is unlikely to be sufficient to satisfy the additional demand and that bodes well for further price appreciation of preferred shares this year.
For more information about NexGen Canadian Preferred Share Funds, please contact your financial advisor.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual fund securities are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer.
This release may contain “forward-looking statements” which reflect the current expectations of NGAM Canada LP and/or its sub-advisor, J. Zechner Associates Inc. (“J. Zechner”). These statements reflect the applicable management’s current beliefs with respect to future events and are based on information currently available to such management. Forward-looking statements involve significant known and unknown risks, uncertainties and assumptions. Many factors could cause actual results, performance or achievements to be materially different from any future results, performance or achievements that may be expressed or implied by such forward-looking statements including, without limitation, those listed under the heading “Risk Factors” in the NGAM Canada LP NexGen Funds prospectus, which is available on NGAM Canada LP’s website and on SEDAR at www.sedar.com. Should one or more of these risks or uncertainties materialize, or should assumptions underlying the forward-looking statements prove incorrect, actual results, performance or achievements could vary materially from those expressed or implied by the forward-looking statements contained in this release. Although the forward-looking statements contained in this release are based upon what NGAM Canada LP and/or J. Zechner believes to be reasonable assumptions, NGAM Canada LP and J. Zechner cannot assure investors that actual results, performance or achievements will be consistent with these forward-looking statements. These forward-looking statements are made as of the date of this release and NGAM Canada LP and J. Zechner do not assume any obligation to update or revise them to reflect new events or circumstances.
NGAM Canada LP is the manager of the Fund and is an affiliate of Natixis Global Asset Management S.A.