Jeff Herold

Jeff Herold, Portfolio Manager, NexGen Canadian Preferred Share Fund

The Canadian preferred share market moved sharply higher in December as large scale buying of preferred share Exchange Traded Funds (ETFs) pushed the prices of individual issues upward. A lack of new issues contributed to the market’s strength. As well, in contrast with recent years, there was relatively little tax-loss selling in December. Rate reset issues performed particularly well as a result of direct investor interest and also due to hedging of structured products. The S&P/TSX Preferred Share Index returned +3.59% in the month.

 

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As noted above, rate reset preferred shares were particularly strong, with the Solactive Laddered Rate Reset Index gaining 5.21% in the month. In addition to higher than normal trading volumes, the creation of new BMO Laddered Rate Reset Preferred Share Index ETF (ZPR) units was particularly high, at $141 million in December and $39 million on December 23rd alone. The recently created RBC Canadian Preferred Share ETF (RPF), which has focussed on rate reset issues, saw an additional $60 million of inflows in the month. While the RPF flows and some of the ZPR inflows reflected demand by end investors, we believe that a substantial portion of the ZPR flow was used by some banks to hedge new structured ZPR notes. The notes, which were very complex and aimed at retail investors, linked their returns to ZPR and became available for sale in mid-December. In some cases, the notes had principal protection.

There were no new issues of preferred shares in December. The absence of issuance was a little surprising given that issuers are sometimes opportunistic when markets are strong, but it probably reflects the relatively small number of companies that issue in the Canadian preferred share market. Most of the active issuers have very specific, planned capital requirements that make the issuers less responsive to market conditions.

The only rate reset shares that reset their dividend rate in December belonged to the MFC.PR.G (Manulife) issue. Manulife announced that an insufficient number of shareholders had wanted to convert to the floating rate alternative, hence all the holders would be receiving the new fixed rate of 3.891%, down from the original 4.40% rate.

In other corporate developments, TransAlta Corporation proposed a plan of arrangement in which all of its existing series of preferred shares would be exchanged into a single rate reset issue that would have a minimum dividend rate. TransAlta currently has four fixed rate reset series and one floating rate reset series outstanding, with all of them trading at significant discounts to par. Under the plan, the existing preferred shareholders would receive a lower number of the new shares, but a higher dividend rate (6.50%) and be compensated by potentially improved liquidity. TransAlta’s notional capital balance of outstanding preferred shares would decline by approximately $300 million, giving the company greater flexibility to issue additional preferred shares in the future. The surprise announcement resulted in some series of TransAlta preferred shares jumping 10% or more in price that day, but they remained well below par. We did not hold TransAlta preferred shares because of credit concerns and the restructuring announcement did little to assuage our concerns.

NexGen Canadian Preferred Share Fund
The Fund earned good returns in December, but trailed the index’s results during the period. The Fund’s less than market weight allocation to rate reset issues resulted in relatively lower returns during the month.

During December, the Fund added rate reset issue holdings of Element Fleet Management, Fortis Inc., and TD Bank. The portfolio proportion held in rate reset issues was 51% at the end of the period, compared to the index’s weight of 73% and the market’s weight of 69%. Perpetual issues made up 43% of the portfolio versus 23% in the index and 24% in the market. We anticipate adding to rate reset holdings and reducing the cash position in the coming month.

Market Outlook and Strategy
Institutional participation growth in the preferred share market which has occurred over the last couple of years is unlikely to reverse any time soon. With somewhat limited supply from the relatively few issuers utilizing preferred shares, the increased demand by institutional investors bodes well for preferred share performance. Even before the tax advantages of dividends versus interest are considered, preferred shares are a cheaper alternative to bonds (when comparing the same issuers). While preferred shares are economically sensitive (they do not perform well in recessions), we believe economic growth will remain positive in 2017. Consequently, we are bullish on preferred shares and believe they should play an ongoing role in investors’ diversified portfolios.

In recent months, rate reset issues have outperformed other preferred share market sectors. In part, this was reflected by the rise in the five-year Canada bond yield from record low levels of ~0.50% to about 1.10%. With the Bank of Canada’s potential interest rate decrease in 2017 and a slight possibility of a rate increase before mid-2018, the likelihood for five-year bond yields continuing to increase seems limited. Thus, the support for rate reset shares from rising bond yields may wane.

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The superior performance of rate reset issues in recent months also appears to have been a rebound from their massive underperformance in 2015 and in early 2016. As a result of the strong upward move in rate reset prices, perpetual issues have become relatively more attractive. Combined with eye-catching yields of 5.50% or more, the relative value proposition of perpetual issues has improved significantly. As a result, we are monitoring the market for potential opportunities to add to the perpetual holdings.

Looking ahead to 2017, there are approximately $6.1 billion of rate reset issues that will be resetting their dividend rates. In contrast with the preferred shares that reset in 2015 and 2016 which had reset spreads generally below 200 basis points, the shares rolling over in 2017 have reset spreads between 260 and 350 basis points. The larger reset spreads combined with higher current five-year Canada bond yields mean that most dividend rates will not experience severe reductions as those of the last two years. However, current new issue reset spreads are well above most of those rolling over this year, so we anticipate that issuers will, in most cases, choose not to redeem the outstanding issues.

We do anticipate a few redemptions within the perpetual sector of the preferred share market. Several issues have dividend rates of 5.80% or higher and issuers will be considering the benefit of refinancing the issues with lower rate reset issues. In addition, BNS.PR.N and BMO.PR.L perpetual issues become callable at par for the first time in 2017 and because they are not non-viable contingent capital -compliant they are probably going to be redeemed by their respective banks.

Finally, we would like to take this opportunity to wish you and your family a healthy and happy 2017.

 

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. The indicated rates of return are the historical annual compounded total returns including changes in share value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. 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.

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