Following their very strong gains in January, Canadian preferred shares continued to move upward in price in February, but at a more subdued pace. Reduced activity in preferred share Exchange Traded Funds (ETFs) probably accounted for the smaller preferred share gains. The Bank of Montreal Laddered Rate Reset ETF (ZPR) experienced a 45% drop in units created from January to February, although a meaningful $81.8 million still flowed into the ETF. We suspect that the lower activity in ZPR reflected reduced hedging requirements for structured notes as the RSP season wound down. Because of the lower demand for rate reset preferred shares, that sector underperformed the broad market for the first time since last September. Also in February, new issue activity increased to four issues, compared with only one the previous month. The S&P/TSX Preferred Share index returned 1.49% in the month.
Following a quiet January, the pace of new issues picked up in February. Details of the four new series of preferred shares were as follows:
The Brookfield Renewable Partners issue was comprised of units, rather than shares, and its payments will consist of a combination of dividends, return of capital, and interest. Each of the Brookfield Renewable Partners, Brookfield Office Properties, and Altagas issues was initially $200,000,000 in size, but was upsized in response to investor demand. The Bank of Montreal issue was limited to $500,000,000 likely because the proceeds will be used to redeem two perpetual issues in March and May which total that amount.
The tiny universe of retractable preferred shares became even smaller in February when Brookfield Office Properties announced it was redeeming all of the BPO.PR.K series and 62.9% of the BPO.PR.J series. In total, retractable issues make up only about 0.6% of the preferred share market.
Also during February, TransAlta decided not to proceed with its previously announced offer to exchange all its existing series of preferred shares into a new series of shares. TransAlta had hoped to reduce the face value of its outstanding preferred shares by over $300 million if the exchange had been successful. No explanation was given for the cancellation, but investor dissatisfaction with the plan was likely the reason. Interestingly, all five series of TransAlta preferred shares appeared to hold their values after the cancellation and did not revert to the lower prices that prevailed prior to the announcement in December.
NexGen Canadian Preferred Share Fund
The Fund performed in line with the benchmark in February. Security selection was favourable during the period, with several holdings including the TransCanada, Shaw Communications, and Cooperators holdings enjoying better than 4.00% returns. The good results from security selection offset the negative impact of our somewhat defensive 5.00% cash position held for part of the month.
The Fund participated in the new BEP.PR.K and BMO.PR.C issues. In addition, we added some small positions in non NVCC-compliant bank preferred shares that are likely to be called in the next two years. Because these issues can only be called once every five years, we believe the respective issuers will choose to call them at the next possible date, because they will receive zero capital treatment after 2021. The yields to next call for these issues were quite attractive.
Market Outlook and Strategy
From a long-term perspective, preferred shares are close to their historical average yield of 5.00%, while alternative fixed income investments such as bonds continue to have yields near low level records. 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.
The path to higher prices may not be smooth if the structured note hedging activity of recent months starts to unwind. Given the illiquidity of the preferred share market, any significant reduction in the ZPR hedges will probably cause some short-term volatility.
As this commentary is being written, the Bank of Canada (BOC) has reaffirmed its stand-pat monetary policy. Citing persistent economic slack and dismissing the recent jump in inflation as temporary, the BOC left its interest rate targets unchanged. It appears that the BOC is unlikely to raise rates for the next 12 to 18 months. As a result, we do not think 5-year Canada bond yields are likely to rise significantly from current levels. That suggests they will provide little support for further appreciation of legacy rate reset issues. In this area of the market, as in others, selectivity will be key to success.
For more information about NexGen Canadian Preferred Share Funds, please contact your financial advisor.
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NGAM Canada LP is the manager of the Fund and is an affiliate of Natixis Global Asset Management S.A.Tags: bond, bond yields, ETF, market, NexGen Canadian Preferred Share Fund, perpetual issues, preferred share market, Preferred Shares, rate reset, yield