The preferred share market declined in August as risk-off sentiment permeated most financial markets. Geopolitical concerns arising from a nuclear shouting match between North Korea and the U.S. were the main cause of the more cautious investor attitude. Terror attacks in Europe and the threat of a U.S. government shutdown exacerbated the risk-off sentiment. In this environment, bond prices rallied and yields declined. 5-year Canada bond yields fell 12 basis points, which caused some preferred share investors to re-evaluate and lower the potential yields for issues resetting in the next two to three years.
The S&P/TSX Preferred Share index returned -0.74% in August. Rate reset issues were the weakest sector, because of the decline in 5-year bond yields. Floating rate issues were also weak, because in the risk off sentiment, it was thought that the Bank of Canada (BOC) was less likely to raise rates going forward, so the floating dividend rates would remain low. Perpetual issues fared somewhat better in the month, eking out small gains on average.
There were two new issues in August. The first was an inaugural issue from Kinder Morgan Canada. The company’s plans to expand the Trans Mountain Pipeline have been attracting political opposition in B.C., notwithstanding federal approval, and that may have resulted in a smaller than hoped for issue, even though it had an attractive dividend rate. The second issue was a perpetual issue from Intact Financial that failed to attract much interest. Details of the issues were as follows:
Institutional interest in preferred shares has declined in recent months. One indicator of that trend has been numerical participation in new issues. The number of institutional buyers, which hit a high of 84 in October 2016 with a Bank of Montreal issue, has dropped sharply in recent months. The new Kinder Morgan issue attracted only 26 institutional buyers, while a TD Bank new issue in July only had 20 institutional participants. Another measure of institutional interest is the proportion of new issues being allocated to institutional versus retail buyers. At the peak of institutional interest, over 70% of new deals were being allocated to institutional buyers. In recent months, institutional participation has rarely exceeded 35% (the Kinder Morgan issue was a notable exception).
Several factors are likely behind reduced institutional activity. Some investment dealers have reported that there has been resistance to purchasing new rate reset issues with reset spreads declining close to 300 basis points. (Recall that, in 2016, most new issues had reset spreads well above 400 basis points.) The lower the reset spread, the greater the risk that the issue will be extended rather than redeemed in five years. Therefore, bond portfolio managers dabbling in preferred shares to improve yields have less confidence comparing the shares to 5-year bond alternatives. Another factor was that some institutional investors were focused on the oversold nature of preferred shares in 2015 and early 2016, and now that the momentum of the recovery has dissipated, they have moved on to other asset classes. A further reason for lower interest in preferred shares has been the decline in rate reset dividend yields from roughly 5.50% a year ago to 4.70% currently.
During August, a number of issuers announced the terms for their dividends to reset and the conversion options to floating rates. For the first time in the nine years that rate reset issues have existed in Canada, some issuers will raise their dividend rates above their respective original rates. The VSN.PR.A shares will reset from 4.40% to 4.46% and the TA.PR.H dividend rate will move from 5.00% to 5.194%.
Natixis Canadian Preferred Share Fund
Pembina Pipeline, Algonquin Power, TransCanada, and Enbridge all lagged the market. In a few cases the Fund’s holdings also underperformed other issues from the same company. Our analysis suggests that the underperformance was primarily due to random price adjustments within an illiquid market and the number of laggards in the month was simply coincidental.
Noteworthy transactions during the month included participating in the new Kinder Morgan issue. In our view, the dividend rate was attractive and the company’s ability to pay dividends was well supported from existing assets and not dependent on the success of the Trans Mountain Pipeline expansion. The Fund also purchased small positions in U.S. dollar denominated issues of Altagas and Enbridge. The allocation to perpetual issues was reduced from 34% to 32% in the month, as we trimmed several perpetual holdings. Rate reset preferred shares increased to 60% from 55% the month prior. In addition, the remaining position in the BMO laddered rate reset ETF (symbol: ZPR) was sold.
Market Outlook and Strategy
As this is being written, the BOC has raised its administered interest rates by 25 basis points. In its announcement, the BOC stated that the increase removed “some of the considerable monetary policy stimulus in place”. That phrase suggested further increases would be required if the remaining stimulus was to be eliminated. While the BOC anticipates that Canadian growth will moderate in the second half of 2017, it also believes that the economy has little remaining slack, which suggests monetary stimulus is no longer required. The BOC’s move resulted in higher 5-year Canada bond yields, which in the past has led to increased demand for rate reset issues rolling over in the next two or three years.
We anticipate that new issue activity will pick up in the next couple of months. The rather tepid reception of recent new issues should result in more attractive pricing for the next few deals. That, in turn, may prompt a resurgence in institutional participation.
From a longer term prospective, preferred shares remain attractive. Notwithstanding the recent rise in bond yields, we are still in an low yield environment and the near 5.00% yields achievable in preferred share portfolios are very competitive. As well, the lack of correlation to bonds will be valuable if the bond market continues to falter and bond yields rise.
For more information about Natixis 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.