The preferred share market enjoyed another good month in July. Rising bond yields and interest rates prompted higher prices for rate reset and floating rate issues, but lower prices for perpetual issues. Fixed rate reset issues gained 2.2% in the month, while perpetual issues declined 1.8%. On balance, the S&P/TSX Preferred Share index returned 1.11% in July.
As expected, the BOC increased interest rates for the first time in seven years on July 12th. The BOC also revised its economic projections: it now expects the output gap, a measure of slack in the Canadian economy, to disappear by the end of this year, rather than in mid-2018 as per the BOC’s previous forecast. Over the balance of the month, bond yields continued to rise as investors anticipated additional rate increases from the BOC. Of note, late in the month, Canadian GDP growth surpassed all economists’ forecasts and the year-over-year increase was estimated at an eye-popping 4.6% pace. The 27-basis point increase in 5-year Canada bond yields during the month and expectations of further interest rate hikes led to buying of rate reset preferred shares, particularly those issues that will be resetting their dividend rates in the next two to three years.
There were only two new issues in July – TD Bank and Capital Power. With dividend rates little changed in recent months, and bond yields moving higher, the reset spreads of new issues have been shrinking. Investment dealers reported that some investors have become reluctant to buy issues with the lower reset spreads, which may explain why the size of the TD Bank deal was smaller than most previous bank issues. Details of the issues were as follows:
Natixis Canadian Preferred Share Fund
The Fund held relatively fewer rate reset issues and more perpetual issues, and that mix lagged the index last month.
Noteworthy transactions during the month included purchases of the new TD.PR.I issue and an existing rate reset issue of Royal Bank. We also reduced cash levels with the purchase of the BMO laddered rate reset ETF, ZPR, on a temporary basis. We plan to sell the ZPR position as attractive individual issues become available. Sales included trimming a few perpetual issues. We also reduced the Veresen Inc. holdings following its takeover by Pembina Pipeline to lower corporate concentration.
Market Outlook and Strategy
The adjustment in yields following the change in the BOC’s policy stance in June has made short- and mid-term bonds more reasonably priced. 5-year Canada bond yields have risen to over 1.50%, which appears to fully discount for another rate increase this year and one in early 2018. Those increases are not guaranteed of course, and may be deferred if the exchange rate continues to appreciate or if the economy stumbles for other reasons. If the bond yield does in fact stabilize, the rate reset sector of the preferred share market will likely stabilize too.
Over the next several months, long-term bond yields could move higher as global central banks reduce their extraordinary monetary stimulus. The U.S. Federal Reserve (Fed) is expected to begin shrinking its holdings of bonds in September and the European Central Bank will likely announce a downsizing of its quantitative easing program. Should they move higher, long-term bond yields could put downward pressure on perpetual preferred shares. However, the impact of central bank moves on longer-term bonds is often quite muted. We note as an example that 10-year U.S. Treasury yields are at the same level as they were in late 2015, prior to the Fed’s four interest rate increases. In light of their relatively higher yields, we anticipate maintaining an above benchmark allocation to perpetual preferred shares.
From a longer term prospective, preferred shares remain attractive. Notwithstanding the recent rise in bond yields, we are still in a 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.