The Canadian preferred share market started 2017 with a bang, outperforming investment grade bonds, common stocks and even junk bonds by a significant margin. Unlike other securities, preferred shares were immune to the volatility arising from the changeover in the U.S. administration. In part, the strong performance of preferred shares reflected investors’ ongoing search for attractive yield combined with limited new issue supply. In addition to investors purchasing outstanding individual issues, preferred share ETF trading volumes hit a record high in January. We believe that much of the ETF activity did not reflect simple buying of the asset class, rather, it was hedging of structured notes linked to the preferred share market. The S&P/TSX Preferred Share index returned 4.05% in January.
The structured notes were created by several banks and sold primarily through their respective wealth management divisions, although some institutions may have also participated. There is no centralised reporting on structured notes, so it is difficult to estimate the total size of the market. Many of the notes were autocallable, principal-at-risk products, linked to the performance of the BMO Laddered ETF (ZPR). The notes will be automatically called and a variable return paid, if on any set valuation date, the level of ZPR is above a predetermined value. However, if the notes are not called prior to the final valuation date, and the value of ZPR has declined, the investor stands to lose a portion of their original investment. Another, less obvious aspect of these structured notes is that they are based only on the price performance of ZPR and the investor does not participate in the dividend yield of the ETF, which could mean forgoing roughly 5% return a year. The structure is essentially a package of bank debt combined with a series of digital call options on ZPR. When a bank sells one of these notes, it shorts the options and hedges that exposure with purchases of ZPR. If new units of ZPR must be created (during January, $148 million of new ZPR units were created), that will result in buying of each of the component series of preferred shares held in the ETF. If ZPR subsequently increases in value, the bank will need to buy additional units in order to maintain its hedge.
In recent months, the volume of structured notes sold appears to have made an increase in the value of ZPR a self-fulfilling prophesy. When the notes are sold, the bank must buy ZPR to hedge its exposure, putting upward pressure on ZPR’s price, which forces the bank to buy even more of the ETF. As additional series of these structured notes are sold, it creates even more upward pressure on the ETF. The risk is apparent when ZPR falls in value. Such a decline might be triggered by some of these notes being auto-called, causing the unwinding of underlying hedges (i.e. selling of ZPR), or perhaps simply by a correction in the preferred share market. Either way, the structured notes have added a layer of potential volatility and risk to the market.
With the substantial interest in ZPR during January, it is not surprising that the return on rate reset preferred shares was higher than the overall market. The Solactive Laddered Rate Reset Index gained 4.76% in the month. Floating rate issues, which make up 6.0% of the market but only 2.6% of the index, surged an estimated 9.3% in the month, perhaps making up some of the ground lost versus rate reset issues in the last four months. Perpetual issues trailed both rate reset and floating rate preferreds, earning only 2.2% on average.
There was only one, relatively small new issue in January. Brookfield Infrastructure Partners LP issued $300 million of preferred units with a 5.00% initial (and minimum) payout and a 378 basis point reset spread. Rather than paying dividends, the units will payout a portion of the partnership’s taxable income. If the taxable income is insufficient to cover the 5.00% payout, the balance will be paid as a tax deferred return of capital. The issuer estimated, but did not guarantee, that the split between taxable income and return of capital would be 50/50 over the next five years. Institutional investors bought 46% of the issue and retail investors received the remaining 54%.
Ongoing interest in preferred shares spurred the introduction of two more actively managed preferred share ETF’s – one from Redwood and the second from Blackrock, managed by Dynamic.
NexGen Canadian Preferred Share Fund
The fund earned modestly less than the benchmark in January. The portfolio held relatively fewer rate reset issues and more perpetual issues and that mix lowered returns slightly. However, favourable security selection partially offset the negative sector mix. Indeed, 13 of the 43 preferred share holdings returned better than 6.00% in the period.
During the month, we purchased new holdings of older, legacy rate reset issues of Veresen and Bank of Montreal. We also added to existing holdings of TransCanada Corp., and Fairfax Financial. The Bank of Nova Scotia and Industrial Alliance preferred shares had little potential for further gains and accordingly, were sold. The proportion of the portfolio held in rate reset issues rose to 53% from 51% a month earlier, compared to the index weight of 76% and the market weight of 69%. Perpetual issues made up 40% of the portfolio versus 21% in the index and 24% in the market. Cash comprised 5% of the Fund, higher than the target due to illiquid conditions in the market. Active share, which is a measure of how different the fund is from the index, is approximately 84%, confirming that we are indeed active managers and not closet indexers. We anticipate adding to the rate reset holdings and reducing the cash position in the coming month.
Market Outlook and Strategy
We are cautiously optimistic regarding preferred shares over the near term. In part, our optimism reflects the yield advantage that preferred shares have versus comparable bonds. That comparison does not even factor in the tax advantages of preferred shares versus bonds. In addition, new issue supply in February may be lighter than demand, as Canadian banks are in “blackout” periods awaiting the release of their first quarter financial results. Our caution arises mainly from how quickly the preferred share market has rallied in the last few months and the unprecedented need to hedge structured notes based on preferred share indices or ETF’s. Should the demand emanating from the notes falter, we would expect to see rate reset issues lose some of their recent gains. In addition, the recent strong gains in preferred shares have led many institutional investors to pause their buying programmes.
From a longer-term prospective, preferred share remain attractive. Notwithstanding the recent rise in bond yields, we are still in an ultra-low yield environment and the 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 yields rise.
For more information about NexGen Canadian Preferred Share Funds, please contact your financial advisor.
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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.Tags: bond, bond yields, ETF, floating rate, market, NexGen Canadian Preferred Share Fund, perpetual issues, preferred share market, Preferred Shares, rate reset, yield