Preferred stocks still have room to run
Preferred stocks have seen a remarkable rebound since the spring of 2020, when the pandemic sent the asset class to the depths. Indeed, funds such as the Signature F Preferred Share rated 4 stars at $ 38.8 million have generated a return of 31.7% in the past 12 months (as of October 1), while its sister product, the $ 87.3 million CI 4-Star Preferred Share ETF (FPR) returned 30.7%. While a lot of good news has been incorporated into returns, portfolio manager John Shaw maintains that the asset class still has upside potential.
3 reasons for the rebound
Consider three themes behind the rebound, says Shaw, vice president of Toronto-based CI Global Asset Management Inc.. “In March 2020, preferred stocks fell as much as Canadian stocks, and generally they don’t fall as far as stocks. It was based on the drop in interest rates. In the summer, the rebound started with the recovery of all risky assets, ”said Shaw, a 31-year industry veteran who joined CI’s Signature Group in 2004 after managing stocks. fixed income from Canada Life Assurance and earned a BA in Economics from Queen’s. University in 1988. The first determining factor was that many preferred stocks were priced well below face value and much of the market was trading for less than $ 18 a share. “That’s quite a discount from a face value of $ 25. Like the good news [on the economy] started to happen, that meant you were going to get some really good returns as the preferred stocks got closer to par.
The second factor was the introduction by the Royal Bank of Canada of a Canadian version of Additional Tier 1 (AT1) capital known as the Limited Recours Capital Note (LRCN). “Essentially, this rating allowed financial institutions to count the security as senior equity on their balance sheets, except they paid interest and got an interest deduction on them,” says Shaw, who is part of a 5-person team overseeing $ 8 billion in corporate bonds and $ 1 billion in Canadian preferred stocks. “This means that LRCNs are much cheaper for banks to issue than to pay after-tax preferred dividends. Immediately, we saw preferred stocks surge because investors recognized that much of the Canadian preferred stock market would be redeemed in the coming quarters. It played a huge role. Last year $ 3.4 billion of preferred stock was repurchased and so far in 2021 that number exceeds $ 7 billion. “We expect an additional $ 1.5 billion to be repaid by the end of the year. In total, $ 10 billion in repurchases represents more than 15% of Canadian preferred stock, with very little new issuance. It is the second main engine.
The third factor has been the gradual rise in interest rates since the summer 2020 low. “Canadian five-year rates are up about 60 basis points (bps) more than a year ago . For rate reset preferred shares, higher interest rates are very important.
Closer to balance
Shaw notes that strong demand for the titles was also a factor. “The amount of redemptions reduced the supply so much that investors wishing to stay involved for higher returns did so. The demand was there throughout the fall and into the first part of 2021. But there is less demand now that the market is more balanced, following strong returns, ”said Shaw, adding that over the years. last few months, people were ready to reduce their holdings. that buybacks continued.
Preferred stocks differ from bonds for several reasons. First, they pay dividends which are taxed at a lower rate than interest income. Additionally, unlike bonds that have maturity dates, preferred stocks have call or repayment schedules and interest reset dates. Indeed, Shaw says it’s very rare for issuers to default on securities. In the event of a business liquidation, the preferred shares are lower than the capital structure and lower than the obligations in the hierarchy of securities. “They’re riskier than bonds, so you should get a higher return. “
The portfolios of the RPF and the Signature F Preferred Equity Fund are virtually identical, although their management expense ratios vary slightly (80bp for the former and 90bp for the latter). Currently, both have a running yield of around 4.9% before fees. This compares to the S & P / TSX Preferred Share Index which has a current yield of 4.66%.
“In contrast, Canadian corporate bonds are earning about 2% and five-year Government of Canada bonds are earning 90 BPS and bank accounts are paying next to nothing. So it’s relatively interesting to have a small amount in Canadian preferred stock at 4.9%, ”says Shaw, noting that mutual fund investors tend to reinvest their dividends while ETF holders rely on a flow. income from the monthly distribution of the ETF.
Lower yields always beat bonds
Looking at the current state of the market, Shaw says it’s been very positive — until very recently. “We now have a neutral to positive outlook and still believe preferred stocks are attractive compared to high quality, high yield corporate bonds. But we recognize that many of the good returns and the conditions that set them up have already played out. So we don’t think there will be such strong returns going forward. Yields may vary from low to medium numbers over the next year, in large part because most of the expected redemptions will have taken place. The only caveat is that if interest rates rise more than expected, the CI team believes the rate reset zone could lead to slightly higher returns.
In managing the portfolio, Shaw uses a mixture of top-down macroeconomic analysis and bottom-up security analysis. “Given the level of interest and level of risk in global capital markets, we believe that monitoring the macro situation from a top-down perspective is essential for the overall positioning of preferred stocks,” said Shaw said, adding that credit markets and the spreads between government bonds and corporate bonds also have an impact on decision-making. “Investing in so-called floats and rate readjustments will generally be better in rising interest rate environments, compared to holding perpetual preferred stocks, which generally do better in rate environments. stable or declining interest rates. “
From a bottom-up perspective, Shaw and his team are looking for companies that they believe will maintain or increase their credit quality. “We also like to find issuers that we don’t think will be issuing as many preferred shares in the future. In this way, the supply of this business is stable or declining. These conditions can sometimes be difficult to find, but these are the conditions we try to look for for the best relative performance. From a technical standpoint, Shaw notes that if they have a strong opinion on a security or if it is trading well below par but the reset rate is low, then that security will generally be more volatile and. riskier. “But the rewards could be a little bigger. Thus, depending on our overall view of the market, we will prefer one type of security over another.
From a sector point of view, financials represent the most important sector with 46% of the portfolio, followed by 17% of pipelines, 17% of utilities and 7.8% of real estate.
Managing a portfolio of around 100 stocks, Shaw cites Enbridge Inc. (ENB) Series P, a preferred share that resets in March 2024. “The price is around $ 18.35 and the current yield is around 6. %. It’s very interesting for the next two and a half years, ”says Shaw, adding that assuming 5-year Government of Canada bonds return 90 points per second, the future yield will be 4.70%,“ but if rates rise as suggested by the forward rate curve the yield could rise up to 5.25%. It’s a security that is doing well in a stable environment and can perform very well if interest rates rise from here. “
Another holding is Great-West Lifeco Inc. (GWO) Series G, a perpetual security. “A lot of Great-West’s securities have higher coupons, so we don’t think this security will be redeemed anytime soon. If they start to buy back the highest paying perpetual securities, it will remain in circulation for a period of time. »Based on a current price of $ 25.45, the current yield is 5.14%. “This is an attractive type of long-term return,” says Shaw, adding that the team views Enbridge and GW0 as strong players in their respective industries and the portfolio includes several issues from both companies.