The stock market suffered a big market drop in the Fall / early Winter, but has since had a substantial recovery. Bonds posted solid returns this past year. Preferred shares have had a very different experience. They declined last year, had a modest recovery and have sold off again in the past few months, leaving many preferred share investors wondering what has happened to the preferred share market and will it ever recover.
The Past Year
Preferred share returns have been anything but preferred over the past few years. In the past 12 months to May 31, the BMO 50 Preferred Share Index has declined by nearly 13.5% on a total return basis (including dividends received), with Fixed Rate Resets down 15%, Floating Rate Preferreds down an incredible 27% and only Perpetuals providing a positive return of 4.3% (price only return is still -1.3% for the past twelve months). On a five year basis, preferred share returns, including dividends have been essentially flat, but on price alone basis, preferred share prices have dropped nearly 23%. Fixed Reset preferred shares have seen their prices drop by over 30% in that same period.[i] Weren’t these investments supposed to be safer than stocks? Does it make sense to still hold them and when can investors expect a positive return?
Preferred Share Structure
Preferred shares are considered to be a hybrid security as they pay a fixed coupon payment (although sometimes the coupon payment is reset at specific intervals) similar to bonds. They also rank between bonds and equity in terms of security, i.e. a preferred shareholder is paid out after the bondholders, but before equity holders and preferred shares offer daily liquidity as they trade on the stock exchange (TSX). For these reasons, they were considered safer and less volatile than equity, but not as safe as bonds.
For many years, preferred shares were an income focused investment that either paid a consistent dividend amount (perpetuals) or the dividend amount changed with short-term interest rates (floating rate). These preferred shares offered a higher yield than equivalent bonds, but the yield premium today is substantially more than it has been historically. Many perpetual preferred shares are paying yields of 5.5%, a 3.8% premium over 30 year Government of Canada bonds that yield only 1.7%.
Things changed dramatically in the preferred share space when fixed reset preferred shares entered the market. Fixed rate reset preferred shares, which pay a fixed dividend rate for 5 years from date of issue are structured in the issuer’s favour. On the 5 year anniversary date, the dividend rate is reset based on the yield of the 5 year Government of Canada bond plus a specific premium yield that was set out at inception. But, if yields have gone up or if the issuer can finance at a cheaper rate, the preferred share can be called at par value.
The rate reset preferred shares became very popular with investors following the 2008 financial crisis, as they were looking for shorter-dated, higher yielding hybrid securities. Fixed resets now comprise approximately 75% of the entire preferred share market.
Many investors thought in 2008 – 2010 that they were buying a 5 year fixed rate preferred share, either not understanding or caring about the rate reset structure. In many cases, these preferred shares may have been mis-sold as 5 year fixed investments without contemplation of the risk that the dividend rate could be reset lower (reset risk) on the anniversary date.
In late 2014-2015 when oil prices cratered, Alberta went into recession and the Bank of Canada cut interest rates, many rate reset preferred shares dropped substantially in price. For example, a preferred share with a 5% yield, but with a rate reset formula of 5 Year Government of Canada plus 2%, saw the new dividend rate drop to 3% or less as 5 year government of Canada bond yields slipped below 1%. Prices on some rate reset preferred shares dropped over 30% within a year. While prices of rate reset preferred shares did go up when the economy started to improve and bond yields started to climb, the sheen had come off rate reset preferred shares.
This Last Year
There have been a few causes for the drop-off in preferred shares over the past year, but the drop has likely been too far and too fast, making many preferred share bargains, offering fairly high yields and the potential for price appreciation (see chart). The causes for the drop are below.
Bond Yields: The biggest investment change over the past year has been the shift in sentiment about interest rates. Early in 2018, the question was how many more times rates would rise and the yield curve reflected this. For example, 5 Year Government of Canada bonds were yielding 2.1% one year ago, but only about 1.35% presently. The yield curve has inverted for much of 2019. This is a scenario when longer-term interest rates are lower than short-term rates. The inverted yield curve often indicates that rate cuts are expected in the short-term and that the economy is slowing. Yet in this environment, stocks have gone up, bonds have gone up, while preferred shares have sold off dramatically.
As investors are supposed to be forward-looking, many have demanded higher current yields for their preferred shares, particularly rate resets, to offset the potential risk that the dividend rate will be reset lower. In many cases, the price drop has been overdone. Enbridge preferred share series D (ENB.PR.D) has seen its share price drop by over 20% in the past year. Yet, its dividend will not be reset for nearly 4 years and is currently paying a yield of 7.2%, nearly 6% higher than the 5 year Government of Canada bonds.
Index Funds: ETFs (Exchange Traded Funds) offer many advantages to investors, such as low cost, liquidity and diversification, but many investors assume that the underlying investments within the ETF are just as liquid as the ETF itself. In the case of preferred shares, this belief is wrong. Preferred shares are often smaller issues of $200 million or less and since many investors have a buy and hold mentality, they do not necessarily trade much. When preferred share ETFs experience sell-offs, the underlying preferred shares have to be sold down, regardless of price. This can make a small decline in the market much more substantial.
Investors Fleeing the Asset Class (Once Bitten, Twice Shy): Many investors who lost money in 2015 on preferred shares have decided to sell their remaining preferred shares or to simply avoid the asset class, by allocating their money to stocks and bonds instead. The last time preferred shares experienced this huge sell-off, institutional investors, like pension funds, began to buy into the market. So far, these investors have not yet returned to this asset class, but at some point low prices and high yields should attract greater interest.
Are Preferred Shares Worth Buying Today?
In general, I think the answer is yes, but some areas offer more compelling value.
Perpetual preferred shares – As mentioned previously, these preferred shares pay the same rate in perpetuity with no risk of the rate being reset. The vast majority of issuers are high quality, investment grade companies, such as the Banks, Life Insurance companies, and Utilities. While their sell-off has been much less than other parts of the market, their prices typically go up when bond yields are dropping, as the consistent high dividend rate should be of greater value to income investors in a low rate environment. For example, as 30 year bond rates have dropped over 0.5% in the past year, long-dated fixed income investments should have experienced price increases of over 10% based on financial math.
As a result, many of these perpetual preferred shares are offering dividend yields of well over 5%, a premium of over 3.5% vs. government bonds. Considering that many investors who are in or near retirement need income from their investments and are targeting return rates of 4% – 6% in their financial plans, shouldn’t an investment that pays consistent, tax-advantaged dividends at a rate of between 5%-6% be in high demand? Yes. They should. For long-term income investors, these preferred shares offer yields high enough to meet their spending needs and an opportunity for capital appreciation.
Deep Discount Rate Reset Preferred Shares. The rate reset market, which has caused most of the problem, also offers great opportunities. Currently, there are many rate reset preferred shares offering yields of 6.5% or more, are likely 3 or more years away from being reset and are likely to be reset at similar or higher rates, so you are getting more than fairly paid for the interest rate risk.
Selected Opportunities in Perpetual Preferred Shares
|ISSUER||Current Yield [ii]||Premium over Bonds [iii]|
|WN.PR.D (George Weston)||5.5%||3.8%|
|BAM.PR.N (Brookfield Asset Management)||6.0%||4.3%|
|ELF.PR.F (E-L Financial)||5.5%||3.8%|
|IFC.PR.F (Intact Financial)||5.5%||3.8%|
Selected Opportunities in Rate Reset Preferred Shares
|ISSUER||Current Yield||Premium Over Bonds [iv]||Reset Date||Projected Reset Rate [v]|
|BPO.PR.T (Brookfield Properties)||7.6%||6.3%||Dec. 2023||6.3%|
|ENB.PR.D (Enbridge)||7.3%||6.0%||March 2023||6.0%|
|FFH.PR.E (Fairfax Financial)||5.4%||4.1%||March 2020||6.5%|
|NA.PR.S (National Bank)||5.8%||4.5%||May 2024||5.3%|
Preferred Share – Case to Buy Them Today
Warren Buffet has often said that the key to investing is buying good companies at fair prices. I believe anytime that you can invest in high quality assets at a cheap price is equally effective. Preferred share issuers are typically investment grade companies, so there is limited credit risk. The dividend payments rank in priority to equity holders and most importantly, they are trading today at substantial price discounts relative to the yield premium investors can collect over bonds. Perpetual preferred shares are paying premiums of nearly 4% over long dated bonds. Typically, this premium is closer to 2%. Rate resets do carry some interest rate risk but that can be reduced substantially by buying issues with different maturity dates while investors can collect premiums of 5% or more over bonds.
In late 2008 through 2009, I bought preferred shares for myself and my clients to earn a high dividend rate with minimal risk of default based on the high quality of the issuers. I also figured that there was a good chance for price appreciation when more normal market conditions returned. By 2011, many of those preferred shares were up over 20% and had paid over 10% in dividends. Preferred shares are unloved today, but definitely offer significant value and a high rate of tax advantaged income. Income investors who do not own them, should definitely consider adding preferred shares to their portfolios, while those that do own them presently will continue to receive high levels of income and may be rewarded for their patience.
[i] Source: BMO CM 50 Preferred Share Index – May 2019. BMO Capital Markets
[ii] Based on June 18, 2019 market prices
[iii] 30 Year Government of Canada Bond
[iv] 5 Year Government of Canada Bond
[v] Based on 5 Year Government of Canada Bond at June 18, 2019 and reset spread