THE YEAR OF THE PREFERRED SHARE?
After years of letdowns, they may do well in 2016. Really
Canadian stock investors are no strangers to disappointment this year, with everything from energy shares to bank stocks getting hammered in the market. But perhaps no segment was more disappointing than preferred shares.
Investors — primarily retail, as they represent the biggest chunk of preferred buyers — have bought up massive amounts of preferred issues in recent years, expecting the segment to benefit from higher interest rates.
Instead, preferred shares were hammered as oil prices collapsed and the Bank of Canada cut interest rates twice in 2015. The S& P/ TSX preferred share index is down 22 per cent in the past 12 months.
The selloff has led many retail investors to sour on what has long been a favoured investment. But sentiment might be shifting heading into the new year. Fund managers are getting bullish and, more importantly, institutional investors are now piling into preferreds.
“I think the timing to buy this right now is extremely attractive, even as the market has bounced back recently,” said Nicolas Normandeau of Fiera Capital Corp. “A lot of these issues are attractively priced right now, so the market should do well next year, much better than 2015.”
If that turns out to be true, investors better reacquaint themselves with preferred shares, which are a hybrid security with features of both equities and fixed income.
Like equities, preferreds do not have a maturity date and represent an ownership interest in the company. But they also pay a distribution yield like fixed income does and don’t carry any voting rights.
Many retail investors like preferreds because they offer preferential tax treatment since the yields are taxed as dividend income as opposed to interest income.
There are a few different types of preferred shares, but most of the market is comprised of perpetuals and rate resets.
Perpetuals don’t have maturity dates and pay a fixed dividend for as long as they remain outstanding.
Rate resets offer investors a fixed dividend until their “reset day.” If an issuer opts not to call in shares when that reset comes, investors can choose to either accept a new fixed rate or exchange the shares for floating- rate stock, which resets more often to track the five-year Canada bond.
Much of the preferred-share selloff this year has been due to steep discounts in the ratereset segment of the market. Rate- reset shares base their payouts on what the Government of Canada five-year bond is yielding when rates are set. That yield has sharply dropped to 0.75 per cent from roughly 1.6 per cent at the end of 2014.
There is a risk that yield could go even lower in 2016, but analysts say the market response has been too harsh.
“Despite the selloff in the pref market, we believe that there is value in buying into some of these fixed-resets that have been oversold,” noted Phil Kwon, fixed-income specialist at Raymond James. “Even if the dividends reset lower, the new dividend in some of these preferred shares will still generate a decent income and much of this bad news has already been priced in.”
There are also signs that institutional players are taking notice of the market after the recent discounts. Retail investors are usually the biggest buyers of preferred shares, with institutional investors representing only 20 per cent of the buyers of an average issuance.
But that has changed with recent issues. In September, for example, Canadian Utilities Ltd. raised $250 million by offering a rate- reset preferred share at a yield of 4.5 per cent, and 70 per cent of the buyers were institutional investors.
The issue also included a new minimum yield feature, offering investors a floor that will prevent the yield from going below what it was issued at. More recently, Royal Bank of Canada came to market with one of the biggest preferred share issuances ever in Canada, offering investors a rate of 5.5 per cent, which will reset every five years at 4.53 per cent above the government fiveyear bond yield.
Institutional investors were again the biggest buyers in this issue, scooping up two-thirds of the shares.
But even as the appetite for preferreds seems to be developing again, plenty of risks remain in the market.
For those preferred shares without a floor, the potential threat of even lower bond yields next year remains. The current overnight index swap market is pricing in a relatively high chance that the Bank of Canada could cut interest rates once again early next year, which would drive bond yields lower and hammer preferreds.
But Normandeau said he sees the rewards outweighing the risks in 2016. He is predicting the potential for preferred shares to provide investors with a total return of between five and 10 per cent next year.
“When you see the kind of premium you get right now, you’re still buying investmentgrade names with credit quality that is still really, really strong for these issuers,” he said.