Along with significant price weakness in the vast majority of asset classes such as equities, bonds, commodities and alternative investments, the Canadian preferred shares asset class has also considerably fallen in price since early October.
There are reasons why the preferred shares asset class showed such sudden weakness.
- Preferred shares have largely been held by retail investors. In recent years, at least 10 relatively new ETFs have come into being making it easier for retail investors to own preferred shares. Increased concentration now makes this asset class prone to market sell offs especially when liquidity events arise. The TSX Preferred Share index dropped by 12.0% since early October and all preferred share ETFs are seeing significant fund outflows forcing them to liquidate their holdings.
- Bulk of the Canadian market for preferred shares comprise of fixed rate reset preferred shares (where the dividend rate is reset every five years at a spread over the five-year government of Canada bond). Both fixed rate resets and floating rate preferred shares (where the dividend is reset every quarter) benefit from a rising interest rate environment and drop in price when interest rates fall. The market is reacting in fear that the pace of interest rate hikes by the Bank of Canada may slow down or even halt. Five-year government of Canada bond yields fell from 2.48% on October 8 to 2.27% on November 20. This fall is material enough to give the market cause to worry.
- The equity contagion has spread to most asset classes and preferred shares have been sucked up in the search for liquidity.
The recent selling in preferred shares is largely driven by fear and fear is keeping investors away. Though portions of the asset class are very attractively priced now, the 2015-16 crash in Canadian preferred shares is still fresh in people’s minds and there seem to be little signs of investors rushing to buy the asset class. When the market decides to reverse course is anyone’s guess. In the meanwhile, dividend yields on floating rate and fixed rate reset preferred shares have risen very dramatically (as preferred share prices have fallen) making this asset class very attractive. The Bank of Canada too is expected to stay the course and raise interest rates next in January 2019. Even if the 5-year government bond yield stays at 2.3%-2.4%, most investment grade fixed rate reset preferred shares are currently priced to yield between 5-6% annually once the dividend rate is reset. Interestingly even preferred shares issued by the Canadian big five-banks (that will be reset within the next 8-10 months) currently offer these type of forward yields.
A good way to gain exposure to the preferred share market in an uncertain market environment is through a laddered strategy comprising of rate reset preferred shares (resets equally weighted over 1-5 years). Floating rate preferred shares are the best possible investment in a rising rate environment, but there are fewer quality issuers to choose from and tend to be a little less liquid than fixed resets.
Preferred share holdings in the Vulcan Intrinsic Value portfolio comprise of a laddered strategy (resets from 1-5 years) and floating rate preferred shares, but may be expanded to include fixed rate resets given recent compelling valuations.