Pref recovery

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   By Guest Blogger Ryan Lewenza

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It’s been a heck of a ride for preferred shares over the last few years. Like everything in 2022, they experienced a big drop with some investors deciding to throw in the towel for this asset class. This short-sighted view caused some investors to miss the recovery that we’ve seen in recent months.

Why do we continue to view preferred shares as an important component within a diversified portfolio?

First a refresher on what these investments are, and why we own them.

Preferred shares are a ‘hybrid’, possessing characteristics of both bonds and stocks. They resemble bonds in that they pay a fixed income stream (dividends instead of interest income) and are impacted by many of the factors that impact bond prices. This includes interest rates, the state of the economy and ‘credit spreads’, which is the difference in yields between corporate and government bonds.

But at the same time, they resemble common shares or equities. They are a type of shares – preferred versus common – which means they rank ahead of stocks as far as dividends (they get paid first) or in the event of bankruptcy/liquidation. And like owning stocks, preferred shares represent ownership in a company.

Now why do we like them?

First, we like that steady and dependable income stream. They pay out quarterly dividends versus bonds which pay semi-annually. And since preferred shares are issued mainly by the big banks and blue-chip companies, we know we’re going to receive those dividends every quarter.

Second, they often more yield than bonds. Currently, Canadian preferred shares are yielding above 5% versus Canadian government bonds (5-10 year maturities) around 3.5%.

Third, because they pay dividends versus interest income, they receive the Canadian dividend tax credit and therefore are taxed at a lower rate. For example, if you live in Ontario and earn between $111,733 and $150,000 you will pay 25% in taxes for dividends versus 43% for interest/GIC income. So, with preferred shares you get more money in your jeans after adjusting for the lower tax rate.

Now the ‘rub’ with these investments is they can be volatile from time-to-time as they were in 2022. This is captured in the chart below. Here I calculated the rolling standard deviation (i.e., volatility) over the last 15+ years.

Note how there are spikes in volatility (2008, 2016 and 2020) and the rising trendline. This is the dotted black line and captures the rising volatility over the last 15 years. Put simply, preferreds have become more volatile in recent years and this is largely due to the changing composition of the Canadian preferred share market.

There are two main types of preferred shares. ‘Fixed resets’ have dividends reset every five years versus ‘perpetuals’, which pay a fixed dividend in perpetuity. In recent years we’ve seen a shift more to fixed resets. And with the low interest rate environment that we’ve been in over the last decade this has led to some dividend cuts, which has weighed on pref prices and largely explains the higher volatility.

Preferred share market rolling standard deviation (volatility)

Source: Bloomberg, Turner Investments

Following the challenging year in 2022, preferred shares have been on a roll over the last few months. Year-to-date Canadian preferred shares are up over 5%. We called this recovery in our 2024 outlook so we’re happy to see this, especially so early in the year. We see a few key factors helping to push preferred share prices even higher this year.

First, they were down in 2022, like everything else and history suggested to us a recovery was on the horizon. Over the last 20 years the Canadian preferred share market has posted a negative return four times. 2008, 2015 and 2022 were some of the biggest down years. In every single case the pref market recovered in the following years. For example, following a rough year in 2008, the preferred share market rallied 27% in 2009. So, history was on our side for a price recovery.

Annual performance for our preferred share market

Source: Bloomberg, Turner Investments

Second, and our focus today, is that 23% of all outstanding fixed resets will have their dividends reset this year and 20% in 2025. As discussed above, a fixed reset preferred share has its dividend reset every 5 years. And with interest rates being high right now a lot of dividend increases are coming for these fixed resets.

An example will help. Currently the GoC 5-year yield is around 3.5%. Let’s say a Royal Bank fixed reset was initially issued with a reset spread of 300 bps or 3% and the 5-year Government of Canada bond yield was 1.5% at the time. Multiplying the 4.5% by the $25 par value would equate to a dividend of $1.125/share.

Today, with the GoC 5-year yield at 3.5%, if this same preferred share was reset today the dividend would increase to $1.625/share (6.5% x $25 par value). In this scenario, the fixed reset would see its dividend increase by $0.50/share or a 44% increase, due to the GoC 5-year yield being 2% higher.

So key point is that we see a lot of dividend increases coming for fixed resets over the next few years.

Percentage of Cdn fixed resets which will be reset

Source: Dynamic Funds

In fact, the dividend increases have already started. One of our main preferred shares ETFs has seen its monthly dividend increase from $0.072/share to now $0.094/share a few months ago. And below is a chart of the iShares S&P/TSX Canadian Preferred Share Index ETF (CPD-T) and it’s 12-month dividend amount is starting to rise.

Dividends rising for the Cdn preferred share index

Source: Bloomberg, Turner Investments

If you’re like me and get excited at month end as dividends start pouring into the account, you’ll love these preferred shares in the coming years as we see this trend of rising dividends being positive for this asset class.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.

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About the picture: “We recently came back to YYC from Mazatlán for a few weeks to take care of some business and these two beauties were on our front walk,” writes Donnie. “I believe they were asking if we might have a rabbit pest control contract for them. Amazing creatures going through a mating ritual. It’s interesting they fearlessly hang around this hood which is minutes from the downtown core. Sadly some neighbours began circling the block in vehicles honking horns apparently concerned for their little designer dogs. It’s sad they couldn’t keep the dogs inside for a couple of hours and appreciate nature. The cats weren’t too concerned and casually meandered to the back yard to continue the dance. Thanks again for all the financial info you gift the steerage.”