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The recent volatility in interest rates has led to a challenging market for preferred shares. James Hunter, Portfolio Manager at TD Asset Management, discusses the outlook for the asset class and why there may be opportunities going forward.
Transcript
Greg Bonnell: While market conversations are often dominated by talk about stocks and bonds, one area that doesn’t get covered as much is preferred shares. Joining us now to discuss his view on this part of the market is James Hunter, VP and Portfolio Manager with TD Asset Management. James, great to have you back on the show.
James Hunter: Hi, Greg. It’s great to be here.
Greg Bonnell: All right, so we talked about preferred shares. We promised the audience a discussion there. For some people who might be new to the space, because it doesn’t get as much of the limelight, briefly remind us about preferred shares or their place as an asset class.
James Hunter: Sure. Yeah. Preferred shares are a type of security that is issued by typically banks and insurance companies. And they pay dividends. Like common shares, those dividends receive tax credits here in Canada. And both securities are publicly traded, as I mentioned.
But like a bond, they’re a little higher in the capital structure. And in exchange for that, they don’t participate in the growth of the company. So they have some features that are kind of like stocks and a few features that are kind of like bonds. They’re a bit of a hybrid investment.
Greg Bonnell: OK, when we’re talking about preferreds, who are we actually looking to in terms of who’s issuing this kind of share?
James Hunter: Right. So if you look at the market in Canada, it’s a $40 billion market. About 60% of that would be financial companies – banks, insurers, some of the diversified financials. The next 20% would be the pipeline companies. There’s another 10% that are utilities, and the last 10% is a mix of other issuers.
So there’s a reasonable balance in the market, but it is dominated by the banks and insurance companies. And one thing to know about preferred shares is that there are three types. So there are fixed rate resets. That’s about 3/4 of the market.
And what it means is you get a fixed dividend for the first five years, and then it resets every five years thereafter. There are fixed-rate perpetual. That’s where you get a fixed dividend indefinitely. And that’s about 20% of the market.
And then the third type is floaters. That’s where the dividend floats up or down based on central bank interest rate policy. That’s about 5% of the market.
Greg Bonnell: So in a market like this and a market that we’ve been through in the past couple of years, when we break it down by three different types of preferred shares, where has the activity been in the market? Where has the interest been?
James Hunter: Well, in the last couple of years, I would say it’s — well, maybe to start with – it’s been a bit of a rough ride for preferred share investors. There have been a lot of ups and downs, and I think a lot of your viewers would probably be aware of that. And the thing that’s really caught the market off guard has been just the volatility in interest rates.
If you think about pre-COVID, interest rates were around 3%. Then they were cut to 0% during the pandemic. We came all the way out of that up to about 5% here in Canada. And that interest rate volatility has flown through into the preferred share market.
The interest in the last couple of years, the best performance has really been from floating rate preferred shares, because they benefit from higher interest rates. But as I mentioned, that’s sort of the smallest part of the market. And so the usual activity, you really see the most of that in the rate reset market. And that’s had its ups and downs. The last couple of months have been a bit better, though.
Greg Bonnell: When you think about preferreds, and, perhaps, the audience might be learning about them for the first time, they might think, OK, why would I choose a preferred share over a bond? There are differences, but what sets them apart? Why do some investors make that choice and say, you know what? Let’s be in the preferred part of the market instead of the fixed income.
James Hunter: Right. So the main area that a preferred share can help your portfolio with is in terms of income. If you think about the income of a preferred share, right now, the yield is about 6%. It’s quite a bit higher than most other parts of the market. And the key in Canada is that that’s a tax-advantaged income. You get the tax credit.
So depending on your marginal tax rate, that could be a 6% yield after tax. So that’s one interesting feature of the preferred share market, which is probably a little bit better than cash, and certainly better than most bonds. The other thing to keep in mind right now is that preferred shares are trading about 20% below par, which means that if the market could continue to move back towards par value in Canada, that’s $25 a share, there is also a capital gains opportunity.
Greg Bonnell: Now, let’s talk about the par value, because, obviously, some people when they take a look at pure fixed income, think the opportunity this year is not only central banks on hold, which they have been for several months, but central banks eventually cutting. Is it the same kind of market conditions that would start to see preferred shares move back toward par?
James Hunter: It’s not exactly the same, but I would say the theme or the rhythm of it is pretty similar. If you put up the chart that I brought along with me, we can look at the last 10 years of the preferred share market. And what I’ve done here is I’ve converted the index to a weighted average per share. And like I said, the par value of that is $25.
So you can see over the last several years, there have been a few drawdowns in the market. But the point that you’ll see in the chart is that the long-term average is about $22 a share. And right now, we’re meaningfully below that – closer to $20 a share, which is that capital gains potential that I mentioned.
And to your question, Greg, I do think that preferred shares can move higher as interest rates come down. The key for the preferred share market, I think, will be interest rates coming down, but just not too much. If interest rates have to come down a lot, that probably means we’re in a recession, which wouldn’t really be great for the preferred share market. But if we get enough cuts that sort of indicate that the economy is going to muddle through a bit of a weak patch, I think that would be good for the market.
Greg Bonnell: I wanted to ask you about some of the risks in this space in terms of investors thinking about preferred shares. You named one of them right there. A recession often hits many asset classes. Preferreds wouldn’t be immune from that. Any other risks when people need to think about preferreds in their portfolio?
James Hunter: The two main ones that we would usually think about are credit risk and interest rate risk. So in terms of credit risk, you’re talking about how secure the company’s earnings are and therefore, how consistently can they pay the dividends. Because, again, preferred shareholders don’t participate in the growth of the company. But it’s really important that they get that dividend income from the issuers.
So we always look at credit risk. And there is a good chunk of the market that has a lower level of investment grade. So that’s one area that I think is of interest right now because you can get some pretty good value in those parts of the market. The other thing is, of course, interest rate risk.
And if you think about rate resets, which, again, is 3/4 of the market, there are two things to look for there. It’s, when will those rate resets reset? Which could be this year or it could be five years from now. And then the other thing to think about is how big is the spread on those securities.
Some of them will have a spread of 100 basis points. So if rates were to go down a lot, they wouldn’t have a lot of interest rate protection. But there are some securities with a 300 or 400 basis point spread. Those would be more resilient as interest rates come down. So those are the things we look at – credit risk and interest rate risk being two of the keys.
Greg Bonnell: Made me think, too, about the liquidity in the market. Is that a concern? Is it a very liquid market?
James Hunter: Well, it has gotten a little smaller in the last few years. There hasn’t been a new issuance since 2022. And there were a number of redemptions a couple of years ago. We could get into some of the details if you want. But the bottom line is there were some redemptions that made the market smaller, but it stabilized, roughly, in the last 12 months.
That’s a good thing, because liquidity is, at times, episodic. I guess what I would say is that there are still 200 preferred shares outstanding in Canada or more, and these are really high-quality issuers. We’re talking about the banks, the insurance companies, the pipeline companies in Canada, some of the utilities. So they’re high quality, and there’s still a couple hundred left. So I think it’s still an investable opportunity.
