Top Canadian preferred fund seeks value in turbo-charged market

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The odds of a rate hike at the next Bank of Canada meeting more than doubled after a blockbuster December jobs report, but Canada's best-performing preferred share fund isn't rushing to adjust its strategy.

"We put less of a focus on interest-rate anticipation and more of a focus on selecting undervalued securities," said Ryan Domsy, manager of the $167-million preferred share fund at Foyston, Gordon & Payne Inc., a Toronto-based investment manager with $13.3-billion under management. "It doesn't matter whether they're floaters, perpetuals or rate resets -- if we're constantly buying what's undervalued, we will outperform."

Preferred shares have had a great run as Canada's economy picked up steam in 2017, culminating in a plunge in the unemployment rate to 5.7 per cent in December -- the lowest in more than 40 years. The Bank of Canada raised interest rates twice and investors expect it do so so at the next announcement on Jan. 17, holding out the prospect of fatter dividends as rates on preferred shares tied to government bond yields reset higher.

The FGP Preferred Share Fund, which is also the sub-adviser for the Evolve Active Canadian Preferred Share ETF, returned 22 per cent in 2017. This makes it the best-performing preference fund in Canada, including mutual funds and ETFs. By comparison, the S&P/TSX Preferred Total Return Index gained 14 per cent last year.

Risk Levels

But Mr. Domsy said there are other factors besides interest rates that should go into investing decisions, including business risk, financial risk and structural risk. He believes this approach gives him an edge over other managers, who tend to measure value using more simplistic metrics like yield-to-reset or yield-to-call ratios.

"When you look at the financials, for example, people paint all banks with almost one brush, which is fairly ridiculous," he said. "There's huge differences between the risk levels of a TD Bank and a National Bank, and when you look at the fixed-income securities that they issue, it's very rarely ever reflected in the pricing or the return characteristics."

The fund's small size gives it an advantage, Mr. Domsy said. "If you're a $3 billion fund you literally have to hold everything, you don't have a choice."

By contrast, FGP's fund can be "a lot more nimble than some of the big managers that have to buy every new issue that comes to market," said Raj Lala, chief executive officer of Evolve Funds Group Inc., whose pref ETF mirrors the FGP fund.

"The nice thing is right now preferreds have actually for the most part lagged the recent changes in interest rates," Mr. Domsy said. "So even if the interest rate increases aren't as aggressive as some people are expecting, I wouldn't expect to see a problem with preferreds. There's still some catching up for them to do."

The fund's top five holdings as of Dec. 29 were as follows: