Preferred shares have made an impressive comeback over the past couple of years, delivering double-digit gains and solid cash distributions.
They are still a good deal. If central banks continue to raise interest rates and bond yields move higher, some of the more beaten-up areas of the preferred-share market could offer the best opportunities for capital gains and rising cash payouts over the next year or so.
The reason boils down to this: Bond yields should rise with interest-rate hikes and make preferred-share distributions more attractive.
The Bank of Canada has raised its key interest rate twice this year.
On Wednesday, the U.S. Federal Reserve raised its key rate by a quarter of a percentage point, marking its fifth increase in the past two years. Economists expect the Fed to keep hiking rates amid strong economic activity and a U.S. tax cut, which could lift Canadian bond yields.
The relationship between rates and preferred shares can appear counter-intuitive, so it's worth looking at what has been driving the volatility in this normally sleepy corner of the fixed-income market.
Preferred shares have similarities to both stocks and bonds. Like bonds, they are generally issued and redeemed at a par price, usually $25. They also pay regular cash distributions, based on their coupon rates (the yield at par).
But, like stocks, they trade on exchanges. And unique to reset preferred shares is the fact that their cash payouts are periodically adjusted according to a predetermined spread above the yield on the five-year Government of Canada bond.
This reset feature hammered many preferred shares between 2013 and the start of 2016. The S&P/TSX preferred share index fell 37 per cent as the yield on the five-year Government of Canada bond began to decline with concerns about the Canadian economy.
The bond yield bottomed out at just 0.5 per cent in early 2016 and the coupons on many preferred shares were reset at percentages far below their previous payouts, making them unattractive.
However, since January, 2016, the preferred-share market has rebounded 29 per cent, thanks to higher bond yields. The Government of Canada five-year bond yields nearly 1.7 per cent, making preferred share resets look much better.
Many preferred shares continue to trade well below par, though. These issues look particularly attractive to some investors because the share prices should rise with bond yields, providing a double whammy of capital gains and a bigger payout.
Doug Grieve, president of Slater Asset Management and manager of the Lysander-Slater Preferred Share ActivETF (ticker symbol PR), expects that the yield on the five-year bond will rise above 2 per cent at the end of next year.
"If I'm correct about that, I want to own preferred shares that will reset shortly thereafter, so a couple of years away," Mr. Grieve said.
One example is Fortis Inc.'s Series H preferred shares (FTS.PR.H): They were issued for $25 each in 2010, with a 4.25-per-cent coupon. In 2015, the coupon was reset at just 2.5 per cent, and the share price fell below $15.
Today, this same issue trades at about $17, which gives it a yield of 3.7 per cent. That's not bad. But in 2020, when the coupon is reset for another five years, the five-year bond yield could be higher than today.
Mr. Grieve calculated that if the bond yield rises to 2.5 per cent, the Fortis preferred shares would be reset at 5.8 per cent, and could send the share price back up to par – implying a gain of $8 a share from the current level, or 47 per cent.
Slater Asset Management sees similar opportunities with preferred shares issued by Manulife Financial Corp. (MFC.PR.I), Sun Life Financial Inc. (SLF.PR.I), Canadian Utilities Ltd. (CU.PR.C), Industrial Alliance Insurance and Financial Services Inc. (IAG.PR.G) and Toronto-Dominion Bank (TD.PF.A).
Is it overly hopeful to expect Canadian bond yields to rise so much?
Perhaps. But the nice thing about preferred shares is that they offer upside even if yields rise modestly, offsetting potential setbacks by other popular yield-generating investments, such as bonds and dividend stocks.
Mr. Grieve said that if bond yields move above his 2018 expectation of 2 per cent, reset preferred shares – which account for nearly 80 per cent of his ETF – should rally another 5 per cent and generate a yield of 4 per cent.
"The market will certainly wake up again if we see the five-year bond yield going higher," Mr. Grieve said. "There is still another leg up in this."