Several readers have written recently to ask about investing in preferred shares and the funds that hold them in the light of the current economic climate. Here are two of those questions along with two others that focus on rising interest rates.
Floating rate preferred shares
Q – With interest rates starting to rise, is this an opportunity to consider floating rate preferreds? – Gunnar A.
A – In theory, floating rate preferreds should perform well during a period of rising rates. That's because their dividend is tied to a benchmark rate, such as prime or the yield on a government bond. When rates rise, the dividend should move higher accordingly, although there will be a delay depending on the terms of the issue. So far, of the floating rate preferreds I checked, most are showing little or no strong upward movement.
One preferred that is trending a little higher is TransCanada's Cumulative Redeemable First Preferred Shares, Series 2 (TRP.PR.F). These shares began trading at the end of 2014 following a conversion from a previous series. They have been battered for much of the time since, hitting a low of $10.19 last February. However, they bounced back in the fall as the interest rates began to rise and are up about 45 per cent from last winter's low.
In this case, the dividend is set each quarter at the rate of a 3-month T-bill plus 1.92 per cent. This means that as the bond yield rises, so will the dividend that investors receive. The latest quarterly payment in November was 15.28 cents per share. Over a year that would work out to a yield of 4.1 per cent. However, with rates on the rise, the dividend should increase in 2017.
Overall, floating rate preferreds should rise in price as interest rates go up, but they won't always move in lock step. Depending on the terms of the preferred there can be a delay of as much as a year between the time rates rise and the stock dividend moves higher. – G.P.
Preferred share ETFs
Q - Our adviser recently advised us to purchase Royal Bank Preferred ETF (RPF). Is this a good investment at this time? Would ZPR (BMO preferred ETF) be a better choice? The funds for this investment are coming from the sale of Inter Pipeline, which I am also not sure was the right thing to be doing at this time. – Carolyn T.
A – No, I would not have advised selling Inter Pipeline, but what's done is done. You are now looking at two preferred share ETFs, presumably because you want less risk with good cash flow.
RPF is a brand-new exchange-traded fund, having been launched only in September. So we have very little history to go on. The fund holds 155 rate-reset preferreds, most of which are rated Pfd-2 or Pfd-3, meaning the default risk is low. The portfolio is heavily concentrated in two sectors, financials (56.4 per cent) and energy (23.7 per cent) and is entirely invested in Canada.
Distributions are made monthly, currently at a rate of 8 cents per unit. That's 96 cents per year, which equates to a yield of 4.4 per cent annually, based on a price of $21.61. Of course, there is no guarantee the fund will continue to pay at the same rate. The management fee is 0.53 per cent.
The BMO Laddered Preferred Share Index ETF (ZPR) has been around quite a bit longer, having been launched in November 2012. So we have four years of history to work with.
The fund tracks an index you probably never heard of, the Solactive Laddered Canadian Preferred Share Index. It includes Canadian preferred shares that meet size, liquidity, listing, and quality criteria. The index uses a five-year laddered structure, which means that one-fifth of the portfolio turns over every five years.
In terms of credit ratings, the portfolio is similar to that of the Royal Bank fund, with 98 per cent of the assets weighting Pfd-2 or Pfd-3. The sector asset weights are a little more diversified, with 40.4 per cent in financials and 24.5 per cent in oil and gas companies.
As with the Royal Bank fund, this ETF focuses on rate reset preferreds. These securities were hit badly when interest rates were falling and investors have paid the price. As of Nov. 30, the fund was showing an average annual loss of 4.7 per cent since inception, fuelled mainly by a drop of 20.2 per cent last year. It has done a little better in 2016 with a year-to-date gain of 1.7 per cent.
Distributions are made monthly and are currently 4.3 cents per unit (51.6 cents per year). It's worth noting that BMO has reduced distributions twice since last December, when they were at 5 cents per unit. At the current rate (remember, no guarantees) the yield is 4.9 per cent based on a price of $10.63.
This fund has total assets of $1.4-billion. The maximum annual management fee is 0.45 per cent.
So which fund to choose? It's a toss-up. Both invest in the same type of securities, rate reset preferreds, and so are likely to show similar performance statistics over time. The BMO fund has a slightly lower management fee, which may translate into a marginal advantage over the years. It also has a higher yield at present, but keep in mind management has cut the distribution twice within 12 months. – G.P.
Green energy stocks
Q - Could you please discuss the reason for the recent downtrend of green energy stocks such as Algonquin Power, TransAlta Renewables, etc.? – Peter M.
A – Blame it on Donald Trump. His election hit these stocks hard, in two ways.
For starters, the U.S. president-elect declared several times during the campaign that global warming is a hoax, dreamed up by the Chinese to destabilize U.S. industry. Since the election, he appears to be backtracking on that hardline stance, telling The New York Times in a recent interview that he is maintaining an "open mind" on the subject. But until his actions show something different, investors see him as a climate change denier who will oppose expensive green energy initiatives and work instead to retain coal-fired generating plants and restore lost mining jobs in West Virginia and Pennsylvania.
Rising commercial rates and the expectation that the U.S. Federal Reserve Board will increase its key rate in December have also hurt most interest-sensitive stocks, which include the ones you mention. There is now an expectation that Mr. Trump's policies will stimulate growth and stoke inflation, which would have the effect of pushing rates even higher in 2017. Higher rates make safe investments like government bonds more attractive on a risk/reward basis when compared to stocks. As a result, share prices tend to drop, pushing yields higher. That's what we're seeing now. – G.P.
Rising interest rates
Q – If interest rates start to rise, what might be the impact on Enbridge? – Stephen B.
A – Enbridge is what we call an interest-sensitive stock. That means its price and yield tend to be affected by rate movements, up or down. Over the spring and summer, when interest rates were falling, the share price rose to a 52-week high of $59.19. The shares dropped back to below $55 after Donald Trump's election victory sparked concerns that interest rates would rise more quickly than expected, based on his economic stimulus plans. The shares have since recovered a little since but are still below their high for the year. Going forward, rising rates will have a downward affect on the stock, however that may be offset by other factors, such as a dividend increase. – G.P.
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If you have a financial question, please send it to me at gpape@rogers.com. Write "Globe question" on the subject line. I can't promise personal answers but I'll choose the best questions for reply in future columns.
Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to www.buildingwealth.ca. Follow Gordon Pape on Twitter at twitter.com/GPUpdates.
Gordon Pape