Preferred shares as a hedge against rising interest rates?
Believe it. The changing profile of the preferred share market in recent years has remade what was once a dismal place to be in a rising rate world.
The S&P/TSX preferred-share index was up 6.3 per cent for the year to July 11, while the S&P/TSX composite was down 0.9 per cent. Weeks of speculation about the Bank of Canada rate increase, which occurred Wednesday, has obviously been good for preferred shares in a way that benefits both the index and exchange-traded funds in the sector. Shares of the Horizons Active Preferred Share ETF (HPR), the iShares S&P/TSX Canadian Preferred Share Index ETF (CPD), the Lysander-Slater Preferred Share ActivETF (PR) and the BMO Laddered Preferred Share Index ETF (ZPR) were all up 5 per cent to 8 per cent for the same period.
A reason for the recent strength of the preferred market is that it's now dominated by rate reset shares, which adjust their dividend rate to changes in interest rates every five years. When interest rates slid lower in 2015, rate resets were hammered by investors who hated the idea of having their dividend-rate reset lower. Now, with interest rates on the rise, the reset feature has come into its own.
Perpetual preferreds – they pay a set dividend and have no set maturity date – are a significant but declining part of the preferred-share universe today. The price of perpetuals is vulnerable to rising rates, though dividends would be secure as long as the issuing company's financials remain strong.
As buoyant as the preferred-share index has been lately, it's still down about 17.5 per cent on a cumulative basis over the past five years. This is a reflection of how badly mauled rate resets were when investors feared lower rates. Expectations of higher interest rates ahead could help the pref market rise even higher, whereas any signs of rates falling back again would be negative.
Preferred share ETF yields are still high in relation to bonds and term deposits, at roughly 3.9 per cent to 4.5 per cent. These yields are what's left over after the comparatively high fees on preferred share ETFs – roughly 0.5 to 1 per cent.