Rising interest rates can put a shine on a number of investments, and Wednesday's rate hike by the Bank of Canada illustrated some of the potential winners. If the central bank continues to raise its key rate in response to a humming economy, these investments will look even better.
This asset class was down in the dumps early last year when the Canadian economy was stumbling, bond yields were falling and Canadian interest rates were stuck at ultra-low levels.
Now, preferred shares are doing well, and for one simple reason: As rates rise, investors can look forward to higher quarterly payouts down the road.
Most rate-reset preferred shares are issued at $25 each and pay a fixed dividend for a defined period, generally five years. After this period, the issuer can redeem the shares or adjust the payout based on the five-year Government of Canada bond yield. The higher the bond yield, the bigger the payout.
For example, Toronto-Dominion Bank recently issued Series 16 preferred shares that will yield 4.5 per cent annually for five years. After this period, the rate will be reset at 3.01 per cent above the five-year bond in 2022. Based on Wednesday's bond yield of 1.63, the yield would be reset at 4.64 – or slightly higher than the current yield.
No wonder the prices of many preferred shares have been rising with interest rates. The iShares S&P/TSX Canadian Preferred Share Index exchange-traded fund, which tracks a diversified basket of issues, was up 0.4 per cent to $14.06 shortly after the Bank of Canada's interest rate announcement on Wednesday morning, while the S&P/TSX composite index fell.
The preferred share ETF is now up 27 per cent from its lows in 2016.
Rising interest rates tend to expand the profit margins on bank loans and they are also good for insurers, whose massive bond portfolios yield more when rates are higher.
Already Canada's biggest banks are mulling the potential benefit of rate hikes. At a conference in Toronto on Wednesday, Royal Bank of Canada's chief executive officer, Dave McKay, said that a quarter of a percentage point rate hike will add $100-million in revenue to its retail banking operations in the first year alone, according to Bloomberg.
RBC was the first big bank to raise its prime rate Wednesday afternoon by a quarter of a percentage point, to 3.2 per cent, effective Sept 7. Toronto-Dominion Bank, Bank of Montreal, Canadian Imperial Bank of Commerce and Bank of Nova Scotia followed soon after with the same increase.
Bloomberg reported that Toronto-Dominion Bank's CEO, Bharat Masrani, also noted the benefits: "As long as the rate hikes are in an orderly fashion and do not tip the economy into a major slowdown," he said, the results should be beneficial.
The response from investors on Wednesday was mixed though – possibly as they wait to hear how the banks will respond to the Bank of Canada's move with their own prime lending rates. As well, a report showing that Toronto-area home prices in August slid more than 20 per cent from their peak in April no doubt rattled some nerves about the health of the housing market.
Still, Royal Bank of Canada nudged up 3 cents to $90.80 (again, in contrast to a broader stock market that was down in afternoon trading) and Canadian Imperial Bank of Commerce rose 70 cents, to $104.80. Toronto Dominion Bank fell 0.3 per cent.
Among insurers, some of the biggest names slipped amid broad concerns about the sector's exposure to hurricanes Harvey and Irma. Manulife Financial Corp. fell 17 cents to $23.84 and Sun Life Financial Inc. fell 38 cents to $46.91.
Perhaps it will take investors a little longer to recognize the offsetting benefit of higher rates.
Rising interest rates send bond prices down. But it's not all bad news: Since bond yields rise when prices fall, bonds become more attractive to investors looking for a heftier payout.
The yield on the Canada five-year bond is above 1.6 per cent today, up from a yield that was below 1 per cent as recently as June. The yield on the two-year bond has doubled to more than 1.4 per cent over the same time period.
Okay, that's still not a lot, but the payouts are becoming far more attractive than cash. If you've been sitting on some cash because low bond yields haven't looked enticing, now could be the time to approach these fatter yields.
Bond ETFs offer an easy way for smaller investors to gain diversified bond exposure. The BMO Aggregate Bond Index ETF, which tracks federal, provincial and corporate debt, fell on Wednesday and is down 3.3 per cent since June. The indicated yield on the ETF is now 2.94 per cent.
The iShares Canadian Government Bond Index ETF has fallen 3.5 per cent since June and yields 2.4 per cent.
-with files from Bloomberg