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portfolio strategy

Stocks in the S&P/TSX composite index are okay as a buy-low opportunity, but you can do way better.

It's a sign of how bizarre things are in the world of finance that supposedly safer preferred shares are falling much harder than the broader stock market. Preferreds were once a low-drama alternative to bonds for generating reliable investment income. Now, they're a top name on any ranking of wealth-destroying investments.

Are you the sort of investor who follows investing giant Sir John Templeton's words about buying when other investors are despondently selling? Then check out preferred shares because there's a bull market in despondency here. As of midweek, the S&P/TSX preferred share index was off about 28 per cent in the past 12 months and 35 per cent in total over the previous three years.

For some ideas on finding value in the preferred share market, let's check in with two money managers. One is James Hymas, president of Hymas Investment Management, and the other is Dustin Van Der Hout, a portfolio manager with Richardson GMP. Both suggest investors look to the hardest-hit part of the pref market, rate resets.

When they were invented several years back, rate resets seemed like a bright solution to the problems posed by shockingly low interest rates. The dividend on these shares would be reset every five or so years, allowing investors to keep pace with what was thought to be an inevitable rebound in rates. As background here, you need to know that rising rates would normally put downward pressure on preferred share prices. With the reset provision, that risk is reduced.

Problem is, rates did the unexpected over the past few years and fell further. In turn, the vulnerability of rate resets was revealed. Just as their dividends can be adjusted higher if rates climb, so can dividends be reduced if rates fall. The reality of rate resets delivering lower dividends for the next five years is the reason investors have been dumping these shares. There has not been a problem with dividends being paid on time.

Let's be clear about the rate reset outlook – there's an ever-present danger of more declines if interest rates keep falling. Yields on Government of Canada bonds hit record lows this week, and rate-reset preferred shares were in retreat yet again. Stable to rising yields would be required for these shares to stabilize and then recover.

Mr. Hymas's quick and easy option for capturing a rebound in rate resets is the BMO Laddered Preferred Share Index ETF (ZPR), which has fallen almost 43 per cent over the past three years on a cumulative basis and now yields a bit over 6 per cent.

Alternative choices are the iShares S&P/TSX Canadian Preferred Share Index ETF (CPD) and the PowerShares Canadian Preferred Share Index ETF (PPS), which track an index that is dominated by rate resets but also includes other preferred types. "These ETFs are a very good alternative for somebody who does not have enough time to do a lot of research," Mr. Hymas said.

For investors seeking individual shares, Mr. Hymas highlighted three particular preferred share issues from insurers. Each traded in the $12 to $13 range at midweek, down from their issue price of $25, and each is down for similar reasons. They have either had their dividend reset recently at levels that are much below what they were when the shares were issued, or they will in the not-too-distance future.

Consider Manulife Financial Series 3 preferreds (MLF.PR.F) – they were issued with a dividend set to yield 4.2 per cent on the issue price of $25 and will reset in June, 2016 at the yield of the five-year Government of Canada bond plus 1.41 percentage points. The five-year Canada bond yield at midweek was 0.5 per cent, which suggests people who bought MLF.PR.F shares at $25 can look forward to a yield of not even 2 per cent.

Buy the shares now, with the shares around $12.25, and your projected yield on reset (based on today's five-year yields), would be just under 4 per cent. That's good compared to government bonds, but you can get higher yields from new preferred shares being issued these days. Why buy those hard-hit shares from Manulife, or similar issues from Sun Life Financial and Great-West Lifeco?

Mr. Hymas said there's potential for regulators to change the rules for insurance companies so that it's less attractive for them to issue preferred shares. If that happens, these shares could be redeemed at $25, which is close to double their current share price. "I can give you chapter and verse on why I think this rule change is going to happen," he said. "Basically, the market is essentially ignoring the possibility."

Warning: Mr. Hymas said the price of these shares is heavily influenced by the five-year Canada bond yield. If it goes up, that's helpful. If bond yields fall further, then there will be more downside for these already hard-hit shares.

Richardson's Mr. Van Der Hout highlighted rate-reset preferred-share issues from Brookfield Asset Management, Royal Bank of Canada and Toronto-Dominion Bank that would also benefit from being redeemed at much higher prices than they're trading at today. The two bank shares traded midweek around $17 a share, while the Brookfield shares traded in the mid-$13 range.

Those Brookfield shares are up for reset on June 30, and people who bought them at $25 can't be happy about it. The shares reset with a spread of 2.3 percentage points over the yield on the five-year Government of Canada bond. That's better than the insurance company preferreds mentioned earlier, but still not great.

What's the appeal, then? At the midweek price of $13.43, those Brookfield shares would yield an impressive 5.2 per cent based on an estimate of the dividend reset to come. That's your near-term incentive. Mr. Van Den Hout said the long-term payoff happens if preferred shares return to favour and Brookfield is able to redeem outstanding rate resets and replace them with new issues that have lower premiums over government bonds. If the shares aren't redeemed, then you continue to benefit from a yield well in excess of five-year government bonds.

Mr. Van Der Hout acknowledges that many investors have become disgusted with preferred shares, but he sees value in the market today. "If you go back three or four years, it was tough to buy high quality and get a good yield. The sell-off in the preferred market has given me and my clients that opportunity."

Value in the preferred share wreckage

Two preferred share experts were asked to highlight some individual shares that look attractive as a result of the big decline in the price of preferred shares over the past few years. Here's what they came up with based on a mix of dividend yield and the potential to be redeemed at a future date at the issue price of $25.

Share Issue &TickerRecent Price ($)Curr. Yield (%)*Next ResetDividend Reset formula is the 5-yr Canada bond yield plus this premium (% points)Yield based on current share price and projected dividend reset using a recent 5-yr Canada bond yield (%)
James Hymas, president of Hymas Investment Management
Great-West Lifeco Series N GWO.PR.N-T12.824.4Dec. 20201.33.5
Manulife Financial Series 3 MFC.PR.F-T12.228.4Jun. 20161.413.9
Sun Life Financial Series 8R SLF.PR.G-T134.4Jun. 20201.413.7
Dustin Van Der Hout, portfolio manager with Richardson GMP
Brookfield Asset Mgmt. Series 24 BAM.PR.R-T13.4310.1Jun. 20162.35.2
Royal Bank of Canada Series AZ RY.PR.Z-T17.15.9May 20192.214
Toronto-Dominion Bank Series 5 TD.PF.C-T17.185.5Jan. 20202.254