With interest rates probably on hold in Canada until 2018, preferred shares in the nation may have room to continue rallying this year.
The securities, equity instruments that because of their regular dividends can appeal to debt investors, have grown in popularity with fixed-income money managers looking for returns in a low-yield world. They've outperformed Canadian stocks and bonds this year.
The index collapsed in early 2016 as preferred shares reset with lower dividend yields to reflect Bank of Canada rate cuts. Issuers responded by adding a yield guarantee to protect investors from further erosion. But now that the central bank looks unlikely to raise rates until next year, investors can find value in perpetual preferred shares that are still trading below their face value.
"Those are the ones that still have some value underneath them as rates increase over time," said Darcy Briggs, a portfolio manager at Franklin Bissett Investment Management, which has $5.5-billion in fixed-income assets. The fund is still watching for opportunities in new-issue and existing preferreds, Mr. Briggs said from his office in Calgary.
The S&P/TSX Preferred Share Total Return Index has returned about 8 per cent year to date, beating the S&P/TSX Composite Index's gain of around 3 per cent and the return of more than 2 per cent on an index of Canadian-dollar investment-grade corporate bonds. Preferred shares, which in Canada usually pay a dividend that's linked to government-bond yields, have returned almost 22 per cent over the past year.
The Canada 10-year government-bond yield was 1.58 per cent at 7:26 a.m. in Toronto, up from a record low of 0.95 per cent in September.
The new-issue market for preferred shares has been fairly muted this year after a glut of issuance at the end of 2016. There have only been five deals, worth $1.6-billion, while there have been three redemptions, worth just over $1.1-billion, said Lutz Zeitler, a portfolio manager at BMO Asset Management.
"It's almost a wash," Mr. Zeitler, who helps manage $1.2-billion, said by phone from Toronto. "There's been very little new issuance to soak up all of this demand."
Institutional investors continue to dominate the new-issue market for preferreds. Deals in recent months have been significantly oversubscribed, as buyers from pension funds to endowments join in the search for yield, said Barry Schwartz, chief investment officer at Baskin Wealth Management.
Those institutional investors need to be prepared to stay in the trade for awhile as they are not especially safe investments in the short term, and liquidity is poor, he said. Preferred shares carry more risk than debt securities, given that only common shares sit below them on the capital structure in the event of a failure.
"Even a small retail investor with a $1-million portfolio blowing out all his or her preferred shares could have a meaningful impact on the price," Mr. Schwartz said from Toronto.
Franklin's Briggs said liquidity should improve in preferreds as institutional investors continue to be the big players. He's watching for more new issuance from the Canadian banks.
Investors may have to look a little harder for opportunities this year, BMO's Zeitler said.
"You're still picking up a very nice yield spread to fixed-income products, so from that perspective, if you compare to the other fixed-income or yield products out there, there's still good value in the space," he said. "However, it's becoming a little more difficult to find really attractive opportunities."