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Investment Ideas What investors should know about the recent plunge in preferred shares

The recent plunge in preferred shares is an early candidate for nastiest investing surprise of the year.

People commonly see preferred shares as being a safer, more stable choice than common shares, said John Nagel, vice-president and director of preferred shares at Desjardins Securities Inc. "But what's happened over the past year? Common shares have soared, and preferreds have tanked."

The S&P/TSX preferred share index was down 9.3 per cent for the year through midweek, while the S&P/TSX composite index was up 5.6 per cent. With the help of Mr. Nagel, let's try to make some sense of what's going on and come up with some suggestions for investors.

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Mr. Nagel's an ideal person for this job because he had a hand in the creation of a particular type of preferred share that is primarily responsible for the recent pullback. That would be the rate reset preferred, which now accounts for roughly 60 per cent of the almost $67-billion Canadian pref share market. As rate resets go, so goes the preferred share index, many preferred share funds and, in turn, investor perception of preferred shares.

Rate reset preferreds began appearing in 2008, when interest rates were falling and everyone thought they'd rebound sooner rather than later. The concept was this: The shares would offer a yield markup over the rate on the five-year Government of Canada bond that would be reset every five years. In a rising rate world, that's an attractive feature.

The problem is, rates edged up and down in the ensuing years and then declined sharply in early 2015. There is a type of preferred share that benefits from lower rates – straight preferreds, also called "perpetuals." But rate resets have been trouble.

Investors clearly bought them with the expectation that the reset would help them tap into a higher yield down the line. Today, however, some of these shares are headed to a reset at a time when rates are at unexpectedly low levels. It all comes down to this: Five-year Canada bonds had a yield around 0.75 per cent at midweek, compared with about 3 per cent five years ago.

You can see the result of this rate decline in Fortis Inc.'s Series H five-year fixed rate reset shares (FTS.PR.H). They currently pay a dividend that yielded 4.25 per cent when issued at a value of $25 per share. The dividend on these shares will be reset on June 1 to produce a dividend yield of 1.45 percentage points above the five-year Canada bond yield. Based on recent bond yields, these shares would, after reset, have a yield of about 2.2 per cent based on the $25 issue price. In dollar terms, the dividend would fall to 55 cents from the current $1.06.

The shares traded this week in the $15.25 range, which meant their yield based on the current $1.06 dividend was 6.9 per cent. Mr. Nagel calculates their yield after the reset at about 3.6 per cent based on this week's share price and a dividend of 55 cents. No matter how you look at it, investors are going to get less in dividends after the reset. Now, what should they do about it?

A useful first step is to understand the trends driving these shares lower. In Mr. Nagel's view, it's entirely the Bank of Canada's surprise move to cut its benchmark lending rate in January. "As soon as the Bank of Canada boosts its rate by 25 basis points [that's 0.25 of a percentage point], these things are going to go back up."

It's conceivable that the Bank of Canada could cut rates before increasing them at some future date, so a price rebound could take a while. The more immediate issue is the dividend. Mr. Nagel stressed the decline in the preferred market lately is in no way a signal of concern about the ability of preferred share issuers to pay their dividends. But there's still the problem of dividends being reset lower.

This may seem a cruel and surprising twist for rate reset preferred shareholders, but it's really just a reflection of the low rate world in which we live. Yields are down on everything tied to interest rates, and rate reset preferreds aren't immune.

Arguably, yields on these shares will still be attractive on a comparative basis after the reset. Those Fortis Series H shares at 3.6 per cent (based on the reset dividend and the current share price) beat anything you'll get in a government or investment-grade corporate bond maturing in 10 years or less. Factor in the dividend tax credit in non-registered accounts and the advantage of rate reset preferreds over bonds becomes even more pronounced.

Some rate reset preferred shares offer investors the choice of having their dividends reset, or converting their holdings to a floating rate preferred share issue. On those Fortis Series H shares, you can move into Series I floating rate preferreds with a dividend yield set at 1.45 percentage points over the three-month Government of Canada Treasury bill rate, which at midweek was about 0.6 per cent. That projects out to 2.05 per cent based on the $25 issue price and a dividend of 51.25 cents, and 3.4 per cent at the midweek share price of $15.25 for the Series H shares.

Mr. Nagel lays out the decision on whether to choose the floating rate option like this: Do you want a lower yield now in exchange for the opportunity for increases if interest rates rise over the next five years, or would you prefer to lock in 3.6 per cent? The floating rate option could end up being the most rewarding, he argues. If rates do go up in the five years to come, you'll benefit in the near term rather than having to wait until the next reset date. With floating rate shares, adjustments are made every three months.

Another thought from Mr. Nagel is to sell part of your rate reset preferred shares and put the money into straight preferreds, which pay a fixed dividend. Straight preferreds have benefited a little bit from lower rates – Desjardins data show they were up 2.5 per cent as a group for the year to April 10, while the preferred share universe was down 8 per cent.

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Still another possibility would be to switch from preferred shares to dividend-paying common shares. They've had a rough go lately as well, but that's a matter for a future column.

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(Note to readers: On the matter of what to do with rate reset preferred shares that have fallen in value, one possibility offered by John Nagel of Desjardins Securities is to sell some and put the money elsewhere. He does not advocate selling all of these shares, as was indicated by an earlier version of this column.)

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