Most people consider preferred shares to be relatively safe. Their market prices bounce around with interest rates, but their dividends are generally thought to be steady and reliable, which is precisely why income-oriented investors buy them.
Well, don't look now but a whole whack of preferred shares – specifically rate-reset preferreds that have come to dominate the market – could soon take a hatchet to their payments.
Some of these dividend cuts will be "absolutely massive," said preferred share expert James Hymas, president of Hymas Investment Management in Toronto.
This will come as a surprise to investors who depend on the predictable cash flow of preferreds, but Mr. Hymas has done the calculations and they paint a grim picture. In the next year or so, he expects many rate-reset preferreds to slash their dividends by 25 to 45 per cent. Depending on what happens to bond yields, many more rate-reset preferreds will likely reduce their dividends in coming years.
The preferred share market is already pricing in the bad news. For example, the iShares S&P/TSX Canadian Preferred Share Index ETF (CPD), an exchange-traded fund that invests in a broad basket of preferreds, has dropped nearly 7 per cent since mid-November. The BMO S&P/TSX Laddered Preferred Share Index ETF (ZPR), which invests exclusively in rate-resets, has fared worse: It's down more than 10 per cent.
The posted yields on these ETFs may look tempting, but they're deceptive. CPD, for instance, is yielding about 4.8 per cent, but that number is based on dividend payments over the past 12 months.With many rate-reset preferred dividends poised to fall, "using the historical dividend rates to calculate your future yield is simply misleading," said Mr. Hymas, who writes the PrefLetter and manages the Malachite Aggressive Preferred Fund.
Based on his calculations – which incorporate certain assumptions including a constant Government of Canada five-year bond yield of 0.93 per cent (compared with about 0.77 per cent as of Tuesday afternoon) – CPD's expected yield is 3.4 per cent.
Rate-reset preferreds became popular during the financial crisis as a way for banks to raise capital, and they've since spread to other sectors including telecoms, utilities, insurers and pipelines. They now account for more than 60 per cent of the $58-billion of preferred shares outstanding in Canada and have cornered the market for new issues.
As popular as they are, not everyone is a fan.
"Investors were sold these things on the premise they were safe," said Hank Cunningham, fixed-income strategist for Odlum Brown. "The underwriting community, suffering from a lack of equity issuance back then, hit on the preferred market and issued a gazillion [rate-reset] preferreds. When underwriters start to issue a lot of things I run away and hide."
The complex features of rate-resets make them difficult to understand for retail investors.
In contrast to straight perpetual preferreds, which pay a fixed dividend, rate-reset preferreds "reset" their dividend every five years based on a predetermined yield spread over the five-year Canada bond.
Alternatively, on the reset date investors can choose a floating dividend that is adjusted every quarter based on the same spread over the 90-day Treasury Bill yield. (For reset purposes, the preferred share's yield is calculated based on its par value of $25. However, the preferred share's actual yield will depend on its market price.)
The apparent interest-rate protection made rate-resets a hit with investors who were worried that rates would rise. But instead of rising, bond yields have fallen to near-record lows. What's more, because of changing market conditions, the spreads that newer preferred shares are paying over five-year Canada bond yields have widened, which means the market prices of existing issues with lower spreads have to fall to offer a competitive dividend yield.
According to Mr. Hymas, the market didn't pay much attention to the looming dangers until early December, when TransCanada reduced the dividend on its Series 1 preferred shares (TRP.PR.A) by a hefty 29 per cent, to 81.7 cents annually from $1.15.
"That issue is very widely held and it's a very big issue. So all of a sudden all of these people who had been ignoring the fact that these things were going to reset so low suddenly woke up," he said.
Other rate-reset issues fell in December after the TransCanada news, and the declines were exacerbated by year-end tax-loss selling, he said.
"And that downdraft turned into a complete rout in January when the Bank of Canada cut the overnight rate and the five-year Canada yield went from 130 [basis points] to 60 in the blink of an eye," he said. (A basis point is 1/100th of a percentage point.)
Investors have been hurt in two ways.
TransCanada's Series 1 preferreds, for instance, were issued in 2009 at $25. On Tuesday, they closed at $20.71. So, in addition to taking a haircut on their dividends, original investors who held on have suffered a capital loss of about 17 per cent. As bad as that is, some rate-reset preferreds have fared much worse, Mr. Hymas said. For example, a Fairfax Financial rate-reset (FFH.PR.E) has lost 37 per cent of its value since it was issued about five years ago.
There's a happy note – if you can call it that – to the carnage. Some rate-reset preferreds have been beaten down so much that they're now trading at attractive valuations, Mr. Hymas said. But that's of little comfort to investors who have ridden these complex and poorly understood securities all the way down.