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yield hog

John Heinzl is the dividend investor for Globe Investor's Strategy Lab. Follow his contributions here. You can see his model portfolio here.

When preferred shares were skidding in recent months, some investors couldn't get rid of their holdings fast enough.

Not Nicolas Normandeau. He was on the other end of the trades scooping up shares at fire-sale prices.

"During the selloff I was buying everything," said the manager of the $430-million Horizons Active Preferred Share ETF (HPR). "I was buying about $4-million to $5-million a day. That's a big number."

As discussed in a recent column, the preferred share route was led by rate-reset preferreds, a complex class of securities that have come to dominate Canada's $58-billion preferred share market. Today, I'll recap what went wrong and discuss why Mr. Normandeau, a vice-president with Fiera Capital and one of Canada's largest preferred share managers, saw the selloff as an opportunity.

Why preferreds plunged

Rate-reset preferreds pay a dividend that is based on a predetermined yield spread over the five-year Canada bond. The dividend is typically reset every five years, so if bond yields rise during that time, the preferred dividend will reset at a higher rate; if bond yields fall, the dividend will reset at a lower rate.

Many investors bought rate-resets – which became popular during the financial crisis – as a way to protect against rising interest rates. But instead of rising, rates fell. And the decline accelerated after the Bank of Canada's surprise rate cut in January.

With government bond yields tumbling to record lows in the first quarter, dividends on many preferred shares have reset at sharply lower rates and others are poised to do the same.

How the math works

As an example, in 2010 Bank of Nova Scotia issued BNS.PR.Y with a par value of $25 and an annual dividend of 96.25 cents, for a yield of 3.85 per cent. The dividend yield was set at a spread of 1 percentage point above the five-year Canada bond yield, which at the time was 2.85 per cent.

Fast-forward to March, 2015. Scotiabank announced that it would reset the dividend on BNS.PR.Y to 45.5 cents annually – a reduction of more than 50 per cent – for a yield of 1.82 per cent. It's the same 1-percentage-point spread, but the new dividend was based on a dramatically lower five-year bond yield of 0.82 per cent. (For reset purposes, a preferred share's yield is calculated on its $25 par value, not on its market value. On the reset date, investors also have the option to take a floating dividend that adjusts every quarter based on the same spread over 90-day treasury bills).

Faced with falling shares prices and reduced dividend income, many preferred shareholders panicked – particularly retail investors, Mr. Normandeau said. "They were just selling every issue they have," he said. That's when he started aggressively investing the cash he had been accumulating.

The rebound

His timing worked out well. Preferred share prices have rebounded in recent weeks and, although he's not buying as aggressively as he was in late 2014 and early 2015, he still thinks many rate-reset preferreds offer attractive potential returns – and acceptable interest rate risks – at current levels.

"I think the Bank of Canada is done. They're not going to cut again this year," he said. Nor does he expect the five-year government bond yield, which sank as low as about 0.59 per cent in early February, to revisit such extreme levels. The five-year bond yield has recently been about 1 per cent.

Many moving parts

What sort of returns can an investor expect from HPR? It's difficult to say, given that the portfolio consists of a mixture of rate-resets, straight perpetuals, retractables and floating-rate securities, all of which respond differently to changes in interest rates, which themselves are highly unpredictable.

However, assuming the five-year bond yield stays roughly where it is – which is by no means guaranteed – the ETF's holdings would have a weighted average projected yield of about 4.61 per cent. Subtracting the ETF's management expense ratio of 0.64 per cent and trading costs of about 0.09 per cent, the investor's projected net yield – after expenses – would be about 3.88 per cent.

That may seem modest. But because preferred shares qualify for the dividend tax credit, for taxable investors it's equivalent – on an after-tax basis – to a yield of more than 5.1 per cent on a bond (assuming the investor lives in Ontario and has income of $100,000. The comparable bond yield will vary by province and income level).

The recent selloff notwithstanding, one of the main benefits of preferred shares is that they are less volatile than common shares, Mr. Normandeau said. For diversification purposes, he recommends that investors allocate 10 to 20 per cent of their fixed-income component to preferreds. As you might expect, he also thinks retail investors should get their exposure through a professionally managed fund, as opposed to investing in individual preferred shares or in a passive, index-tracking ETF.

"This market is complex. This market is sometimes tricky," he said. "That's why you need someone who understands all this complexity."