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investor clinic

The investments that I'm most comfortable with are bonds and bonds funds. My only worry is what happens when interest rates rise. I try to ladder the bonds, and I hold several laddered ETFs. However, I'd like to know whether there is a class of fixed-income investment that is likely to move up with interest rates, as a sort of hedge against the rest of my fixed-rate portfolio.

One asset class you might consider is rate-reset preferred shares. The sector has been beaten up badly this year, but there are signs the worst may be over.

More on that in a moment. But first, a quick refresher.

Dividends on rate-reset preferred shares are adjusted every five years based on a fixed yield spread above the five-year Government of Canada bond. So, if the five-year Canada yield rises, rate-reset preferred shares should perform well.

Floating-rate preferreds – a related asset class – also stand to benefit if interest rates rise. The dividends on floating-rate preferreds are adjusted every quarter based on a spread above 90-day treasury bills. (Rate-reset preferreds can usually be converted to a floating-rate option on the reset date, which is how many floating-rate preferreds are created.)

Keep in mind, however, that if the five-year Canada yield falls, rate-reset preferreds will likely perform poorly. This is precisely what happened over the past year, when the five-year Canada yield plunged from about 1.7 per cent in September, 2014, to its current level of about 0.84 per cent, causing massive losses among rate-reset issues.

The carnage came as a brutal shock to investors who had purchased rate-reset shares primarily for protection from rising interest rates – without considering what would happen if rates fell instead.

The good news is that rate-reset preferreds – as well as conventional preferred shares – have rebounded recently. The BMO Laddered Preferred Share Index ETF (ZPR), which invests exclusively in rate-reset issues, has jumped more than 11 per cent since Oct. 14. The iShares S&P/TSX Canadian Preferred Share Index ETF (CPD) and the Horizons Active Preferred Share ETF (HPR), both of which hold a mix of adjustable-rate and conventional preferreds, are up about 9 per cent from their recent lows.

All three ETFs have been attracting a lot of new money from investors recently. According to a CIBC report, ZPR received inflows of about $34.8-million over the past week – the highest among all Canadian ETFs. CPD was in third spot, with inflows of $26.7-million, and HPR was sixth, with $12.4-million of new funds.

"Those are very significant inflows," said Jeff Herold, chief executive officer of J. Zechner Associates, which manages preferred shares for pension and endowment funds as well as the NexGen Canadian Preferred Share Fund.

"What's happened, I think, is that all of a sudden some institutional investors decided, 'Okay that's cheap enough,' and started to come into the market."

However, he's still cautious on rate-reset preferreds, for a few reasons. First, given the sluggish economy, the Bank of Canada is in no hurry to raise interest rates, which could keep a lid on the five-year yield. Second, Mr. Herold is expecting some Canadian banks to issue preferred shares over the next few months, and that new supply – potentially at relatively high yields – could put pressure on existing preferreds. A third concern is that, if the preferred rally fizzles, rate-resets could be hit the hardest because they have posted the biggest gains recently.

If you're looking to control your interest-rate risk and diversify your bond portfolio, straight perpetual preferred shares are another option, he said. Their yields are generally higher than bond yields from the same issuer, and the yield advantage is even wider after taking into account the dividend tax credit. (The same is true of rate-reset issues).

Some investors worry that straight perpetual preferred shares – which have a fixed dividend – will tumble if interest rates rise. But that's not necessarily the case, Mr. Herold said. While bonds and preferred shares often exhibit some correlation over short periods, "over longer periods of time, preferred shares don't seem to follow bonds," he said.

Rate-reset preferreds are complex securities and I would recommend that you study them thoroughly and understand the risks before investing. I've discussed them in detail in several recent columns, which you can read online at tgam.ca/EKJp, tgam.ca/EMIj and tgam.ca/ELzx.

Disclosure: The author owns units of CPD.