Preferred share investors have enjoyed an incredible run of late and the question for exchange-traded fund (ETF) investors now is whether it is too late to join the party.
The S&P/TSX Preferred Share Index has returned about 30 per cent over the past year, making it one of the best returning asset classes since the pandemic market downturn.
There are some arguments in favour of a continued strong performance for preferred stock funds, which at the best of times offer the income of bonds and more stability than regular equities.
Chalk up the popularity of preferred shares to the hunger from investors for yield, the anticipation of rising rates and a lack of supply.
“It is almost like the perfect storm for preferred shares,” says Alfred Lee, a portfolio manager and investment strategist with BMO Global Asset Management in Toronto.
The expectation of rising interest rates some time in the future is keeping investor interest in preferreds strong.
“Rising rates are on the horizon whether it is next year or the year after, so that is good for preferred shares,” explains Mr. Lee.
The BMO executive, who manages the BMO Laddered Preferred share ETF (ZPR-T), expects the Bank of Canada to gradually begin moving rates higher as soon as next year – and likely well before the U.S. Federal Reserve begins pushing its rates up.
Not only do preferred shares provide yield, they also offer “a very good tax-efficient yield as well,” Mr. Lee adds.
Rising interest rates would provide a boost to the value of preferred shares generally. Canada’s preferred market is characterized by issuers that reset their dividends every five years to adjust for any change in the interest rate of the Government of Canada five-year bond. About 70 per cent of the preferred market is made up of rate reset shares.
Preferred share ETFs have also benefitted from the effect of scarcity; the dominant issuers of preferred shares in Canada have traditionally been the big banks. Rather than add to the pot, however, they have been redeeming some preferred share issues and swapping them out as a source of capital with limited recourse capital notes (LRCNs).
In terms of new preferred stock issues, Canadian companies have only sold about $300-million so far in new issuance after the pandemic roiled 2020 total of $150-million. In 2019, another down year, about $2.1-billion of new preferred shares were issued.
“Over the last two and half years, we have only seen about $2.6-billion in new supply hit the market,” says Alex Kastanis, vice-president of research with National Bank Financial in Toronto.
He notes that about $6-billion worth of preferred shares have been redeemed or are soon to be redeemed so far this year, which will put pressure on investors to replace that source of income.
“There are not many options on the bond side with interest rates, so they are going back into preferred shares which help drive prices up,” Mr. Kastanis explains.
He describes the preferred market as “a little bit overpriced.”
For investors looking to add exposure to preferred share ETFs, it makes sense to pay a little more in fees for an active ETF rather than a passive one in a market defined by scarcity, redemptions and higher rates down the road.
Passive ETFs have pre-established criteria as to how they will replace redeemed preferred share issues “while active funds can be a little more selective,” Mr. Kastanis says.
An expectation of higher rates looks to be priced into preferred share ETFs. If rates rise higher and faster than expected, that will translate into better returns for investors. However, if rates don’t increase as quickly as expected or other investment alternatives to preferred shares emerge, “we might see some switching or a little bit of decrease in price,” he adds.
A more optimistic outlook comes from Nicolas Normandeau of Fiera Capital Corp., who manages the Horizons Active Preferred Share ETF (HPR-T).
With preferred shares providing an average yield of just over 4 per cent and “a little bit of capital gains possible over the next 12 months,” preferred share ETFs could return a total of 5 to 7 per cent, says Mr. Normandeau, who is based in Montreal.
“Much less than what we just had but still okay in this fixed-income world where rates are still low,” he says.
His rosy outlook depends on more share redemptions on the part of issues as well as a successful reopening of western economies after the pandemic and a five-year rate increase for government debt.
ETF investors looking for potentially better returns from preferred shares should consider U.S. preferred funds which generally provide higher returns, roughly 1 per cent higher annual yield than their Canadian counterparts, says Mr. Lee of BMO, which offers the BMO US Preferred Share Index ETF (ZUP-T).
“For income-oriented investors, U.S. preferred shares might actually be better because even when you net out the withholding tax, the yield on U.S. preferred shares is much higher,” he says.