Canadians love dividends, and preferred share ETFs are dividend-paying machines. How this dream match-up went sour is a classic story of the right investing product appearing at the wrong time.
Exchange-traded funds holding preferred shares have, in fact, been machine-like in paying monthly dividend income to investors. But their share prices have fallen over the past five years, a startling result from an investment product that has been used as a bond substitute.
There’s a temptation to blame investors when they buy things that turn on them, but let’s go easy here. Tough times for preferred share ETFs are a result of forces that have surprised economists and investing strategists, specifically the persistence of low interest rates. If you hold these ETFs, don’t do anything until you understand the big picture.
ETFs have come into their own in the past few years as a go-to portfolio building block, in part because they provide a low-cost, diversified way to access investment categories that are hard to buy directly. Preferred shares were a natural for ETF companies looking to build assets. Even experienced investors find prefs hard to research and understand.
Close to $6-billion has been invested in preferred share ETFs, but most of that money is concentrated in a few funds. The $1.9-billion BMO Laddered Preferred Share Index ETF (ZPR), posted an average annual loss of 2.7 per cent for the five years to July 31, the $1.3-billion Horizons Preferred Share ETF (HPR) lost 0.2 per cent annually over that time frame and the $1.2-billion iShares S&P/TSX Canadian Preferred Share Index ETF (CPD) lost 1.1 per cent.
What makes these numbers especially painful is that they’re total returns. Even with dividends factored in, preferred share ETFs have been five-year money losers. Blame these disappointing results on the unpredictability of interest rates.
Today’s preferred share market is about 70-per-cent weighted to rate reset preferreds, where the dividend is adjusted every five years to reflect changes in interest rates. These rate reset shares originated roughly 10 years ago, when rates had bottomed and a strong rebound was anticipated. Rates did rise in 2017-18, but the trend fizzled as global economic growth slowed.
Since last fall, we’ve seen the worst possible environment for rate reset preferred shares and the ETFs that hold them. “Interest rates are going down and dividends [for rate resets] are tied to interest rates,” said Alfred Lee, portfolio manager and investment strategist at BMO Asset Management.
Issued at $15 in November, 2012, ZPR shares have traded in the low $9 range in recent days. Long-time shareholders have seen it all during that span. For example, ZPR plunged 20 per cent in 2015 as investors began to realize that the early batch of rate resets would likely have their dividends adjusted lower.
ZPR rebounded strongly in 2016 and 2017, with gains of 6.8 per cent and 14.5 per cent, respectively. With the Bank of Canada raising rates over this period, rate resets were able to validate their usefulness in a rising rate world. “Between 2015 and about nine months ago, preferred shares were probably one of the top-performing asset classes,” Mr. Lee said.
The happy time for rate reset preferred shares ended last October as the yield on the five-year Government of Canada bond, the usual benchmark for rate reset preferred shares, began a plunge to current levels around 1.2 per cent from about 2.5 per cent. You can see this decline at work in the mostly double-digit losses for preferred share ETFs over the past 12 months (see accompanying table).
The people selling preferred shares and the ETFs that hold them include investors who used rate reset preferreds as a way to profit from rising interest rates, said James Hymas, a preferred-share specialist who manages the Malachite Aggressive Preferred Fund for high-net-worth investors.
“The other class of sellers are people who are selling just because these shares are going down,” Mr. Hymas said. “They’ve take pretty significant losses in the last eight months or so and they’re saying, ‘I’m out.’”
Mr. Hymas’s guideline for investing in preferred shares is that you should only use money you’re pretty sure you’re not going to need for 10 years or more. That way, you can ride through the periods of volatility that seem to be inevitable in a world where interest rates keep defying expectations. Pref shares are particularly attractive in non-registered accounts, where the dividend tax credit applies.
You also have to be realistic about preferred share dividends. Lower interest rates mean a reduced dividend flow from the rate reset shares that dominate the preferred market. Mr. Lee reports that 121 rate reset preferred share issues have had their dividend reset, 82 of which were adjusted lower.
The current yield on ZPR – what investors can expect today based on current dividend flows – was about 5.9 per cent early this week. Mr. Lee estimated this yield would fall to 5.6 per cent if all the shares in the ZPR portfolio reset their dividend using the five-year Canada bond yield of the moment.
Bond yields could definitely fall further, so there’s a risk that the yield from rate reset preferreds might be lower still. But Mr. Hymas points out that there’s nothing exceptional about holding income-producing investments that renew at lower yields.
This happens all the time when investors use five-year ladders of guaranteed investment certificates. That’s where you invest equal amounts in GICs with terms of one through five years and then invest maturing GICs back into a new five-year term. Anyone who has done this in recent years knows that it’s common to renew at lower rates.
It’s also important to understand that the problems faced by preferred share ETFs have nothing to do with the quality of the securities they hold. While Mr. Hymas points out that some less financially solid companies have entered the preferred share market in the past 10 years or so, most issuers are big banks and other blue chips that can be relied on to pay their dividends.
Preferred share ETFs are a hostage to interest rates, then. The rate reset shares they mostly or exclusively hold are pummelled when rates fall and they’ll have their day when rates rise. “As a matter of fact, I think they’re going to shine even if things stay the way they are now,” Mr. Hymas said. “I believe they’re totally oversold at this point.”
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Rob Carrick