Something odd is happening in the preferred share market: It’s disappearing.
The securities, which pay a fixed distribution like bonds but trade on stock exchanges like stocks, have long been a draw for investors who like income-generating investments with tax advantages.
But new issues have become a rarity. In fact, just one Canadian company has issued preferred shares in the first half of 2020. Intact Financial Corp. issued $150-million worth of preferred shares in mid-February, prior to the pandemic-driven lockdown and the start of tremendous stock market turbulence.
Since then: nothing. That compares with about a dozen major issues in each of the previous three years, with an average issue size of more than $300-million.
“I think people have been slammed so many times trying to bottom fish in preferreds they have moved on,” Chris Currie, a fixed income portfolio manager with Goodwood Inc., said in an e-mail.
Poor performance is certainly an aspect to this downward trend. Although distributions are generally safe – they can only be cut after a company eliminates dividends on its common shares, and preferred share issuers tend to be blue chip banks and telecom providers – preferred share prices have been particularly volatile this year.
According to Phil Kwon, a fixed income analyst at Raymond James, Canadian preferred shares declined 22.8 per cent in the first quarter (including distributions). That marks a more severe downturn than the 20.9-per-cent decline in Canadian stocks and far worse than the 1.6-per-cent gain by Canadian bonds, challenging the widespread assumption that these are relatively low-risk investments.
Although preferred shares have rebounded impressively from their March lows, they are still down more than 14 per cent this year. That’s worse than the 10.9-per-cent decline, year-to-date, for the S&P/TSX Composite Index.
The reason: Three-quarters of Canadian preferred shares are what are called fixed resets, which pay a fixed cash distribution for a set period. At the end of this period, the distribution is reset to a specified level above Government of Canada bonds.
As interest rates and bond yields fall, investors face the prospect of smaller distributions when companies reset the yields on their preferred shares.
Consider that the recent yield on the Government of Canada five-year bond was just above 0.36 per cent, down from more than 1.6 per cent at the start of the year. If a company issued a preferred share with a yield of 5 per cent, and the yield will be reset at, say, three percentage points above the five-year bond, the new rate would be reduced to less than 3.4 per cent (based on a par price of $25).
That’s not as enticing, which is why many preferred shares have fallen well below their issue price of $25. As well, the asset class can be volatile because issues are generally not huge (unlike common share listings or bonds) and tend to be unpopular among institutional investors.
“Preferred shares are illiquid and not well understood. To me if I have learned anything in this market downturn, it is that income doesn’t equal safety,” Barry Schwartz, chief investment officer at Baskin Wealth Management, said in an e-mail.
There is a case for preferred shares, though.
John Nagel, a long-time preferred share expert who is now a Toronto-based managing director at Leede Jones Gable Inc., a Canadian investment firm, said that a lot can happen over the next three-and-a-half years: Bond yields should rise with an improving economy as the novel coronavirus pandemic recedes, which could make beaten-up preferred shares a profitable way to bet on better days ahead.
“I suspect that by 2023, five-year Government of Canada bond yields will be a lot higher than 0.36 per cent,” Mr. Nagel said in an interview.
He highlighted the case of Bank of Nova Scotia’s series 40 preferred shares (BNS.PR.I-TSX). The shares, which were issued in 2018 with a yield of 4.85 per cent, now trade below $18 and yield more than 6.8 per cent.
The catch: In January, 2024, the fixed rate on the shares will be reset at just 2.43 percentage points over the five-year bond. In other words, today’s 6.8 per cent yield will fall to less than 4 per cent, based on current bond yields and the current share price.
But if bond yields rise between now and the reset date, the prices for preferred shares such as these ones could rally – and perhaps this year’s drought in newly issued shares will be a short one. But right now, the lack of issuance suggests one thing: Investors are wary.
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