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In keeping with the theme of the current bull market for everything, preferred shares have been utterly spectacular over the past year or so.

The S&P/TSX Preferred Share Index was up 42 per cent for the 12 months to May 31 on a total return basis, pretty much what you’d have made with an investment in the tech-dominated Nasdaq 100 Index (with currency hedging). Not bad for an asset class that by tradition is valued for income, not capital gains. By comparison, the S&P/TSX Composite Index was up just 34 per cent over that period.

Preferred shares have been uncharacteristically hot in the past year – the preferred share index return for the past 10 years is just under 3 per cent on an average annual total return basis. What’s ahead for the next 12 months? Expect returns of about 6 per cent to 7 per cent on a total return basis for the year ahead, says Nicolas Normandeau, a portfolio manager with Fiera Capital Corp. in Montreal, who runs the $1.8-billion Horizons Active Preferred Share ETF .

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“Are we going to see as strong a performance as we’ve seen so far? Not at all,” he said. “There’s less capital gains potential, but there’s still some.”

Rising interest rates will support a preferred share market that is dominated by rate reset shares, where the dividend rate is reset every five years to adjust for changes in the five-year Government of Canada bond.

The market is also benefiting from the fact that the big banks, major players in the preferred share market, are redeeming some of their preferred share issues and replacing them with a security called limited recourse capital notes (LRCNs). Some non-financial preferred share issuers are also redeeming prefs in favour of a security similar to LRCNs. The net result is a decline in the supply of prefs at a time when they remain in strong demand from income investors.

We’ve seen almost two years of preferred shares closely tracking the common shares that make up the S&P/TSX Composite, but Mr. Normandeau thinks this correlation will ease somewhat.

“If the equity market is down 10 per cent, you should expect the pref market to be down 2.7 per cent,” he said. “When there’s a big correction like we had last year, the correlation gets close to 1.0 [both move pretty much in unison]. We saw prefs performing almost as badly as the equity market.”

Prefs still offer something for the income-hungry investor, said James Hymas, president of Hymas Investment Management Inc. The dividend yield on the S&P/TSX Preferred Share Index is about 4.5 per cent, compared with a yield of 0.8 per cent from the five-year Government of Canada bond.

Mr. Hymas urges investors to collect their dividends and learn to live with price fluctuations like we’ve seen in the past two years.

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“One thing with preferred shares is that you have very little institutional presence, and it’s institutions that generally keep the markets on track,” he said. “Extreme price volatility is simply part of the retail market.”

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