The forward momentum in the stock market is so strong that even preferred shares are rising with gusto.
But there’s one corner of the preferred market that could still be undervalued – floating rate preferreds. If interest rates rise as expected in the years ahead, these floating rate shares would be especially appealing.
Most preferred shares these days are of the rate reset variety, where the dividend is reset every five years to adjust for changes in the yield on the five-year Government of Canada bond. Floating rate preferreds typically have their dividend rate adjusted every quarter, or even monthly in the case of some BCE Inc. shares. The reference rate for setting the dividend is either the average prime rate at selected big banks or the 90-day treasury bill rate. Investors may get 100 per cent of these rates, or a portion of it.
The longtime lameness of preferreds is captured well in the annualized 10-year total return to Feb. 28 for the S&P/TSX Preferred Share Index – just 2.4 per cent. But things have changed over the past 12 months, with the index surging 17.4 per cent. Bank and Insurance as well as regular rate reset preferreds have led the charge, and floating rate preferreds have risen as well. Still, these shares typically traded in late March at levels below their $25 issue price.
John Nagel, preferred share specialist at Leede Jones Gable, says these floating rate preferreds may actually be more suited than some fixed rate resets to the rising interest rate environment widely expected for the years ahead. “I’d much rather have something that adjusts quarterly or monthly than I would every five years,” he said.
Here’s an example of a floating rate preferred share issue Mr. Nagel likes right now – Brookfield Asset Management Inc. Series 2 (BAM.PR.B), with a yield is 3.67 per cent based on the current prime rate of 2.45 per cent and a share price of $11.68. If prime rises to 2.95 per cent, the implied yield based on today’s share price rises to 4.42 per cent; another increase of a further 0.25 of a percentage point in prime takes the implied yield to 5.17 per cent. The formula for these is 70 per cent of average prime based on a $25 par value.
Another example is BCE Inc. Series AB (BCE.PR.B), where the dividend is reset monthly using a ratcheting formula that gives shareholders a minimum of 50 per cent of prime and a maximum of 100 per cent, depending whether the shares trade just below or just above the par value of $25 (a lower price means you get more of the prime rate). BCE.PR.B now pays 100 per cent of prime and will do so until it trades over $25. The shares traded in late March around $16.05 which gave them a current yield of 3.8 per cent.
Some other floating rate preferred issues Mr. Nagel likes include
- Fairfax Financial Series F (FFH.PR.F)
- Brookfield Asset Management Series 13 (BAM.PR.K)
- Cenovus Energy Inc. Series 2 (CVE.PR.B)
- TC Energy Corp. Series 2 (TRP.PR.F)
- Brookfield Renewable Partners LP Series 2 (BRF.PR.B)
All of these shares have current yields that range between 3 and 4 per cent, and have traded at prices much below their $25 issue price in recent days. If interest rates turn lower because of disappointing economic news, expect these shares to drop in price. If rates go up as expected, Mr. Nagel says you’d very likely get both higher dividends and a corresponding increase in your share price.
While floating rates have moved higher in price over the past year, Mr. Nagel thinks there’s more to come. “I don’t think anyone’s gotten excited about them yet.”
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