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More than a dozen years ago, some clever investing people thought of a way to build preferred shares so these securities could thrive amid rising interest rates.

Okay, so these financial engineers were a bit early with the creation of rate reset preferred shares. But the sharp rise in rates they anticipated in the late 2000s did finally materialize this year. How are preferred shares holding up so far? Not great.

Rate resets account for roughly 80 per cent of a preferred share market that has fallen about 9 per cent on a total return basis for the year through the beginning of May. The S&P/TSX Preferred Share Index had a great year in 2021, rising 19 per cent amid the expectation of rising rates. Now, with these increases actually happening, the index has reversed course.

Logically, this makes little sense. Rate resets are designed so that their dividend is recalibrated every five years to maintain a specified yield premium over five-year Government of Canada bonds – 2.5 to three percentage points in many cases. The five-year Canada bond yield has soared this year, which suggests that rate resets coming up for a rate adjustment will get a significant bump in payout.

And yet, there’s a strong negative sentiment toward pref shares right now, said Doug Grieve, portfolio manager for the Lysander-Slater Preferred Share ActivETF (PR-T). “Our reasoning is simple,” he added. “We feel that the inflation story has spooked the market.”

Rate resets seem well-suited to withstanding the rate increases used to quell inflation. The problem, according to Mr. Grieve, is that a substantial position in preferred shares is held by diversified fixed-income funds that are getting hit hard by rising rates. These funds are selling their preferred shares, taking profits in some cases, and creating an excess of supply.

Additional selling pressure has come from investors who have trimmed their holding in pref share exchange-traded funds, thereby forcing these funds to sell shares in their portfolios into an already weak market. Still more selling pressure has come from limited recourse capital notes (LRCNs), which are a new type of pref-like security issued by banks.

Mr. Grieve sees an opportunity in this sell-off for investors who are willing to live with some volatility in order to potentially benefit from, first, a strong yield and, second, the potential for capital gains as pref share prices recover lost ground. “It’s tough to say when, but probably at some point in the summer there is going to be a real slingshot effect,” he said.

Bond yields are getting attractive these days, thanks to falling bond prices (yields and prices move in opposite directions). The yield on the FTSE Canada Universe Bond Index was up to about 3.5 per cent in early May.

But pref share yields are higher, with the potential to get better as rates rise further. The current yield after fees for PR is 5.8 per cent, which looks particularly good in taxable accounts where the dividend tax credit is available.

Don’t touch prefs unless you’re prepared for volatility. The preferred share index has an annualized total return of 2 per cent over the 10 years to April 30, which represents a blend of great years like 2021, and some pretty bad ones when rates fell instead of rising as expected by the clever types who invented rate resets.

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