There are no perfect solutions in investing. This includes rate-reset preferred shares, which you have to be loving if you’re a yield-starved investor who bought these securities in the past year or two.
Rate resets were designed for just the sort of rising interest-rate environment we’re seeing these days. With a bond or what’s known as a perpetual preferred, your yield is your yield. As rates rise and your yield looks less competitive, the price of your bond or preferred share will fall. Rate resets address this by providing the issuer the opportunity every five years to reset your yield to adjust for changes in rates.
As long as rates are rising, there’s a tailwind for rate resets. That’s the backstory for the strong price gains for rate resets in the past few years. The Solactive Laddered Canadian Preferred Share Index, used as a benchmark by the BMO Laddered Preferred Share Index ETF (ZPR), has annualized gains of 11.7 per cent for the three years to Sept. 30.
When the rate outlook changes, so will the prospects for rate resets. It’s happened before. Rate resets were developed in the aftermath of the financial crisis, a time when it was expected that rates would quickly head back to more normal levels in the near to medium term. When that didn’t happen, rate resets plunged. Investors didn’t want to hold a security that could have its yield adjusted lower. That’s the catch with rate resets – they adjust to both rising and declining rates.
The Solactive Laddered Canadian Preferred Share Index has had two losing years since 2012, when ZPR was introduced. There was a 2.4-per-cent dip in 2013 and a 19.9-per-cent plunge in 2015. The compound average annual five-year return to Sept. 30 is just 1.3 per cent.
The yield on ZPR today is pretty good at 4.2 per cent, which is a premium of nearly two percentage points over five-year Government of Canada bonds. The risk with ZPR going forward is not so much whether investors will get their dividend payments. Rather, it’s that the price of ZPR shares will fall hard when rates decline.
Investors often tell me they’re fine with price volatility in a security that pays a reliable dividend. But some of these people underestimate the distress they’ll feel when their overall portfolio results are dinged by a security whose price has plunged 10, 20 or whatever per cent.
Rate resets look inviting these days, but they’re not a perfect solution to the problem of generating a decent yield. Use them as a component of a diversified income portfolio, but keep an eye out for the day they turn nasty.