After the volatility over the past few months, this year, the S&P/TSX Composite index seems to be headed upwards, gaining close to 10% year-to-date, as against the S&P 500, which up around 5% for the same duration, according to Morningstar Direct data.
Though fears of a recession seem to be past us, many investors believe that growth might likely be slower in 2019.
One of the potential risks that several investors have been watching is that of an interest rate hike, but with the U.S. Federal reserve becoming more dovish, that possibility seems remote, with Morningstar analysts expecting only a single hike in mid-2020.
“Because the Fed has indicated that there will be a pause on rate hikes, it takes the pressure off the Bank of Canada to hike rates. If rates here stay flat, that is not a bad thing,” says Jean Mathieu Gareau, Portfolio Co-Manager, Intact Investment Management.
With a recession at bay, interest rates stabilizing, but volatility expected to continue, where should investors turn? Some investors who are more conservative, but want exposure to corporates, look to preferred share funds.
“Investors that want higher income, and more tax efficient income, should consider preferred share funds. With these funds, you get around 5.5% dividend yield, which is relatively attractive. This is also a great hedge for investors that hold bonds,” Gareau says.
Gareau manages the four-star, bronze-rated, NBI Preferred Equity Income F.
He believes that though we have seen a lot of volatility in the recent past, the one way that investors can protect themselves is through diversification.
“Diversification should be across credit, structure and sectors. In this late end of the economic cycle, we like stability. We have played more conservatively in 2018, and we expect to continue the same in 2019, and to be more conservative than our peers,” he says, reiterating that he favors stability.
He points out that it is important for investors in preferred shares to focus on the 5-year Government of Canada rates. At present, that rate is around 1.85%. “Internally, we believe that if the rate stays at or near 1.7%, 80% of all resets will reset higher. So, there is upside potential there. For us, we don’t see any immediate change to our strategy because of an interest rate movement. In fact, we have been planning for a stop in interest rate hikes for the past 12 months,” Gareau says.
The NBI Preferred Equity Income F holds 31% in fixed perpetuals, 65% in rate resets, and 3% in floating rate holdings.
The holdings in fixed perpetuals are overweight the benchmark and forms the core of Gareau’s portfolio. “We like these securities because they are high yield and less volatile, meaning more stable with higher income,” he points out, adding that the yields are higher – between 5.5% to 5.9%, so these generate stable income and stable price returns.
“With rate resets we favor the barbell approach", he said. He invests in discounted resets that have upside potential and higher torque to interest rates, while compensating by holding other resets that are expected to get called and have low volatility.
In terms of sectors, Gareau is underweight banks and overweight life insurance.
“Banks have one risk – they must present supply whether it is a good or a bad market. As a result, there is a constant stream of supply, and there is repricing risk. Earlier this year, there were new issuances that helped reprice the market lower. So, at the moment, we are cautious on banks,” he explains.
On the other hand, he likes life insurance as a sector, because it has a spread that is 30 basis points higher than the banks. “These companies are well capitalized, and have tried, tested and robust business models. Moreover, they are not plagued by excess supply, so there is no repricing risk,” he says.
Finally, what are some individual names he likes? Gareau picks three - one in the perpetual space, and two in fixed resets. But he points out that it would not be wise to buy any of these in isolation.
“The key to investing is diversification. We would not recommend that any investor own any of these picks on a standalone basis, as each of these have specific risks, whether this risk is on the spread, the sector, on interest rates, or any other risk. We recommend that preferred equity income investors own a fund or an ETF to get better diversification,” he points out.
On the perpetual side, Gareau likes Power Financial Corp Pref Share (PWF.PR.G). It has a 5.8% yield and is above par with a price of $25.15. “The company has great credit and has low volatility on the upside or downside,” Gareau says.
On the fixed reset side, one of his picks is Brookfield Office Properties Inc Pref Share (BPO.PR.G) which has a 6.2% dividend yield, is priced at $19.60. His final pick is IAG Preferred G (IAG.PR.G). “The yield here is relatively low at 4.8%, but it resets in three years to around 5.95%. So there is a potential upside of 25%”, he says.
