While equities and fixed income performed well in 2019, the Canadian preferred share markets generated only modest gains. Yet Roger Rouleau, a Montreal-based preferred share portfolio manager and vice-president at 1832 Asset Management LP sees gains on the horizon as enticing values emerge in the asset class.
“There are three main drivers for the Canadian preferred share market, two of them are fundamental and one is technical,” says Rouleau, co-manager of the 4-star rated $840.6 million Dynamic Preferred Yield Class. “The two fundamental drivers are investor appetite for credit risk and interest rates. When you are buying a preferred share you are extending credit to the issuer and taking on credit risk. This means investor sentiment towards credit is one of the asset class’s big drivers.”
Investment-grade corporate bonds have done quite well in 2019, Rouleau notes. “But there is a pretty big gap between where the preferred share market has traded and where you would expect it to be based on credit instruments.” This is where the second factor, interest rates, comes in.
“Eighty percent of this market is structured as rate-resets,” explains Rouleau, a Montreal native who joined 1832 Asset Management in 2012 after earning a Bachelor of Commerce in 2002 from the University of Toronto and working at firms such as Natcan Investment Management. “You buy a new issue and the coupon is fixed for five years. On the fifth anniversary, you have a choice: you can either get a new coupon fixed at a pre-determined spread above the government of Canada five-year bond, or you can float above three-month T-bills, at the same spread. This means if you buy this preferred share you are cheering for higher rates in five years. If rates have moved higher, then your coupon will move higher.”
Why preferreds paused
Unfortunately, the preferred share market in 2019 suffered because the benchmark five-year government of Canada bond yield has dropped to 1.7%, after peaking earlier at 2.5%. “If you owned a rate-reset, you would expect to get one percentage point less on your coupon than a year ago. That’s pretty relevant when the typical coupon is 4-5%. That means you’re getting 25% less yield than you expected. What we had in the fourth quarter of 2018, and have continued to have, are low rates. Central banks around the world were worried about the outlook for growth and proceeded to cut rates. This has been very positive for equities and credit and bonds. But if you are a Canadian preferred share owner, and hoping for higher rates, that’s not what the market is expecting now.”
The scenario is reflected in returns. Silver-rated Dynamic Preferred Yield Class Series F returned 4.19% in calendar 2019, compared to 3.48% for the S&P/TSX Preferred Share Total Return Index. On a three-year basis, the fund averaged 2.87%, versus 2.68% for the index and 1.47% for the Preferred Share Fixed Income category.
The drop in rates is not the only factor that has hurt the category. The technical factor known as flow of funds is also to blame. “What we have seen going back to October 2018 has been some consistent outflows from the asset class,” says Rouleau, who shares duties with Marc-Andre Gaudreau, lead manager and vice-president and senior analyst Alexandre Mathieu. The team manages $6 billion in credit-related asset classes.
“January and February 2019 were months when there was a lot of money flowing out of the asset class. Technicals tend to exacerbate the performance of the asset class. As the outlook for higher rates dimmed, people said to themselves, ‘We’re getting out. Rates are not heading higher so why should we own preferred shares?’”
Fed rate cut was a recession tell
Rouleau maintains we are late in the economic cycle. “There was a slowdown in growth and central banks responded by cutting rates. But we are at a crossroads. If you look at history, every time central banks have cut, it’s been in response to slowing growth. They did so in 1994 and 1998, and were successful in turning things around,” observes Rouleau. “We find ourselves in the ‘insurance cut’ scenario. But every recession also starts with ‘insurance cuts.’ Is this going to be like 2006-07?” Still, Rouleau does not believe a recession is around the corner and maintains there are a few years to go, mainly because we have not experienced an inflation shock and lending standards are loose.
From a strategic viewpoint, Rouleau is running about 8% cash. “We can respond to opportunities in the event of a market pull-back because we have the dry powder to do so,” says Rouleau. “Like I said, we are at a crossroads: it looks like we are not going into recession. But there are similarities to 2007, when we had an inverted yield curve. The jury is out as to what the near-term holds. The other factor, as we’ve seen in previous weak years, is tax-loss selling,” says Rouleau, noting that preferred shares are one of the few asset classes that have losses in 2019 which can be offset against the capital gains made by stocks and bonds. “We expect selling pressure on the market [in December]. Having a higher allocation in cash is not a bad idea in terms of being able to respond to any potential opportunities.”
The last time this scenario occurred was in 2015, when the fund returned -6.72%, versus -10.7% for the category. In 2016, the fund rebounded and returned 8.26%, compared 8.33% for the category.
Currently, the bulk of the portfolio, or 66.4%, is in rate reset preferred shares, compared to 78.7% for the benchmark S&P/TSX Preferred Shares Index. There is also 13.2% in fixed-rate preferred shares, versus 18.9% for the benchmark and 3% for so-called ‘floaters’, versus 2.4% for the index. The fund has a running yield of 4.9% before fees.
A preference to position for upside potential
The large rate-reset component reflects where the team sees the better risk-reward proposition. “When we build the portfolio, we always ask ourselves, ‘What is our potential upside? Are we comfortable with the issuers?’ And when we look at the different types of securities, we ask ourselves, ‘What is my best risk-reward trade-off?’”
The portfolio has about 170 securities from 31 issuers. Compliance rules prevent Rouleau from discussing individual securities in detail. But he does admit the team is comfortable with the pipeline industry, for example. “In a world where you can’t build more pipelines, whoever has pipelines is set. That’s a segment where there are some pretty resilient business models. Management of some of these companies is very creditor-friendly and concerned about their ratings. They are watching out for us, which is what we like. And many securities are priced cheaply. The yields are very attractive,” says Rouleau, noting that some preferred shares from firms such as Enbridge Inc. (ENB), and Pembina Pipeline Corp. (PPL) are yielding 6.5-7%.
Going forward, Rouleau is optimistic, partly on the grounds that the 2020 U.S. presidential campaign may see talk of further tax cuts. “Some of the uncertainty in the market will fade. That will put a floor under interest rates,” says Rouleau. Indeed, it is quite possible that the five-year government of Canada bond yield will move up again, which would be supportive of the preferred share market.
“It’s a cheap asset class but the interest rates argument has to be resolved,” argues Rouleau. “There is a tug of war between rates and credit. To move higher, you have to have some resolution on the rates side.”
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