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The recent torrid performance of preferred shares is too good to last, but fund managers say there’s still more upside for these securities that combine elements of fixed income and equities. The key reasons: favourable interest rate trends, shrinking supply and attractive yields.

Preferred shares and funds that invest in them have produced returns more like hot growth stocks over the past year, making yields on high-quality government or corporate bonds look even skimpier by comparison.

In the 12 months ended June 30, the S&P/TSX Preferred Share index soared 36.6%, and some actively managed ETFs did even better. Over the same period, the FTSE Canada Universe Bond index was down 2.4%.

Because of periodic adjustments made to their payouts, most preferred shares don’t behave like other fixed-income asset classes in response to changes in interest rates. When rates go up, bond prices go down. And the longer a bond’s duration — a measure of its interest-rate sensitivity — the greater the losses.

For preferred shares, the opposite tends to be true. That’s because more than 75% of Canadian preferreds have rate-reset provisions, whereby their fixed payouts are adjusted at least every five years.

Yields on rate-reset preferreds are linked to changes in the five-year Government of Canada bond rate. While still low by historical standards (0.97% at the end of June), the five-year benchmark bond rate is up sharply from 0.36% a year earlier. Because of their positive correlation with rising rates, rate-reset preferred shares received a welcome boost.

“It’s a negative duration asset class when you think about it,” said Marc-André Gaudreau, manager of the $729-million Dynamic Active Preferred Shares ETF and Dynamic Preferred Yield Class, a mutual fund with a similar mandate. A vice-president and senior portfolio manager in the Montreal office of Toronto-based 1832 Asset Management LP, Gaudreau is head of the credit team that manages more than $5.3 billion, including $1.9 billion in dedicated preferred-share mandates.

Noting the huge fiscal stimulus by governments in North America and the mass vaccinations for Covid-19 that are enabling the economy to gradually reopen, Gaudreau said the odds are that central bankers eventually may face pressure to raise interest rates. This will benefit preferred shares as an asset class and increase the probability that positive returns will continue, “especially relative to anything else in fixed income.”

Weighed against this outcome is the equity risk associated with preferred shares, which was evident during the severe market downturn last year early in the Covid-19 pandemic. Despite their outsized 12-month gains, three-year returns on preferred ETFs are mostly in the range of 4%–5%. Back in 2018, when the Canadian stock market was also down, some preferred share ETFs had double-digit losses. Consistency isn’t their strong suit.

Since preferred shares are subordinated debt, they rank lower than bonds in the event of corporate insolvency. And unlike bonds, they have no maturity dates. “A year ago, it was risk-off and we had a global recession, so the asset class came down significantly,” said Gaudreau.

With recession fears having eased, prospects now appear favourable. Over the next 12 months, the Canadian preferred market could return 5%–7%, said Nicolas Normandeau, vice-president and portfolio manager, fixed income, with Montreal-based Fiera Capital Corp. Fiera manages the $1.8-billion Horizons Active Preferred Share ETF and the $52-million Horizons Active Hybrid Bond and Preferred Share ETF.

 Most of this projected return, about 4%, consists of dividend yield, with some potential for capital gain. The Horizons Active Preferred ETF recently had about 45% allocated to preferreds that trade at discounts below their $24 issue price.

Yields on preferred shares are similar to those of high-yield bonds, which Normandeau described as an asset class with comparable credit risk. On average, preferreds currently yield roughly twice as much as investment-grade corporate issues.

Better still for investors in non-registered accounts, Canadian dividends — including those paid on preferreds — are eligible for dividend tax credits. The tax advantage varies by province and by individual tax brackets. In Ontario, for example, a 4% dividend yield is roughly equivalent, after tax, to an interest yield of 5%.

A ground-breaking positive development unique to Canadian preferred shares is the emergence of limited recourse capital notes (LRCNs) and other types of hybrid securities. Both are reducing the supply of preferreds, which has positive implications for share prices.

LRCNs were pioneered by Royal Bank of Canada in July 2020 after a favourable ruling by the Office of the Superintendent of Financial Institutions (OSFI), with other banks following in short order. Sold to institutional investors, LRCNs are classified by OSFI as regulatory capital but are interest-bearing. Since interest is tax-deductible while dividends are not, LRCNs are a cheaper source of funds for financial companies than preferred shares.

Consequently, Canadian financial institutions — which account for more than half of the preferred-share market — will continue to redeem their expensive preferred shares and replace them with LRCNs.

Currently, the benchmark S&P/TSX Preferred Share index has a market capitalization of about $60 billion and about 225 constituents. Both those numbers are expected to shrink substantially. Normandeau expects almost $5 billion in preferreds might be redeemed in the remainder of 2021, and potentially another $6.8 billion next year.

Further contributing to the shrinking supply of preferreds are redemptions by non-financial companies, such as utilities, in favour of hybrid bonds that receive equity treatment on corporate balance sheets but are interest-bearing and therefore tax-deductible.

“It’s not full-on equity but it’s not full-on debt,” Gaudreau said. “It basically has the best of both worlds for the issuer.”

The actively managed Dynamic ETF has the flexibility to also invest in LRCNs, hybrid bonds, U.S. preferreds and hybrids, and traditional bonds. But heading into the second half of this year, Gaudreau and his team think the risk-reward tradeoff is more attractive for Canadian preferreds. The reason: unlike rate-reset and floating-rate preferreds, prices of these other securities could come under pressure in an expanding economy since central bankers might eventually have to increase interest rates.

LRCNs and hybrid bonds don’t play much of a role in the Horizons Active Hybrid Bond and Preferred Share ETF either, under its new name and wide-ranging fixed-income mandate that took effect in March. “We still think there’s more value within the pref market,” said Normandeau. “Not all of them, so you have to be really careful of which ones you select.”

He added that as more preferred shares are redeemed, the ETF will eventually hold more LRCNs and hybrid bonds.

Even while focusing on preferreds, active managers like Fiera can use securities selection to their advantage. “There’s still a lot of preferreds that trade at discounts,” Normandeau said. “And that’s where we put our overweight.”

Of the two Canadian preferred ETFs with 10 years of history, the Horizons Active Preferred Share ETF has returned an annualized 3.9% to June 30, ahead of the 2.4% return of the iShares S&P/TSX Canadian Preferred Share Index ETF.