Hand with chalk is drawing Risk and reward balance scale on the chalkboard

Income-seeking investors for whom preferred share ETFs would seem to be an enticing proposition had better be prepared for a bumpy ride. Although often thought of as fixed-income investments, preferreds are subject to equity-market risk. The latest harsh reminder was in the fourth quarter of 2018, when the S&P/TSX preferred share total return index lost 10%.

“Everything started with the global equity sell-off,” says Nicolas Normandeau, vice-president and portfolio manager with Montreal-based Fiera Capital Corp. and lead manager of the $1.6-billion Horizons Active Preferred Share ETF. “There was a real repricing of risk.”

Also contributing to the fourth-quarter sell-off of preferreds, he adds, was the widening of credit spreads in the bond markets, nervous buyers opting to sit on the sidelines, and advisor-driven tax-loss selling in the retail market.

“Valuations are way better than in October. But what we think will happen this year is that in 2019 it will remain volatile,” Normandeau says. Assuming relatively stable equity markets and no economic recession this year, the Fiera team estimates the Horizons ETF would be able to earn, roughly, the coupon rate, which is currently around 5%.

Preferred shares have become attractively priced relative to other asset classes, says Ryan Domsy, vice president and portfolio manager with Toronto-based Foyston Gordon & Payne Inc. (FGP). “In particular, we currently see great value relative to bonds.” FGP manages the $232-million Evolve Active Canadian Preferred Share ETF, which launched in September 2017.

Domsy says the value stems from the dividend yields on preferreds, which are much higher than dividends on common stocks or interest payments on bonds. Yields on preferred shares are on average well over double that of the 1.91% yield of five-year Government of Canada bonds.

Preferred-share funds are most suitable for non-registered accounts, thanks to dividend tax credits. But it also may make sense for clients with smaller accounts, who are investing only in registered plans, to have some exposure to preferreds, says Christopher Doll, vice president, ETF sales and strategy, with Toronto-based Invesco Canada Ltd.

Doll cites relatively low volatility and low correlations with other assets as positive attributes of preferred shares for retail investors. By holding preferred shares in a registered plan, says Doll, “you’re giving up some tax efficiency but you’re still getting a high yield. You’re still getting the diversification benefits.”

The negative correlation with bonds can be explained by the fact that roughly 80% of the preferred-share universe consists of rate-reset issues. Unlike bond prices, which move in the opposite direction of interest rates, rising rates bode well for rate-reset preferreds.

Generally, rates on these preferreds are reset every five years, and are based on a set percentage above the five-year Government of Canada bond yield. Since the five-year bond yield is much higher than it was five years ago, rate-reset issues are resetting at significantly higher rates.

Even among rate-reset preferreds, there’s an array of dividend-paying provisions.

“It’s a complex market,” Normandeau says. “Some have low resets, some have mid resets, some have high resets.” All of them, he adds, represent “a totally different bet as to interest rate moves and also credit moves.”

At roughly $70 billion to $75 billion in total market capitalization, the Canadian preferred universe constitutes a small niche of the Canadian capital markets. At last count, there are only 14 ETFs that invest exclusively or primarily in Canadian preferred shares, with combined assets of a little more than $7 billion.

The bulk of the assets are held in the ETF category’s big three, led by the $1.8-billion BMO Laddered Preferred Share Index ETF, which invests in a portfolio of rate-reset preferreds diversified by maturity dates.

Next in size is the $1.6-billion Horizons Active Preferred Share ETF, the largest actively managed offering. The third-largest, and the most broadly representative of the asset class, is the $1.4-billion iShares S&P/TSX Canadian Preferred Share Index ETF, which has about 240 holdings.

Launched in April 2007, the iShares fund is the oldest ETF in the category, and its track record is indicative of the ups and downs of this asset class. This ETF has lost money in two of the past five calendar years – down 8.4% in 2018 and an even worse 15.3% plunge in 2015.

A variation on the indexing theme is the $179-million Invesco Canadian Preferred Share Index ETF, which tracks the NASDAQ Select Canadian Preferred Share Index. Of the six ETFs that invest mainly in Canadian preferreds and have at least a three-year history, the Invesco offering is the only one with an above-average Morningstar rating for risk-adjusted historical returns.

“It is a combination of the 100 highest-yielding, lowest-volatility dividend-paying preferred shares in the marketplace,” says Doll. “And so it is what we like to call a ‘factor’ or ‘smart beta’ tilt on the asset class.”