The Canadian preferred share market is shrinking, but investors in these dividend-paying securities — and the investment funds that hold them — have reason to cheer.
The steep losses of 2022 — when preferreds as an asset class were down about 18% — has given way to a multi-year recovery, with gains in the 25% range last year and continued positive returns this year to date.
About 80% of the Canadian market consists of rate-reset preferreds, whose dividends are adjusted up or down every five years in relation to a fixed-income benchmark, normally the five-year Government of Canada bond yield.
These shares slumped when resets took place during the period of rock-bottom interest rates, and have benefited as rates have risen. Market participants have also expressed confidence that rates won’t return to previous lows.
There are currently about $46 billion in Canadian preferred shares, down from about $70 billion five years ago, said portfolio manager Nic Normandeau of Fiera Capital Corp. Montreal-based Fiera manages the $920-million Global X Active Preferred Share ETF.
In the first nine months of this year alone, about $4.4 billion in preferreds have been redeemed. Banks and insurance companies have been switching to limited recourse capital notes (LRCN), a form of regulatory capital that pays interest.
Unlike with dividends, interest rates are tax-deductible for the LRCN issuer. Similarly, non-financial companies are redeeming their preferreds in favour of interest-bearing hybrid securities.
As a result, institutions and other investors who have had preferreds called by the issuer and want to, or are required to, continue to hold preferreds must bid up prices to replenish their holdings. “That’s another big driver of strength of the pref market since the lows of 2022,” Normandeau said.
The $1-billion iShares S&P/TSX Canadian Preferred Share Index ETF has participated in this robust rebound with a 23.9% return in calendar 2024 and a year-to-date return of 11.4% through the end of September.
However, passive investing in Canadian preferreds has proven to be volatile. The iShares ETF lost 18.4% in 2022, reflecting the broad market for which it is a proxy. And it has received a poor FundGrade rating of D from Fundata Canada Inc. and a below-average two-star Morningstar Rating for its risk-adjusted past performance.
The category’s largest contender, the $1.4-billion BMO Laddered Preferred Share Index ETF, represents a variation on the indexing theme. Its portfolio of Canadian rate-reset preferreds is equally weighted in maturity buckets ranging from one to five years, thus mitigating the volatility associated with changes in five-year Government of Canada rates and improving risk-adjusted returns.
Preferring active management
Most preferred ETFs are actively managed. They have the distinct advantage of security selection within Canada, and the flexibility to hold U.S. preferreds and invest in LRCNs or hybrids, both in Canada and the U.S.
“It’s basically making sure that you do your own security selection decision based on your own fundamental work and also the structure,” said Dynamic Funds’ Marc-André Gaudreau, vice-president and senior portfolio manager of Dynamic Active Preferred Shares ETF.
Since the preferred market is less liquid than some other types of fixed-income, “the capacity or the potential to outperform the benchmark is higher,” said the Montreal-based Gaudreau, whose ETF is one of the category’s best performers and has a five-star Morningstar rating.
Other actively managed funds that have outperformed their peer group include Global X Active Preferred, NBI Active Canadian Preferred Shares ETF and TD Active Preferred Share ETF.
“The other thing that’s very important is the flexibility in our mandate. We don’t have to be fully invested in the $25-par pref market in Canada,” Gaudreau said. “We can go to the U.S. We can go to the institutional preferred share market.” LRCNs and hybrids are also held in the Dynamic portfolio.
For his part, Fiera’s Normandeau is above market weight in rate-reset preferreds versus the fixed-rate perpetuals. Among the rate reset issues, he favours those with low- to mid-reset yields that are trading at discounts. These securities, along with having capital gains potential, are less likely to be called away by issuers.
The Global X portfolio also emphasizes high credit quality, Normandeau said. “In this environment right now, you’re not really paid to go to a weaker credit name.”
Diversification benefits
Additionally, said Normandeau, there’s value in holding LRCNs and hybrids in terms of diversification, provided that the managers can find a good deal. “Even if it’s (fully taxable) interest income, it makes sense to own them.”
In recent years, diversification had not paid off when investing in U.S. preferreds. Brompton Flaherty & Crumrine Investment Grade Preferred ETF, along with BMO US Preferred Share Index ETF and Purpose US Preferred Share Fund have lagged well behind their Canadian counterparts.
However, Dynamic’s Gaudreau is looking to increase his fund’s exposure to U.S. preferreds, as the portfolio management team has done in the past. He cited valuation reasons, saying the Canadian preferred market has gone from being extremely cheap in 2022 to now expensive at the margins. He also expects shrinking supply in Canada to be less of a factor in supporting the prices of preferreds.
Chris Cullen, senior vice-president and head of ETFs with Toronto-based Brompton Funds Ltd., said the roughly US$600-billion American preferred market is much larger and has more diverse rate-reset structures, including fixed-to-floating. A majority are fixed-rate shares.
For that reason, said Cullen, the U.S. market “doesn’t chase yields up and down” as does the Canadian market that is heavily weighted to five-year rate resets. The Brompton ETF also has more than three-year protection for a majority of its portfolio against getting called by the issuer to be replaced with a lower yield.
An ETF alternative that has some similarities to preferred share ETFs is a split-share strategy, of which the largest is the $610-million Brompton Split Corp. Preferred Share ETF.
This ETF invests in a portfolio of dividend-paying preferred share classes issued by split-share corporations, a type of closed-end fund. Along with other split-share ETFs, including Quadravest Preferred Split Share ETF, they’re placed in the Alternative Credit Focused category.
Cullen said split shares are a form of rate-rest preferreds but with more investor-friendly provisions, since resets tend to reflect market conditions rather than being tied to a predetermined formula.
“The returns have been higher than the Canadian pref market and have also been less volatile,” said Cullen. “They can be a very attractive part of a fixed-income portfolio.”
This article has been updated