Welcome to the conclusion of our two-part post on preferred shares. In our last post we discussed the characteristics, sensitivities and recent performance of the preferred share asset class as a whole. Today we will be reviewing a subset of the preferred share universe, the fixed-reset preferred share, and the impact this class of preferreds has had on the broader preferred share market.

 

Q. What has happened to preferred shares? (Part Two)

 

The answer to this question lies in another class of preferred shares, fixed-reset preferreds. Fixed-reset preferred shares make up approximately 70% of the total preferred share market and, unlike perpetual preferreds, fixed-reset preferreds have a correlative relationship to interest rates. When rates rise, fixed-reset prices rise. When rates fall, fixed-reset prices fall. Unfortunately, with interest rates having fallen sharply over the past few months, many fixed-reset preferreds have fallen as well.

 

The degree to which an individual fixed-reset preferred has been impacted by the declines in interest rates can depend on a couple of variables. When a fixed-reset preferred share is issued, the company that issues it agrees to pay a certain dividend for the next five years. At the end of those five years, the company has the option to call (buy) the shares back at issue price or reset the dividend for the next five years at a predetermined premium above the prevailing five-year government of Canada bond rate at the time of reset. When the interest rate of the five-year government bond has fallen, the investor runs the risk that the issuing company will choose to reset the dividend rate at a lower level than its current rate, resulting in a loss of income for the shareholder. Thus, in a declining interest rate environment, fixed-reset preferred shares that have lower reset premiums, and who are closer to their reset date, will tend to see their share prices decline as investors try to gauge the amount they can expect their income stream to fall post reset.

 

The Preferred Way Forward

 

The question then becomes what to do with your fixed-reset preferreds. The answer will depend on the two variables we mentioned above. If the reset premium on your existing preferred is relatively low and/or there is a short window until the next call/reset date, it may make sense for income focused investors to explore other options. If the reset premium is relatively high (above 3%, for example) you may not see your dividend stream decline by too much if the company decides to reset the dividend. Similarly, if the next call/reset date is still a few years out, this timeframe may provide a long enough runway for interest rates to recover to the point where the reset event will not have a negative impact.

 

Outlook

 

For investors with a medium-term outlook (four or five years), there may actually be some interesting opportunities in the space at the moment. At present, the vast majority of fixed-reset preferreds are trading at a discount to their par price. As a result of these share declines, the dividend yields on offer from some well-known and well run companies can range between five to seven percent at current market prices. This means that shares with longer terms to reset and high reset premiums may provide an opportunity to receive above average income in the near term, followed by the potential for capital appreciation over the medium term if interest rate conditions improve. While there are risks to this approach, if interest rates were to decline further share prices will likely decline, it may be worth reviewing for a portion of the income component of a portfolio.

 

We would be happy to review your preferred share exposure with you, or discuss this asset class in greater detail. Please do not hesitate to contact us with any questions you might have about this post or your portfolio in general. Similarly, if you have any questions you would like to see answered in a future post, please send them to us using the contact email below.

 

Andrew.Czernik@cibc.ca

 

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