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Rogers Group Financial (RGF) publishes a quarterly newsletter, The Financialist, which is written by the advisors of our firm. The articles are aimed at providing meaningful information relevant to the specific needs of our clients, and each covers a variety of topics (including specific investment strategies and the details of individual investment products).  The latest issues of The Financialist are below; for a complete archive and access to printable .pdf articles, please click here

The Financialist • Issue 131 • October 2016

BY John K. Hale, CPA CGA CFP

It's no secret that today's low interest rate environment poses a real challenge for Canadian
investors who depend on an income stream from their investments. Long- term Government of Canada bonds are currently yielding less than 2.0% and the interest rates on GICs are not much better. As a result, many investors have been attracted to Canadian preferred shares where annual dividend yields are commonly in the 4-5% range.

While preferred shares do provide a high level of secure income, the performance of the Canadian preferred share market in 2015 reminded us that preferred shares do not necessarily provide the same level of "safety of principal" as other fixed income investments.

In 2015, the total return on the S&P/TSX Canadian Preferred Share Index was negative (-14.95%). So far in 2016, the index has recovered slightly and is up +1.70% as of August 31st, 2016.

So what happened?

The main culprit for the under- performance can be traced to one particular type of preferred share in the index known as "rate reset" preferred shares. Unlike "perpetual preferred" shares, which pay a fixed dividend amount, rate reset preferred shares have a feature whereby that the dividend rate will reset (usually after five years) to the five-year Government of Canada bond yield plus a small premium of 1% or 2% or 3% etc., depending on the credit quality of the issuer. While this reset feature can be attractive when interest rates are rising, the exact opposite is true when interest rates fall.

Rate reset preferred shares gained in popularity after the financial crisis of 2008, when interest rates were falling. At the time, many also thought that interest rates were already at or near a bottom and would be higher in five years.

Fast forward to 2015 and interest rates were not higher, but in fact, went lower after the Bank of Canada lowered rates in January and again in July. Many rate reset preferred shares were sold off reflecting the fact that the dividend payments would now reset to a lower level. This was particularly bad news for the index (and for the exchange-traded funds and mutual funds that track it) in that rate reset preferred shares comprise nearly 60% of the index and thus, they have a significant influence on its overall performance.

In response, the rate reset preferred share market is adjusting to this "lower for longer" interest rate environment.

More recent issues of new rate reset preferred shares are now featuring reset rates in the range of 4-5% with some even including a minimum "floor" level on the reset dividend rate. These higher reset rates should help bring price stability to the value of reset shares going forward. As these newer issues are included in the index, we should see more stability in the index as well.

What are Preferred Shares? Preferred shares are equity securities that provide investors with a fixed dividend which must be paid before the issuing company can pay dividends on its common shares. The dividend is stated by a coupon rate and is normally paid out quarterly or semi-annually.
In the event of the issuer becoming bankrupt, preferred shareholders have a claim on the assets of the issuing company that is senior to common shareholders but behind bond holders.

Types of Preferred Shares

Perpetual/Straight Preferred: This type of preferred share has no maturity date and pays a fixed dividend for as long as they remain outstanding. They can be redeemed (called) by the issuer, but the investor has no retraction rights.

Rate Reset: This kind of preferred share pays a fixed dividend rate for a set period of time (usually five years) until the reset date. If the preferred share is not called by the issuer on the reset date, the investor has two options:

1.    The investor can keep the preferred share with the new dividend rate until the next reset date. The reset rate is predetermined and typically a spread above the five-year Government of Canada bond.

2.    Investors can often exchange their shares for a similar floating rate preferred share.

Floating Rate: A floating rate preferred share pays a dividend that adjusts (floats) in relation to a reference rate, typically the prime rate. Some issues of these shares have a minimum dividend or a “floor” and the dividend is adjusted every three months.

Retractable: A retractable preferred share allows the investor to redeem the share at par value on a specified date.

What are the Risks?

Interest Rate Risk: Many preferred shares pay out dividends based on a fixed percentage rate and thus, the price of the underlying shares are affected by changes in interest rates. Like bonds, preferred shares have an inverse relationship with interest
rates and, as rates rise, the price of the preferred share will fall and vice-versa. Preferred shares with longer terms and lower dividend rates are more  sensitive to changes to interest rates.

Call Risk: Callable preferred shares tend to have higher yield to compensate investors for the call risk. Call risk is a disadvantage to the investor because the continuity of the dividend stream
is uncertain.

Credit Risk: Credit risk refers to the issuer's ability to pay its obligations. A decline in credit quality can negatively impact the price of preferred shares.

Liquidity Risk: Preferred shares often have light trading volumes. This lack
of liquidity can thus cause exaggerated swings in price when buy or sell volumes exceed normal levels.

The preferred share market in Canada is complex. Please consult your Rogers Group Financial advisor to discuss if preferred shares are appropriate for your portfolio.

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