Rate-Reset Preferred: Could Big Sell-Off Mean An Opportunity?
It wasn’t that long ago that fixed-income allocations of retirees’ portfolios could be dominated by GICs and Canada Savings Bonds, safe instruments that provided decent returns.
But in these days of low interest rates and yields, those fixed-income alternatives don’t provide an income at all when you factor in inflation. This is why non-traditional income products have become very popular and, as such, many people have been drawn to the idea of investing in rate-reset preferred shares.
Rate-reset preferreds began appearing in 2008, when interest rates were falling and everyone thought they would rebound sooner rather than later. The concept was this: the shares would offer a yield markup over the rate on the five-year Government of Canada bond that would be reset every five years. In a rising rate world, that’s an attractive feature.
Like bonds, preferred shares offer regular payments, but like stocks, those payments are in the form of dividends which are taxed at lower rates. When you combine these features with the fact that preferred shares generally yield higher than bonds, it's not hard to see why many people like them.
However, this year has been a very big wake-up call that rate-reset preferred shares have some pitfalls that investors should know about, especially in our current economic environment.
The problem is, against popular consensus, five-year yields ended up declining sharply in early 2015. Investors clearly bought them with the expectation that the reset would help them tap into a higher income down the line. Today, however, some of these shares are headed to a reset at a time when rates are at unexpectedly low levels. It all comes down to this: five-year Canada bonds had a yield around 0.75 percent at midweek, compared with about three percent five years ago.
It’s conceivable that the Bank of Canada could cut rates before increasing them at some future date, so a price rebound for rate-reset preferred shares could take a while. Yet the dividends will continue to get paid as long as the credit quality is good. But there’s still the problem of dividends being reset lower.
This may seem a cruel and surprising twist for rate-reset preferred shareholders, but it’s really just a reflection of the low-rate world in which we live. Yields are down on everything tied to interest rates, and rate-reset preferreds aren’t immune.
What To Do From Here?
- If you are unable to stomach the fluctuations, rate-reset preferred shares are not for you. You might want to look at short term corporate bonds as an alternative
- If you are able to tolerate price fluctuations favour to the highest quality Preferreds (PF1/PF2 ratings) with the highest reset rates.
- Most importantly, pay much more attention to the reset rate and reset date versus the current coupon.
If you currently own a preferred with good credit quality and your investment time frame is more than five years, than most likely it is worth hanging on as prices will eventually stabilize and even rebound, if and when rates go higher.
If you own a lower rate-reset preferred, be prepared for the price to stay low for a very long time. Possibly think about trading up for the same company but with a higher reset.
Getting access to all this information is very hard as a retail investor. Every preferred share is different and it can be very hard to sort out.
Stephane Ruah, Director Wealth Management and Investment Advisor, Richardson GMP, Montreal, QC
(514) 288-4018 or (866) 697-7174,
Stephane.ruah@richardsongmp.com
http://dir.richardsongmp.com/the.rmgroup
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