Stock Smarts: Preferreds Fizzle
Preferred shares are supposed to be a low-risk way to generate tax-advantaged cash flow but lately some of them have been behaving strangely. Gordon Pape explains why.
If you own a lot of preferred shares in your income portfolio, you’re probably feeling somewhat confused at this stage. They’ve been zigging when they normally would be zagging. As of the close of trading on March 24, the S&P/TSX Preferred Share Index was down 4.8% for the year. What’s going on?
Let’s back up the truck. In January, the Bank of Canada caught everyone by surprise by cutting the target overnight rate by a quarter point, to 0.75%. That’s normally good news for interest-sensitive securities. REITs, utilities, and other defensive stocks responded accordingly.
Preferred shares are also interest-sensitive. But in this case, that sensitivity had a negative impact on pricing.
To understand the problem, let’s suppose a reset preferred came out in October 2010 with an initial rate of 5% and a five-year reset at 2.5 percentage points above the Canada five-year bond yield. This preferred would be up for reset this coming October. If the bond yield remained at 0.72%, the new rate would be 3.22%, well below the current 5% rate. Faced with that possibility, investors would mark down the price of the shares accordingly.
Floating rate preferreds, which only comprise a small percentage of the index, were also negatively affected by the Bank of Canada rate cut. One issue that took an immediate hit was the BCE Series S, which has its rate adjusted every month. Because of this, any increase or decrease in the Prime will quickly trigger a dividend change, which will affect the price of the stock. That’s why we saw a big drop in the share price after the Bank of Canada rate cut. The payment dropped from $0.0621 per share in February to $0.059375 in March. Another cut in the Bank of Canada rate would trigger a similar dividend cut and share price decline.
Perpetual preferred shares, by contrast, got a boost in price from the Bank of Canada cut. With no change in their payments, their yield looks even more attractive in a falling rate environment.