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.

The Investment Strategy Group of CIBC Wood Gundy explained why in a comprehensive report on the preferred share sector. The report noted that about two-thirds of the S&P/TSX Preferred Share Index is made up of reset preferreds, many of which are due to be reset soon.

These shares pay a fixed return for five years, after which the rate is reset at a pre-specified percentage over the yield on a Government of Canada five-year bond. When the central bank cut its overnight rate, the yield on the benchmark five-year bond plunged to as low as 0.58%. It bounced back to 0.99% on March 6, buoyed by the fact the Bank of Canada did not cut again at its March 4 meeting. But by March 24 it was back down to 0.72%. Investors are still concerned the central bank could slice off another quarter point in the spring, with a corresponding negative impact on reset preferreds.

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.

The bottom line is that the way in which a specific preferred reacts to interest rate movements depends on how it is structured. That’s why a mix of high-quality preferreds is the best approach, as opposed to focusing on a single type.