by Richard Phillips, Chief Investment Officer and Kevin Muir, CFA, Market Strategist
Executive Summary
Canadian preferred shares have underperformed bond portfolios over the past two decades.
Combined with higher volatility, this poor performance has resulted in a considerably lower Sharpe ratio for preferred shares.
Although specific preferred issues might offer opportunities, there are most likely better choices than owning preferred shares as a long-term investment for most investors.
Preferred Shares over the Past Couple of Decades
Canadian preferred shares have a long history of offering investors a tax-advantaged fixed-income alternative to the traditional bond and stock market. Although they remain a popular choice among retail investors, we believe that increased risk makes them less desirable than many other fixed-income replacements.
During the 1990s 10-year Canadian government bonds yielded between 5% and 12%.
This was a fortuitous period to be investing in fixed-income, and preferred shares proved no exception. Plummeting yields made geniuses out of anyone who put money to work. It was in this environment that many retail brokers’ love affair with preferred shares was born. These securities offered a tax-advantaged yield with the added attraction of being listed on the stock exchange making them easy to trade.
Then in the 2000s the Great Financial Crisis hit. Almost overnight, the credit risk associated with these preferred issuers overwhelmed the benefits of collapsing interest rates: preferred securities plummeted. Instead of protecting investors from their crashing equity portfolios, preferred shares joined the panic and the S&P/TSX Preferred Total Return Index declined by a little more than 30% from 2006 to 2009. Although this was better than the 50% decline in the S&P/TSX Composite Total Return Index during the same period, it was a shock compared to a traditional corporate bond return. For example, the Bloomberg Canadian Aggregate Bond Index fell by only 5% during this same period.
In the years following the Great Financial Crisis financial markets recovered and preferred shares clawed back their losses. However, preferred shares differ from regular equity in that they are often callable by the issuer. Facing much lower interest rates, many preferred share issues were called away as companies found alternative, less expensive methods of financing, replacing the higher coupon preferred issues with newer lower-yielding instruments.
As the early 2010s progressed, many investors worried that this new low-interest-environment was an anomaly brought on by quantitative easing and other extraordinary monetary easing measures. Pushing back on the idea of locking in rates at historically low levels, investors demanded participation in the event that interest rates increased to previous, higher norms.
It was in this environment that rate-reset preferred shares gained popularity. These preferred shares typically had an initial fixed dividend rate, but after five years the rate was reset at a spread linked to the 5-year Canadian bond yield . This protected investors from what-everyone-believed-to-be-an-imminent-rise-in-yields. If Canadian bond yields rallied, preferred share dividends would also increase.
Unfortunately, 2015 saw the 5-year Canadian bond rate collapse from 1.60% to 0.50% and with it, preferred shares.
Within a period of less than a decade, Canadian preferred shares experienced two declines of approximately 30%.
Preferred Shares versus Bonds
The collapses in value proved that a preferred share portfolio was much more volatile than a bond portfolio.
But what is sobering is that this increased risk did not produce higher returns. A comparison of the S&P/TSX Preferred Total Return Index versus the Bloomberg Canadian Aggregate Bond Total Return Index shows that over the past two decades, bonds have dramatically outperformed preferred shares.
Preferred Share Return and Risk Metrics
So let’s think this through. Preferred shares have been both more volatile and have produced less return? We are aware of the tax-advantaged nature of preferred share dividends versus bond interest returns, but since every investor’s tax situation is unique, we will not delve into those details.
Rather, investors need to make their own assessment of whether the following risk/return statistics adequately compensate for the tax difference.
The investment merits of owning preferred shares over the long-run seem tenuous at best.
Trading Opportunities
Although we don’t believe preferred shares as a whole to be an attractive portfolio addition at this time, there are situations where a trading opportunity presents itself. If we look at the rolling 12 month performance of preferred shares relative to bonds we can see that profitable trading opportunities have arisen whenever preferred shares have under-performed by 20%.
This can be demonstrated by charting the 12 month forward returns of the preferred index versus the rolling 12 month relative performance of the two asset classes.
Pay close attention to the green shaded area: an astute reader will notice all forward returns for the preferred index have been positive after a 16% under-performance of preferred shares versus bonds.
Over the past 12 months (as of March 29th, 2019) preferred shares have declined by approximately 12% versus the bond index. While trading prospects are improving, unfortunately we are not yet in that “sweet spot” where all returns have been positive going forward.
A Bet on Higher Forward Rates
We have spoken about the change that occurred after the Great Financial Crisis when the majority of preferred shares being issued shifted to rate-reset preferred shares. But what does this mean from a trading perspective?
The popularity of rate-reset preferred share issuance has created a situation where the preferred share index is now correlated with forward yields. If we plot the 3-year 5-year forward Canadian yield rate (what the 5-year Government of Canada yield will be 3 years hence) against the S&P/TSX Preferred Total Return Index, we notice an increased correlation of the yield to the preferred share index.
Assuming this relationship continues to hold, the conclusion that needs to be drawn is that investors in Canadian preferred shares should be rooting for higher future rates, not lower. Most importantly, investors should be aware of the sensitivity to this forward rate.
Preferred Shares as an Asset Class
We have been treating Canadian preferred shares as an asset class and refrained from examining opportunities that might exist in individual issues or certain sectors. We have also purposely avoided getting too caught up in the details of the “spreads to corporates” and other quantitative bond analysis.
Although it is easy to highlight preferred shares’ poor past performance over the past couple of decades, explaining the returns is considerably more difficult.
One key fact to consider is that the issuers of these securities are sophisticated, financially savvy institutions who understand the benefits embedded in the finer details of these preferred securities. Issuers often have the right to call the preferred share security. This means that when conditions benefit the issuer, the issuer calls and refinances the issue. When conditions are not so favourable, the issuer leaves the existing preferred shares outstanding, with investors left holding underperforming securities. Over time, this right has benefited the issuer much more than the investor, and has resulted in the poor performance of the asset class.
Increasing Use of ETFs Has Made the Problem Worse
Over the past decade there has been tremendous growth in passive indexing and the use of ETFs. Canadian preferred shares have not been immune to this trend. The flagship Canadian preferred ETF, the iShares S&P/TSX Canadian Preferred Index ETF, symbol CPD, has gone from less than 1 million shares at the time of the Great Financial Crisis, to more than 100 million today.
Even though we don’t believe that it is attractive to treat Canadian preferred shares as an asset class that should simply be bought and put away, the retail market obviously feels differently. Interestingly, many sophisticated credit managers have anecdotally spoken about the distortions arising from the increased amount of indexation within the Canadian preferred share market. At times of stress, all the preferred shares in the index need to be sold regardless of the individual merits of a specific issue and regardless of the potential illiquidity. As more investors are indexing as opposed to researching and picking individual issues, there may be a growing number of specific opportunities which arise for the astute investor.
There Are Better Places to Invest
Although we are always on the lookout for opportunities in the preferred share space, on balance we believe the asset class to be a poor choice compared to other alternative yield funds available to the accredited investor. The preferred share market is volatile and has returned less than comparable bond indices. Relative to bonds, preferred shares have been the worst of both worlds. Yes, experienced investors can take advantage of specific opportunities caused by distortions, but on the whole, we believe, preferred shares as an asset class should be avoided more often than not.
East West Investment Management provides portfolio management advice to Canadians with the objective of substantially increasing a portfolio’s yield while reducing its volatility. To learn more about our services please email invest@eastwestfunds.com or call 1.416.646.9999.