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Preferred shares have been enjoying a strong run so far this year. James Hunter, Vice President, Director and Portfolio Manager with TD Asset Management, looks at what’s pushing the preferred market higher and the outlook going forward.
Transcript
Anthony Okolie – While we’ve seen some positive performance out of the equities so far this year, there’s also some interesting trends happening in another part of the market that doesn’t get covered quite as much. Joining us now to discuss what he’s seeing in the preferred share market is James Hunter, vice president and portfolio manager with TD Asset Management.
And, James, thanks for joining us.
James Hunter – Hi, Anthony. Nice to be back.
Anthony Okolie – So recently, we’ve seen a rally in preferred shares. What’s driving this trend?
James Hunter – Yeah. So preferred shares are up about 20% off the bottom that we saw back in October. And I would say that’s a welcome relief for investors. It’s been a painful couple years. And we’ve seen 30% drawdowns in the last 10 years. You can really see that in the first chart that I brought along. It takes the Preferred Share Index and it converts it to a weighted average price per share.
In 2015, you can see that prices came down a lot as oil prices and interest rates collapsed. In 2020, of course, we had the pandemic and then, in 2022, 2023, this inflationary environment and fears of a recession. So preferred shares are a much better bid the last couple of months, as you mentioned. And I think that’s really two reasons.
Number one, we have clarity around the tax status. We got that in November. And that really invited institutional investors back to the market. And then, number two, the banks have started to resume calling some of their preferred shares. And that’s a theme that we’ve seen before, but it’s a good catalyst for the market. And when sentiment was so negative like it was in the fall, if you get any kind of catalyst, you can have prices increase quickly.
Anthony Okolie – OK. Now, you’ve also been focused on some of the trends with bank preferred shares. What’s happening there?
James Hunter – Right. So in the banks, you have to remember that they make up about 30% of the market for Canadian pref. So they’re important. And the last time we saw a new issuance was in 2019. So it’s been a number of years. And what the banks actually started doing a number of years ago was calling them in. And they’ve been replacing them with other types of securities, really to diversify their sources of funding and because they can be a cheaper cost of capital. So that’s what we’ve been seeing.
And I think one thing to keep in mind is that there was a pause on that activity, that calling and the redemptions. That pause was last year and the year before. And it happened for a couple of reasons. One was that the banks had to increase their capital ratios. The regulator was increasing the capital requirements. So that was something they had to catch up on.
And then the other factor was acquisitions. If you remember, Royal Bank (RY:CA) was acquiring HSBC Canada, BMO was acquiring the Bank of the West. And those acquisitions, they need a digestion period because there’s legal risk, there’s operational risk. So it just takes a little time to get through. But those acquisitions have now closed. So that’s what has helped cause the banks to start redeeming the prefs again.
Anthony Okolie – OK. And remind us, outside of the banks, what are some of the other types of issuers in preferreds?
James Hunter – Right. So you’ve got pipeline companies, utility companies, some diversified financials. So it’s not just financials, although that’s 60% of the market. And I would say you’re not seeing the same types of trends in those other parts of the market.
Anthony Okolie – Well, why is that?
James Hunter – Well, a lot of the issuers, they don’t have the option to issue many other types of securities. The banks are really well-known companies. They’re very big. So they have different verticals in the capital markets they can hit, which is not to say that the utilities or pipeline companies don’t have market support. They absolutely do. But it’s just not as common to see them going into other types of capital. So most of those issuers have been resetting their preferred shares.
Anthony Okolie – OK. So given that backdrop, where do you see things going from here for preferreds?
James Hunter – Right. So like we talked about, it’s been a really good six months for preferred shares. And I would say the outlook we have today is still positive. If you think about it, you’ve got a yield of over 5%. And you’ve probably got 5% upside or more to get prices back towards those longer-term averages. So a 10% total return, it’s still pretty attractive.
The things that I would keep in mind are that we’ve got that, as I mentioned, the clarity around the tax status. That’s not going to change. And then the other thing is the banks are going to redeem their preferred shares, a trend that we’ve started to see, and that could go on for a number of years. And I think those two factors are going to help lift the market a little bit higher over time.
Anthony Okolie – OK. So you talked about some of the positives. You talked about that nice juicy yield. What are some of the risks to the sector?
James Hunter – Yeah, that’s a good question. And I think the number one risk to keep in mind would be recession. It’s the one thing that everybody has been worried about, and it’s been on our minds for a number of years. Recession would do a few things. It would hurt corporate profitability. Credit spreads would probably widen. Interest rates could come down. And if they came down a lot, I think that would be an important negative for the preferred share market.
It’s just not something that we’re seeing today. We’ve got good population growth in Canada. We’ve got budget deficits and higher commodity prices. Those are all things that should help support the economy. And that’s why I think the recession fears are a bit overblown.
