The Bank of Canada is mulling its first interest-rate hike in seven years, and an unlikely winner in this dramatic shift in monetary policy has emerged: preferred shares.
The S&P/TSX preferred share index marked its biggest one-day gain of the year, rising nearly 1.2 per cent on Tuesday. The move in what is typically a sleepy corner of the market comes a day after the Bank of Canada's senior deputy governor Carolyn Wilkins hinted that broad economic growth could lead to higher interest rates.
The overnight rate has been sitting at 0.5 per cent for nearly two years, following a couple of rate cuts as the Bank of Canada wrestled with low inflation, weak economic activity and depressed energy prices. But Ms. Wilkins said that economic conditions are improving, and markets are taking her new tone seriously.
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The Canadian dollar shot above 75 cents (U.S.), up more than a cent over the past two days. The Government of Canada two-year and five-year bond yields surged, as prices slumped. And dividend-generating utility stocks dipped initially before ending the day relatively flat.
However, investors are embracing preferred shares in this environment. The reason behind their appeal? In some cases, higher rates mean bigger quarterly payouts down the road.
Preferred shares are generally issued at $25 each, and can be bought on stock exchanges throughout the day. Investors like them for their fixed income characteristics: The shares generally pay a fixed distribution rate over a set term. When the term expires, the rates on some preferred shares are reset to reflect the current environment.
This was a problem when the Bank of Canada was cutting interest rates and bond yields were falling. Preferred shares that might have been yielding 5 per cent were being reset at rates significantly lower, which weighed on share prices. Between 2013 and 2016, the preferred share index sank about 36 per cent.
Over the past 18 months, though, things have been improving. Some companies (notably the big banks) have been issuing preferred shares with generous yields and attractive reset rates – and the prospect of rising interest rates adds to their appeal.
For example, National Bank of Canada announced earlier this month that it is issuing preferred shares that will yield 4.45 per cent until 2022. Then, the payout will be reset every five years at 343 basis points (or 3.43 percentage points) above the five-year Government of Canada bond yield.
Here's how it works. Let's say that in 2022 the five-year bond is yielding 2 per cent, up from about 1.15 per cent on Tuesday, because the Bank of Canada has followed through on hints and raised its key interest rate several times. National Bank would reset the rate on this particular series of preferred shares to 5.43 per cent, or nearly a full percentage point higher than the already-attractive starting payout.
It's a tantalizing offer: Rising interest rates mean rising yields. It is particularly attractive in the case of older preferred shares that are now nearing dates when their rates will be reset.
John Nagel, a former preferred share analyst with Desjardins Securities and now an independent consultant, estimates that about 40 per cent of rate-reset preferred shares will be reset over the next three years – potentially delivering bigger payouts and higher share prices.
"If your view is that rates will increase soon, then purchasing some of the heavily discounted lower-spread issues resetting in late 2018 or after may prove attractive," Mr. Nagel said in an e-mail.
Or, you can buy an exchange-traded fund that holds a basket of these shares, providing diversification across a number of different companies.
The iShares S&P/TSX Canadian Preferred Share Index ETF (ticker CPD) yields 4.7 per cent. The BMO Laddered Preferred Share Index ETF (ZPR) holds preferred shares whose rates are reset periodically. It yields 4.3 per cent. The Horizons Active Preferred Share ETF (HPR) is an actively managed fund. It yields 4.5 per cent.
Exciting? No. But if the prospect of rising interest rates is weighing on parts of your portfolio, these preferred shares look like a good solution.
Disclosure: The author personally owns units of CPD.