Last updated: Mar-18-2019

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Veteran business journalist and investigative reporter Olev Edur takes you behind the performance numbers for close-up look at the people, processes, and portfolios that make investment funds tick.

By Olev Edur  | Tuesday, August 15, 2017

Preferred share fixed-income funds are on a roll these days, after a calamitous 2015. The average return for the 13-fund category for the one-year period ended July 31, 2017, was a healthy 16.1%, compared with -11.93% for calendar year 2015. Of course, 2015 was bad for equities as well (the overall Canadian Equity category averaged -6.8% for that year, but is up 5.8% for the year through the end of July 2017). But the reasons for the two turnarounds were largely unrelated, according to Jeff Herold, co-manager (with Dax Letham and Ian Clare) of Toronto-based J. Zechner Associates, which sub-advises NGAM Canada’s Natixis Canadian Preferred Share Fund (NGAM is an affiliate of Natixis Global Asset Management SA in Paris, France).

The Canadian equity tumble was a not entirely unexpected correction. The S&P/TSX Composite fell from 15,234 on February 2015 to 12,822 by the end of the year, ending a bull market that had risen all the way from 8,123 in February 2009 (it has moved back above the 15,000 mark in recent months). The preferred share “hiccup,” on the other hand, was a fixed-income issue related to interest rate trends and expectations.

“In 2015, people were worried that forthcoming rate resets would push dividend rates lower on preferred shares if they bought them at that time,” says Herold. “So why not wait and buy them later?” He adds by way of explanation that originally preferred share dividend rates were fixed for the duration (“perpetuals”), but most now undergo “rate resets” every five years to more closely align dividend rates with prevailing interest rates. “Seventy to 80% of the market now is resets,” he says.

So, for example, if the prime rate is 2% and the dividend is 5%, and the interest rate moves to 2.5%, the dividend is reset at 5.5%; if the interest rate moves to 1% the dividend is reset at 4%. But this feature makes them much more sensitive to interest rate changes and expectations. And because preferred shares have no maturity date, resets can exhibit the same magnified volatility as very-long-term bonds.

“In 2015 the interest rate fell and the spread was quite narrow, so some [reset rates] dropped by 50%, although perpetuals dropped only 2%,” Herold recalls. He adds that his fund weathered the storm better than most because of a 70% allocation in perpetuals as well as a high cash position going into 2015, resulting in a 3-year average annual compounded rate of return of 2.9% through the end of July, compared with the category average of 1.8%. “We will use cash for defensive purposes, and can buy up to 40% in bonds and cash equivalents, although the highest we got was 18%.”

Now, however, with interest rates on an upward trajectory, investor interest and anticipation is building. “Investors believe that when there’s another reset, they’re going to get better rates going forward,” says Herold. “People are more optimistic, and demand is driving prices up.”

Meanwhile, his team is prepared on the upside. “As active managers, we can take better advantage of market inefficiencies than ETFs [exchange traded funds], since the preferred share market is not as liquid as the bond and equity markets,” says Herold. Active management also enables the fund to better seek value in a market that can be affected by rate resets as well as spreads, call dates, and the potential for new issues, which can have a depressing effect as investors await newly issued rates.

“We’re also better diversified – that’s another way we reduce risk,” Herold adds. “We limit issuers to 5% of total assets, so our top five holdings represent 23% to 25% of total assets, compared with as much as 36% in ETFs that are based on the benchmarks. That matters, because some issuers can have as many as 15 or 20 preferred shares, all affected the same way by market or corporate changes. He cites the example of Enbridge Inc. (TSX: ENB), whose multiple preferred shares were all downgraded recently as a result of restructuring.

In addition, the fund has been shifting its focus from perpetuals to resets that respond better to rate increases. “We were over 70% in perpetuals, but now we’re at 60% resets,” says Herold.

“We’re positive about the longer-term outlook for preferreds,” Herold concludes. “Bond yields are still low, and more and more fixed income investors are looking to help those yields by adding preferreds. And we think this demand will continue to grow, because while interest rates are starting to move upward, bond yields will not rise dramatically – it will be more of a slow increase.”

Olev Edur is an experienced financial and business journalist and a frequent contributor to the Fund Library.

Notes and Disclaimers

© 2017 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without written permission is prohibited.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

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