Preferred shares, which make up more than 60% of this fund, are often thought of as having a high degree of interest rate sensitivity. Like bonds, the price of preferreds tend to move in the opposite direction of interest rates. So when the Bank of Canada Governor Stephen Poloz shocked the markets by cutting the Bank’s key overnight lending rate by 25 basis points, most people assumed that would be a good thing for this fund.
Unfortunately they were wrong. The fund lost 2.67% in the quarter, largely for two reasons, first, its preferred holdings were hit hard in the quarter, and the equity portfolio is largely overweight in energy, which was lower on plummeting oil prices.
Delving deeper into the preferred share portion of the portfolio helps explain why the fund was down in the quarter. The reality is the preferred market is more diverse than you might think. In Canada, there are really four types of preferreds; straight perpetual, retractable, floating rate, and fixed rate resets. Perpetual and fixed rate resets are the most prevalent, making up more than 92% of the preferred share market in Canada.
Perpetual preferreds are the most bond like because they pay a fixed dividend as long as it is outstanding. So when rates moved lower, they did what was expected, and rallied higher. Unfortunately the fund was underweight perpetuals.
By far, the most popular type of preferred in Canada, and the fund, is the fixed rate reset. With a fixed rate reset, the dividend rate is reset every five years or so, and often uses the Bank of Canada overnight rate as its baseline. So, when the overnight rate is cut, and many fixed rate resets soon to be reset, they were punished, dropping by more than 7% in the quarter. This was also a key reason for the drop in this fund.
While the 2.67% loss looks disappointing, it is in line with its benchmark, which was down by 2.6% in the quarter. I have also maintained that this is a great safe harbour in periods of equity market volatility because of its high weighting in preferreds. I still believe that to be true.
Looking ahead, while many believed the Bank of Canada was certain to cut rates again after January’s surprise, that’s not necessarily the case. While the shorter term impact of falling oil has been severe, it is not out of line with the Bank’s expectations. They are monitoring the situation and will adjust rates as they see fit for the conditions. Assuming the economy unfolds as expected, the Bank will likely keep rates on hold as the output gap starts to close.
This does not bode particularly well for fixed rate reset preferreds, as the lower overnight rate will put pressure on reset rates. That said, I wouldn’t expect further selloffs as most of the bad news has already been built in. With the equity sleeve of the portfolio, it is invested in big, blue chip dividend paying companies like the banks, energy producers, telcos and other utilities. While not expected to generate big gains, they should provide steady growth and a nice dividend stream.
One potential risk is we may see a cut to the distribution if there is a drop in the underlying yield of the portfolio. Currently, the fund pays $0.04 per unit, which equals an annualized 4.5% at current prices, and roughly in line with the underlying yield of the fund.
On balance, I remain cautious on this fund. I don’t see any major catalyst that will push it sharply higher, but barring a sharp move in rates, either way, I don’t foresee any major drops. I expect it to continue to deliver low, but relatively stable returns going forward.
It remains a good fund for more conservative investors seeking some modest exposure to the equity markets. It should provide better downside protection than a pure dividend fund, but will likely underperform in a rising market environment.