Preferred Rally Has Some Sizzle Left in Canada, Top Manager SaysBy
Rising rates, solid credit quality should support market
‘It’s hard to see anything bad happening to the asset class’
Preferred shares have further room to gain in Canada as a revving economy keeps interest-rate hikes coming and credit quality strong, according to the manager of the best-performing fund in the sector.
The Dynamic Preferred Yield Class Fund has returned 9.2 percent this year, according to data compiled by Bloomberg. That outpaces 26 similar mutual funds that have assets of more than C$500 million ($395 million) as well as the S&P/TSX Preferred Total Return Index which has gained 8 percent.
The Bank of Canada will likely raise rates once more before the end of the year after tightening policy in July, while big issuers such as banks, insurance and pipelines companies look stable, the fund’s manager said.
“With that kind of background, it’s hard to see anything bad happening to the asset class before the end of the year," Roger Rouleau, who is one of the managers of the fund which has C$784 million ($614 million) of assets, said in an interview.
Preferreds, many of whose dividends reset with higher interest rates, have outperformed Canada’s main equity gauge as well as corporate bonds amid the central bank’s hawkish turn. They’ve rebounded from a slump in early 2016 after the shares reset with lower dividends to reflect Bank of Canada rate cuts. Some issuers responded by adding a yield guarantee to protect investors from further erosion.
Dynamic invests about 78 percent of its fund in rate-reset preferred shares that offer a fixed dividend for 5 years until the next reset date. The fund began allocating more of its investments into Canada during 2015 when the central bank was cutting rates and the market was cheap compared with the U.S. Now it has about 85 percent invested north of the border compared with as little as 50 percent in Canada before December 2015.
It’s a bit trickier to find value now as some preferreds are no longer cheap and trading above par but a good chunk of the market still trades at a substantial discount compared with the U.S., Rouleau said. He looks for companies with strong balance sheets that aren’t necessarily "pristine" but have good management. Its top holdings include preferred shares of Canadian Imperial Bank of Commerce, BCE Inc. and Bank of America Corp.
While rising rates may benefit rate-reset preferred shares, what really drives the asset class is credit work, Rouleau said.
"The real bad scenario is when you start having defaults," he said.
He’s keeping an eye on the housing market, since many issuers are banks. Canada’s benchmark home price fell 1.5 percent in July from June, the most in nearly a decade after government moves to tame the market, including a tax on foreign buyers in Toronto as well tighter mortgage regulation.
"The more we can tighten up the housing market and the mortgage market, the better it is for everybody," Rouleau said.