Canadian preferred shares were hit hard during the broad sell-off of the fourth quarter. The S&P/TSX Preferred Share Index declined more than 11% over the three-month period, roughly mirroring the decline in the S&P/TSX Composite Index. However, unlike the equities, preferred shares have not recovered; instead, they have remained mostly flat. This opens up an opportunity to solve a problem created by policymakers.
One of the casualties of monetary policy in the aftermath of the credit crisis and Great Recession has been the ability of savers to generate income without taking undue risk. The major central banks of the world, including the US Federal Reserve Bank, the European Central Bank and the Bank of Japan, have used unconventional techniques such as quantitative easing (QE) to drive down both short- and long-term interest rates. As a result of these policies, forty percent of government debt globally in mid-2016 carried negative interest rates. Today, negative interest rates on government debt are still not unusual in many countries. Investors have fewer options to generate income in this environment and therefore need to look elsewhere. We suggest investors consider the benefits of the preferred shares from Canada’s top corporations.
Income Options for Individuals: Traditional Sources vs. Canadian Preferred Shares
As a direct result of unconventional central bank monetary policies, Canadian savers have been penalized with low income from traditional bank accounts, money market funds and government bonds. For example, most recently the pre-tax income generated from $1-million of savings in risk-free money market funds is about $20,000 annually, or under $2,000 per month, according to a Purpose Investments analysis of common money market products. While this is a vast improvement from the rates available in the mid-2010’s, it is hardly an income stream that rewards savers for years of responsibly putting money away for retirement or other financial goals.
One alternative to risk-free interest income is to purchase a life insurance annuity, taking only marginally more credit risk over a traditional savings account. Currently, life insurance annuity rates provide roughly 4.4% cash-on-cash return for a typical 60-year old individual, according to quotes provided to Purpose Investments. That represents a lifetime pre-tax monthly income of about $3,667 per month for $1-million of savings or principal. However, there are numerous disadvantages to purchasing a life insurance annuity, including the inability to get out of the product, the inability to transfer the assets to an heir and the lack of lack of upward adjustment to inflation.
A better alternative income stream comes from the preferred shares of Canadian corporations. As a result of the sell-off in Canadian preferred shares in late 2018, an investor can generate a pre-tax equivalent income stream of 6% to 8% from the most credit-worthy corporations in Canada. These include the Royal Bank of Canada, Toronto-Dominion Bank, Manulife Financial Corporation, TransCanada Corporation and Brookfield Asset Management Inc., to name a few. The preferred share coupon payments also protect against inflation indirectly through periodic coupon adjustments that are directly tied to Government of Canada bond yields. For $1-million of savings, the resulting pre-tax equivalent monthly income is roughly $6,000 in perpetuity to start, with periodic inflation adjustments in the future.
Current Canadian Preferred Shares Market Valuation is Attractive
The prices of Canadian preferred shares often move with the prices of the common equity of the same issuers. Prices also move with the level of 5-year Government of Canada bond yields, which are used as a benchmark when resetting coupon payments on rate-reset preferred shares (higher bond yields generally mean higher prices for the preferred shares).
The most widely quoted benchmark index for the Canadian preferred share market is the S&P/TSX Preferred Share Index. Most recently, the index has been trading at a level around 630, something unseen since July 2016. The 5-year Government of Canada bond yields roughly 1.70% in early 2019 or about three times the 0.60% yield prevalent in July 2016. Using this comparison, the preferred share market in Canada is significantly more attractive than it was in mid-2016. The asset class is yielding over 100 basis points more, despite the index value being at similar levels.
A return to the same interest-rate environment from mid-2016 is highly unlikely as that was the period when government interest rates bottomed in major markets and central bank interference in the bond market was at its peak. It was in that period when 40% of government debt globally had negative yields. Thus, the Canadian preferred share market currently appears to be discounting a scenario in interest rates we view as highly unlikely.
Canadian Preferred Shares Are an Attractive Income Option
An extended period of low interest rates has proven challenging for savers with a low tolerance for risk. Traditional bank savings accounts and money market funds have provided very little risk-free income. Life insurance annuities provide a higher income stream but are restrictive in many ways. While these may improve over time, they aren’t especially attractive at the moment. On the other hand, Canadian preferred shares provide higher income with the potential for capital appreciation, with low incremental risk of non-payment. The sell-off in late 2018 has made Canadian preferred shares particularly attractive, especially when viewed through the context of the history of the asset class. And, preferred shares offer further benefits, including seniority in the capital structure and inflation protection. Going forward, we see interest rates rising over time, which should provide a further tailwind for Canadian preferred shares.
— Sandy Liang, CFA is the Head of Fixed Income at Purpose Investments and Jeremy Lin, CFA is an Associate Portfolio Manager. Sandy and Jeremy manage Purpose Canadian Preferred Share Fund.
Note: Yields as at March 6, 2019. Payments calculated on a monthly basis for ease of comparison. Equivalent Monthly Income is the monthly pre-tax income on $1 million of savings. Tax calculations are based on the highest marginal tax rate in the Province of Ontario in 2019, 53.53%. Equivalent Monthly Income calculation assumes investor is in highest marginal tax rate and earns the full tax credit on eligible dividends.
All data sourced from Bloomberg unless otherwise noted.
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