Taking the preferential option

While economic conditions are easing, there are still bumps ahead. Why U.S. preferred shares may provide an attractive route to returns

Taking the preferential option

Since 2000, Brompton Funds has built a reputation for providing innovative, income-oriented, alternative investment solutions for individual investors in Canada. It has a long, successful track record of delivering well-conceived investments that are focused on providing investors with a meaningful level of regular distributions. Its funds are designed to address investors’ cash flow requirements and to provide them with value-added diversification strategies.

Brompton believes U.S. preferred shares currently present an attractive opportunity for investors to realize attractive levels of income with long-term capital appreciation potential.

Why U.S. preferred shares and why now? 2022 was a difficult year across the board with the U.S. Federal Reserve announcing seven Fed funds rate increases from March to December leading to price declines. U.S preferred shares fared better than most other asset classes such as fixed income, but they were affected.

It appears that the bulk of the rate hikes are now behind us. The intention of the rate increases was to slow the U.S. economy and tame high levels of inflation.

Chris Cullen, Senior Vice President and Head of ETFs at Brompton, notes that there appears to be a recent easing in the economic outlook.

At the time of writing, inflation appears to be falling with corresponding improvements in the economy.

“However, the unprecedented pace of increases to the Fed Funds rate in 2022 may still pose risks to the global economy” Cullen said.

Markets appear to be pricing in the risk of recession in 2023 which could potentially lead to higher defaults for fixed income. This means lower credit quality borrowers (such as high-yield bond issuers) have a greater risk of default compared to investment grade preferred share issuers, due to weaker balance sheets and greater sensitivity to rising interest costs and weakening economic conditions for lower credit quality borrowers.

By contrast, credit quality in the U.S. preferred market is very solid, Cullen observed.

“This is good news for U.S. preferred share investors,” he said, adding: “Issuers are primarily rated investment-grade. The main U.S. preferred issuers are large, well known financial services companies such as banks and insurance companies, along with stable public utilities and pipeline companies. All offer solid balance sheets and reliable cash flow that will allow issuers to cope with potentially challenging market conditions.”

Banks remain well capitalized and highly regulated, and most are “asset-sensitive”, meaning earnings should increase with higher interest rates. Large U.S. banks passed the June 2022 Federal Reserve stress test, showing that as a group they could withstand more than US$600B in losses while continuing to function under a high-stress scenario.

Higher interest rates means that issuers can now invest policyholder premiums and maturing investments into higher-yielding securities, providing an opportunity to improve profitability.  Higher interest rates also mean a reduction in the value of future policy liabilities, resulting in stronger capital positions in the insurance sector.

Brompton believes Canadian investors can benefit from diversifying into U.S. preferred shares. The preferred share market in the U.S. is fifteen times larger than the Canadian preferred share market. In contrast to Canadian preferred shares, over the past decade, U.S. preferred shares have both outperformed and displayed far lower volatility.

From an historical performance perspective, the real determining factor for long-term investor returns for fixed income generally, but especially for U.S. preferreds is the income level, which is higher today than in 2022.

Cullen said: “Given the high quality of U.S. preferred issuers, we expect good support and stability in 2023 for market prices of U.S. preferred share prices, even in a recession scenario.”

He added: “Currently the U.S. preferred market’s effective yield is approximately 6.4%, which has more than doubled from 2.8% only one year ago.  2023’s high income levels combined with lower trading prices give investors a compelling entry point into U.S. preferred shares.”

Brompton offers two entry points to U.S. preferred shares in the form of two exchange-traded funds (ETFs) it manages, Brompton Flaherty & Crumrine Investment Grade Preferred ETF (BPRF), which is unleveraged and Brompton Flaherty & Crumrine Enhanced Investment Grade Preferred ETF (BEPR), which is leveraged to approximately 30% of total assets.

Both ETFs are actively managed and provide unitholders with a stable stream of monthly distributions with the goal of preserving the net asset value per unit.

This document is for information purposes only and does not constitute an offer to sell or a solicitation to buy the securities referred to herein.  The opinions contained in this report are solely those of Brompton Funds Limited (“BFL”) and are subject to change without notice. BFL makes every effort to ensure that the information has been derived from sources believed to be reliable and accurate. However, BFL assumes no responsibility for any losses or damages, whether direct or indirect which arise from the use of this information. BFL is under no obligation to update the information contained herein. The information should not be regarded as a substitute for the exercise of your own judgment.  Please read the relevant prospectus or annual information form before investing.