Why rate reset preferred shares are undervalued

Portfolio manager says asset class provide crucial protection

Why rate reset preferred shares are undervalued

Rate reset preferred shares are potentially undervalued from both an interest-rate perspective and a credit perspective.

That’s the view of Alfred Lee, director, portfolio manager and investment strategist, BMO ETFs, who believes many have priced in interest rate levels that are lower than the current five-year government of Canada and the rate on the forward curve.

And from a credit perspective, he said that many were issued at wider reset spreads in recent years given the necessity for banks to issue preferred shares compliant with the Basel 3 ruling.

With recent new issues coming at more normalized reset spreads, Lee believes this should be supportive of the overall rate reset market as credit spreads compress.

He said: “From a portfolio construction standpoint, rate resets are one of the few asset classes that provide protection against rising interest rates.

“Traditional asset classes, such as stocks and bonds, tend to be negatively impacted by rising interest rates. Rate resets can be used as a core holding in a portfolio to provide protection, mitigate the risks of rising rates, and offer low correlation to traditional assets.”

Lee said that the BMO Laddered Preferred Share Index ETF (ZPR) provides investors with efficient exposure, adding that as one of the most actively traded ETFs in Canada, the secondary market liquidity allows it to trade at tight spreads in normalized market conditions.

ZPR has notably outperformed the broader S&P/TSX Preferred Share Index by 6.93% on a total return basis since January 20, 2016, the date in which the BoC stated they were no longer reducing interest rates.

Lee explained that the Bank of Canada’s decision to raise rates twice last year meant a repricing of bond yields on the short end of the yield curve, with many economists becoming increasingly hawkish coming into 2018 and revising expectations for multiple rate hikes by the Canadian central bank this year.

However, he said that the most recent GDP of 2.7% has been a negative trend since last summer, which has led many investors to focus on the negatives, such as high household debt, the softening of the real estate market and a temporary shutdown of some production facilities in the oil sands.

He said: “Consequently, we have seen a moderation in bond yields on the short end of the curve in recent months. 

“With the gains in short-term rates taking a pause, rate-reset preferred shares have been largely flat year-to-date. However, investors should note that the asset class still remains attractive. On a stand-alone basis, we view the pause in short-term yields to be temporary, as many of the recent setbacks in the Canadian economy, such as the shutdown in oil production, are temporary.

“In addition, as indicated by the strong negative reading in the Citi Economic Surprise Index – Canada, a positive economic surprise would likely now be more possible, which could be the catalyst for short-term bond yields to move higher again. Over the longer term, the BoC is still looking to tighten monetary policy, which potentially means higher rates further out.”