Brompton Funds Head of ETFs believes it's time to take profits and seek out more attractive yields in the U.S. market
The Canadian preferred shares market has spectacularly outperformed over the past 18 past months, averaging about a 30% return. Chris Cullen, Head of ETFs at Brompton Funds believes the juice has now been squeezed out of the market and that it’s time for investors to take some profits and seek more attractive yields in the better diversified U.S. market.
Prior to 2020, the market had languished for a number of years as retail investors realized that rate reset spreads, in a lot of cases, gave them disappointing results in a low interest-rate environment. Previously, yield on the five-year Government of Canada five-year, plus the spread, gave investors about 5%. This is now closer to 3%, which has caused a wave of selling and a depressed market price.
Cullen explained to WP that this status quo was shaken in July of 2020 when RBC announced it had received approval to launch its inaugural LRCN offering, which would enable it to get a certain amount of equity credit for issuing a bond while still being able to deduct interest payments. And because LRCNs, which can’t be sold to retail investors, are considered a bond for tax purposes, the interest comes out of their earnings before taxes and reduces the bank’s tax burden.
By getting equity credit and interest deductibility to reduce taxes, RBC gets the best of both worlds.
No juice left?
This supercharged the Canadian ‘pref’ market as the bank could sell LRCNs to institutions and take the proceeds to redeem preferred shares that were outstanding and more expensive on an after-tax basis. Analysts predicted that preferred investors would take that capital and plough it back into a shrinking market, driving up prices. However, Cullen said this is not happening.
He said: “There has been a tremendous run in the preferred shares market since then. But is it really preferred share investors taking their redemption proceeds and reinvesting? Or is it just a virtuous cycle of retail investors hearing analysts saying there is going to be a run in the market because of all the reinvestment of redemption proceeds?”
Valerie Grimba, Director, Global ETF Sales & Strategy, RBC Capital Markets, said the bank is only too happy to sell into strength after the phenomenal numbers year to date. She said: “We think a lot of the juice has gone in the space and would rather allocate that capital elsewhere.”
To answer Cullen’s question, she is not seeing those redeemed preferred shareholders put their money back into the market. Instead, the ETF flows are favouring high-rate reset preferreds that, for example, offer a 400 basis points spread, taking that overall yield closer to that 5% mark. These higher-rate preferreds are also the focus of LRCN issuer redemptions, and the inventory is dwindling. The low-rate options that are still left on the table do not look attractive and people are looking outside of preferred shares into equities and other fixed-income opportunities.
Flows in the ETF space and preferred shares represent just 1% of flows in 2021 YTD. Grimba believes the analysts’ reinvestment thesis is flawed and that it’s time to step away. So where to turn? Flaherty & Crumrine is subadvisor for the Brompton Flaherty & Crumrine Investment Grade Preferred ETF, and Chad Conwell, an EVP, told WP the U.S. preferred shares market offers similar characteristics to the Canadian market but with more yield.
To compare, Canada’s preferred securities market is US$59 billion in market size, features 341 issuers, produces a 4.2% yield and has 10-year annualized volatility of 11.3%. U.S., meanwhile, is a US$590 billion market with 1,217 issuers, yields 5.1% and has 10-year annualized volatility of 6.1%.
Conwell said: “The reason you’re seeing a bit more of a stable market and better performance is that it’s simply a more diversified market with different types of issuers and securities. It’s bigger, obviously, but importantly, the issuer and investor bases aren't simply domestic. You also get access to European issuers, to Asian issuers, to banks from anywhere Australia, New Zealand and even some emerging markets.”’
Less risk, more stability
Institutionally-structured preferreds, like LRCNs, are more ingrained in the U.S. and have been targeted by institutional investors for the past 20 years. As a result, it’s a wider and more competitive market compared to Canada, which consists largely of retails investors. South of the border, retail, institutional buyers, asset managers, and insurance companies help produce a market that is more stable when faced with event risk or interest rate changes.
Despite similar credit risk, the U.S. also provides relatively low correlation. While Canadian preferreds’ fortune has traditionally been closely linked to the government five-year and rate events or scares, the make up of the U.S. market is not as temperamental.
Conwell believes Canadian preferreds may have run their course of recovery with not much left for price recovery and prospective returns from today's vantage point is low yield.
“I don't want to overstate the U.S.’s case; we should not expect price recovery here anymore either,” he said. “But our yields are better than Canadian yields and that's really the attraction. From a stability perspective, we also look attractive relative to other fixed-income asset classes, so we continue to expect demand. And then we have all these different buyers that will continue to invest to keep the market relatively stable, so there's just a lot more liquidity and diversification.”