Newly-minted preferred shares are available only to institutional or accredited investors on the OTC Institutional Bond Market. But it’s legacy fixed resets, available to retail investors individually and through preferred share funds, that are currently in the spotlight as they offer the potential for robust returns throughout 2024.
Fixed resets, also known as rate resets, renew every five years and offer a built-in fixed reset spread on top of the rate of Bank of Canada five-year bonds. The issuer of the fixed resets has the option to either call or extend the issue at the five-year anniversary, based on a date and pricing schedule set out when the shares are issued.
If the issuer calls the shares at reset, shareholders are typically informed about a month before the reset date.
“When these preferred shares last reset in 2019, they failed to generate much excitement, because the five-year rate finished that year at just over 1.5 per cent,” says Doug Grieve, president of Slater Asset Management, an independent asset management firm specializing in Canadian preferred shares. “We really like the 2024s — preferred shares coming up for reset this year — because their new coupon is much larger than in 2019.”
Assuming a five-year Bank of Canada rate of 3.5 per cent at reset in March, some 2024s offering a current yield of 5.69 per cent will offer a new yield of greater than 8.3 per cent.
Grieve notes that the fixed reset market is publicly listed and extremely transparent, and the math that determines future yields requires only simple addition — yet these preferred shares aren’t always on the investor radar.
“The prices of fixed resets can be volatile,” he says. “And the majority of investors buy them based only on current yield, because they don’t trust themselves on guessing where the five-year bond rate is going. They start to become attractive closer to the reset date.”
Seasoned fund managers tend to be very selective about the shares they buy, considering the size of the reset spread, the credit rating of the issuer, the overall attractiveness of the company which issues them, and the fine print in the underlying contracts with the shareholder.
Slater carefully times its entry into various fixed reset shares. The closer to the reset date, the easier it is to price in the Bank of Canada five-year rate and the sting of inflation. Earlier entry requires some confidence in predicting both those rates.
It’s also wise to consider an exit strategy.
“The five-year coupon may be very attractive right now, but at some point during the next five years it may not continue to look this way, so I may consider selling before the next reset,” Grieve says. “The general rule of thumb is that you’re probably in good shape for the first two years, if not three — then you’re probably looking for an exit. However, preferred shares lack the liquidity of equities, so a well-planned exit becomes even more important.”
There’s nothing particularly significant about the size of the current crop of fixed resets, he says, other than the fact that a large number of deals came to market in 2019, resulting in robust offerings in 2024. Following the March tranche, a generous supply of shares will continue to reset through December.
Grieve says that the word on dividends for 2024 fixed resets hasn’t fully percolated through the marketplace yet. The 2024s are also trading at a discount because skittish investors are concerned about future inflation.
“What’s exciting in today’s market with discounted preferred shares is that investors can anticipate one of two outcomes,” he says. “Either these generous dividends will arrive, or the issuer calls them in at par, and the owner receives the capital gain.”
Both Lysander-Slater Preferred Share Dividend Fund and Lysander-Slater Preferred Share ActivETF, which are comprised of roughly 75 per cent fixed resets as at the end of 2023, have rallied in recent weeks as discounts narrow.
“I believe that the news about the 2024 fixed resets and these attractive dividends is starting to get priced in,” Grieve says. “But I wouldn’t say it’s fully priced in by any means.”
Lysander Funds offers Lysander-Slater Preferred Share Dividend Fund and Lysander-Slater Preferred Share ActivETF.
For more information on Slater Asset Management, visit: https://www.slaterassetmanagement.com.
For more information on Lysander Funds, visit: www.lysanderfunds.com
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