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Canadian Preferred Shares: High Yields Supported by Strong Growth?

2022 was a year of exceptional difficulty for Canadian preferred share investors, as a combination of credit concerns and interest rate volatility resulted in losses. Now with yields well in excess of 6% on most issuances in Canada, Canadian preferred shares might be an area of untapped opportunity for investors looking for income that can outpace inflation.

Things to Consider:
• Offering a very attractive yield that could average close to 6% or more over the next five years
• A normalization of the yield curve, with short-term rates flattening and mid-term rates rising could support rate reset preferred shares
• Non-financial preferred shares in utilities and energy are offering strong relative value
• Mid-rate reset markets with spreads of ~ 300 bps over five-year bonds offer the best relative value suggesting this is a risk that will likely have a bigger impact on preferred shares going forward

The Horizons Active Preferred Share ETF (HPR) is positioned with a high-conviction belief that preferred shares could generate attractive returns in 2023 with a focus on sectors that are believed to offer the highest potential growth in this asset class.

Year to date, the performance of the broader Canadian preferred share market, as represented by the S&P/TSX Preferred Share Index, has contracted by -15.52%, as of November 30, 2022. After achieving a total return of 19.35% in 2021*. Much of the pain in 2022 has been directly related to concerns about corporate credit (preferred shares are a lower tier credit) and interest rate volatility that has made assessing the likelihood of being extended rather than called – called extension risk – tricky to navigate.

Here’s the key development; with the five-year interest rate in Canada now above 3%*, there is substantial support for Preferred Shares to provide a yield that is in well of excess of 6% in the near future.

The following chart shows the income yield sensitivity of the yield of the Horizons Active Preferred Share ETF based on Fiera’s internal assumptions on all preferred shares structures including extension/redemption assumptions. In Fiera’s view, if rates on the Canada five-year bond were to effectively decline by 50%, to 1.5%, we would expect most of the issuances in HPR to potentially yield in excess of 5.95% for the next five years. If the five-year rate were to converge with the overnight rate, which is currently 4.25%, yields would start to range between 6% and 8% for the next five years.

*Source: As at Bloomberg, December 2022.
Sources: Fiera Capital, Bloomberg, As of November 30, 2022.

While some active preferred share managers are retreating to more defensive positions, Nicolas Normandeau, Vice President and Portfolio Manager at Fiera Capital (“Fiera”) and sub-advisor to HPR, believes that there could be an opportunity on the horizon in 2023 for the Canadian preferred share marketplace and is positioning the ETF for potential growth in the asset class in the year ahead.
Generally, Fiera manages HPR by holding a large portfolio of preferred share issuances to manage the inherent liquidity challenges of preferred share investing and focuses on overweighting areas of the segment they believe offer opportunities and underweighting areas where there is a risk. For example, HPR will overweight based on the reset levels they like, or the sectors, but won’t get too tied up in concentrated positions on individual names in those categories.

Looking ahead toward 2023, Fiera Capital is managing HPR with the following approaches and outlooks in mind:

  • Focus on Growth Versus Defence: While some preferred share ETFs are currently defensively positioned, with a portfolio overweight to perpetuals and higher-rate resets, Fiera has taken an overweight approach to mid-rate resets and preferred shares they believe will benefit from growth in the segment next year.
  • Interest Rates Will Remain Elevated: Fiera believes the interest rate curve is too inverted currently with the overnight rate at 4.25%, the key five-year rate at 3.05%, and the ten-year rate at 2.8%. Fiera expects that short-term interest rates will remain elevated (although maybe don’t rise) and that the five and ten-year rates will likely have to increase to bring normalization to the rate curve (rate stabilization). This could create a unique opportunity for Canadian rate-reset preferred shares, which could see a nice pick-up in their reset spread if the five-year rises to meet the short-term rates.
  • Mid-Rate Reset Market Conviction: Relative to the approach currently taken by some other preferred share ETFs, Fiera has a much bigger conviction position on the mid-rate reset market, with a 40% allocation to mid-rate resets with 3.00% or higher weight. While not performing that well this year due to the expansion of extension risk and rising rates, if rates stabilize and the five-year increases, this area of the preferred share market could offer significant upside, according to Fiera.
  • Overweight in 2024-2025 Rate Resets: Fiera is overweight in the rate-resets that have reset dates around 2024 and 2025, and they believe that again, as the rate stabilizes, this segment of the market offers the potentially most attractive value and upside.
  • Sector Weighting Toward Energy and Utilities: HPR is overweight to high-quality energy and utility names. While in 2022, the utilities and energy have been outperformed by financials, Fiera believes these former sectors offer better risk-adjusted yields and value versus financials, particularly the very high-quality names in those sectors, including Fortis, Enbridge, and TC Energy.
  • Underweight to Perpetuals: Fiera has decreased its exposure to perpetuals. The rationale for this is straightforward – Fiera does not expect there to be a meaningful backup in interest rates in 2023 – they expect rate stability but at higher interest rates. This means that the mid-rate resets offer a better risk/return profile in their view if the interest rate curve normalizes. Perpetuals would be expected to generate excess return relative to the broader preferred share market
    if interest rates decline.
  • High-Conviction on Risk/Reward Trade-Off: Fiera has taken on a more high-conviction view that preferred shares in general offer one of the best risk/reward trade-offs of fixed-income asset classes in 2023, offering very high yields relative to corporate bonds, and they expect that inflows will return to the category, once there is a comfort level with credit conditions and rate normalization.

Commissions, management fees and expenses all may be associated with an investment in the Horizons Active Preferred Share ETF or the Horizons Active Hybrid Bond and Preferred Share ETF (“HPR”, “HYBR” or the “ETFs”) managed by Horizons ETFs Management (Canada) Inc. The ETFs are not guaranteed, their values change frequently and past performance may not be repeated. The prospectus contains important detailed information about the ETFs. Please read the relevant prospectus before investing.

Certain statements may constitute a forward-looking statement, including those identified by the expression “expect” and similar expressions (including grammatical variations thereof). The forward-looking statements are not historical facts but reflect the author’s current expectations regarding future results or events. These forward-looking statements are subject to a number of risks and uncertainties that could cause actual results or events to differ materially from current expectations. These and other factors should be considered carefully and readers should not place undue reliance on such forward-looking statements. These forward-looking statements are made as of the date hereof and the authors do not undertake to update any forward-looking statement that is contained herein, whether as a result of new information, future events, or otherwise unless required by applicable law.

This communication is intended for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase exchange traded products (the “Horizons Exchange Traded Products”) managed by Horizons ETFs Management (Canada) Inc. and is not, and should not be construed as, investment, tax, legal or accounting advice, and should not be relied upon in that regard. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. Investors should consult their professional advisors prior to implementing any changes to their investment strategies. These investments may not be suitable to the circumstances of an investor.

The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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