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In a recent PWL white paper, I stated that the BMO S&P/TSX Laddered Preferred Share Index ETF (ZPR) is the preferred share ETF that “we’re most comfortable with” because “it focuses on less risky Fixed Reset preferred shares”. Since publishing our paper, Fixed Reset preferred shares have come into some problems, as pointed out by John Heinzl. When they first became popular during the financial crisis, one of the big attractions to Fixed Resets was that they reset their dividend every five years based on a predetermined yield spread over the five-year Canada bond. In a period of rising rates this would protect their value, but rates have been falling consistently. ZPR, which only holds Fixed Reset preferred shares, has returned -8.4% in Q1 2015, a very surprising collapse.
What went wrong?
Most of ZPR’s depreciation occurred in January. We believe that three related and almost simultaneous events fuelled the problem:
- The Bank of Canada announced a 0.25% surprise interest rate cut, which resulted in a yield decline on the 5-year Government of Canada bond from 1.3% to 0.6%. All of a sudden, investors holding Fixed Reset preferred shares had to cope with a much lower expected yield on their holdings.
- The Royal Bank of Canada launched a new Fixed Reset preferred share issue with a very wide reset spread of Canada +276bps.
- A lot of Fixed Reset preferred shares have a reset spread in the low 200bps range; with 5-year Government of Canada bonds now yielding far less than 1% (0.74% at the time of writing), many of these Fixed Reset preferred share issues will reset with a dividend rate of less than 3%.
Investors have not been willing to accept the expected low yields on their Fixed Resets, so prices have dropped below par to bring yields up to a more acceptable level. In summary, the widening of credit spreads has caused a price decline in Fixed Reset preferred shares.
Current market conditions
With the steep decline in prices, the vast majority of Fixed Resets are trading at a discount to par. The average discount on the issues held by ZPR is roughly 10%, with the low reset years (2015, 2016) trading at 26% and 16% discounts respectively. I believe most of this “reset surprise” has now been priced into the market.
I still believe perpetual preferred shares are riskier than fixed reset preferred shares, but the latter have recently been way more volatile than I would have imagined, barring a major credit crunch or equity crash. The recent events highlight that fixed reset and perpetual preferred shares entail different risks. Perpetuals are exposed to 30-year bond yields and preferred credit spreads, while fixed resets are exposed to 5-year bond yields and preferred credit spreads.
Going forward, it will be taken under consideration whether Fixed Resets on their own are preferable to a mix with Perpetuals for risk management purposes. Managing risk properly requires an acknowledgement that investment portfolios are exposed to random unpredictable events; the only effective way to handle this risk is to diversify broadly across several asset classes and [within asset classes] by holding thousands of securities.