A Purpose Investments report says “an investor can generate a pre-tax equivalent income stream of six per cent to eight per cent from the most credit-worthy corporations in Canada”.
Contrary to their name, and unlike other parts of the market which have raced to new highs since correcting last year, Canadian preferred shares remain unjustly neglected, argues portfolio manager Sandy Liang. “It’s kind of perverse. Some of the highest-quality shares from the highest-quality issuers were hit the hardest,” he says, citing Royal Bank of Canada and Toronto-Dominion Bank as examples.
You can bring home the bacon with dividends from these two blue chip preferred stocks.
Mr. Liang is head of fixed income at Toronto-based Purpose Investments, as well as a portfolio manager and a chartered financial analyst (CFA). Starting out in the financial industry in 1991, he has specialized in fixed-income investments since the mid-’90s.
To illustrate the scale of the decline since September, Mr. Liang notes that the S&P/TSX Preferred Share Index, which he stresses is based on share prices rather than returns, was steady throughout 2018, ranging between 700 and 720 points. As of September 2018’s end, it stood at about 710 points. “When the market volatility hit . . . the index went straight down for the fourth quarter,” says the portfolio manager. “Right now it’s sitting at about 630,” which has not been the case since mid-2016, he told Investor’s Digest in an April 22 interview. “This year-to-date, it hasn’t done much.”
Pre-tax income of 6% to 8% from blue chip stocks
A Purpose report prepared by Mr. Liang and associate portfolio manager Jeremy Lin notes, “As a result of the sell-off . . . an investor can generate a pre-tax equivalent income stream of six per cent to eight per cent from the most credit-worthy corporations in Canada.”
Blue chip stocks such as Manulife Financial Corp. and the major Canadian banks were “hit pretty disproportionately” in the sell-off, Mr. Liang says. The portfolio manager attributes the beating they have taken to the influence of passive, index-based ETFs. Given the highest-quality companies (based on market capitalization) have the highest weighting on the preferred share index, when it began to drop, passive fund managers indiscriminately sold those shares to match the index, leading to a vicious cycle, he argues. “The whole market is about $80 billion, which is not that big,” the analyst notes.
On a long-term basis, he says the outlook for preferred shares is healthy because of the high likelihood of interest rates rising. Central banks have backed away from the quantitative easing that drove up bond prices before the shift to a bond bear market in mid-2016. While many still adhere to negative interest rate policies, again to drive up bonds, those rates are unsustainable in the long run and make bond prices unrealistic, he asserts. “The fixed-income bubble has gotten out of hand.” Even if interest rates do not improve in the short term, preferred shares will continue to pay out coupons (periodic interest payments on the principal investment) like clockwork, says Mr. Liang. “The instances where high-quality companies miss interest payments are almost non-existent. There are no better companies in this country than the ones that issue prefs.”
Most preferreds re-set rates; bonds don’t
Buying preferred shares is also more appealing than buying bonds because most preferred shares are ‘rate-reset’, meaning the rate paid out on coupons changes periodically in line with Canadian government bond yields. Thus, their investors can benefit from higher rates and inflation, Mr. Liang explains.
The analyst names the Brookfield Asset Management Inc. Preference Shares Series 26 (TSX—BAM.PR.T) and TransCanada Corp. Preferred Shares Series 9 (TSX—TRP.PR.E) as his ‘best buy’ recommendations.
“It’s one of our top picks among the issuers,” he says of Brookfield. “Brookfield is bar-none one of the strongest credit profiles in Canada.” The Series 26 shares’ par value is $25 each and it has an internal rate of return of 6.0 per cent, translating to a taxable equivalent of 7.8 per cent. “This is a preferred share that trades at a deep discount to par,” says the analyst.
At present, the company has only about $10 billion in preferred shares and debt on a market capitalization of more than $60 billion. “There’s a lot of value cushion in these preferreds but on top of that, Brookfield has been creating shareholder value for decades,” Mr. Liang says. In addition to direct asset management (namely real estate, renewable power, infrastructure, and private equity), Brookfield owns asset managers and makes fees from them, incurring relatively little cost to themselves.
ROI on pipelines is strong
TransCanada’s Series 9 shares offer an internal rate of return of 6.1 per cent, translating to a taxable equivalent of 7.9 per cent.
“The pipeline business is actually very favourable right now because the return on pipeline investments is very strong,” says Mr. Liang. Low oil prices in Canada have forced producers to pump it to other markets, raising pipeline demand.
TransCanada’s market capitalization is also around $60 billion. Mr. Liang admits that it has slightly more debt than Brookfield, but adds that most of its business is regulated and under long-term contracts, so earnings are not volatile.
This is an edited version of an article that was originally published for subscribers in the May 10, 2019, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.
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Investor's Digest of Canada •7/7/19 •