Bonds and preferreds for income investors

Probable interest rate hikes this year may be subdued but will still limit the attraction of current fixed-income investments. These rate hikes will, however, benefit our recommended floating-rate preferreds.

What to do about bonds

Rising rates will benefit floating rate preferred shares.

Despite some volatility, Canadian bond prices have been on a bit of a tear since early in the fourth quarter of last year. At that time, the FTSE TMX Canada Universe Bond Index traded around the 1025 level. Since then, it has risen to about the 1065 level, for a gain of nearly four per cent. Year to date, the index is up 1.2 per cent, with corporate bonds outperforming.

The strong performance of bonds has been caused by investors seeking safe-haven assets in a global economy that seems to be slowing. However, this performance may not be sustainable if the Bank of Canada and US Federal Reserve increase rates later this year, as they are expected to do. We, therefore, think yields are likely to rise this year, though any increase will likely be modest in view of the more subdued growth outlook.

But even a modest increase will limit the attraction of fixed-income investments. Consequently, we continue to recommend you underweight this asset in your portfolio and limit the terms to maturity and duration of your bond holdings.

What to do about preferred shares

Since we last updated our preferred share list in our December 14 issue, the S&P/TSX Preferred Share Index has climbed 1.0 per cent. Over this period, our floating-rate preferred shares have underperformed, declining an average of 5.2 per cent. Meanwhile, our three straight fixed perpetual shares have increased an average of 3.6 per cent.

The outperformance of our fixed perpetuals would seem to suggest that investors are expecting the Bank of Canada to cut the target for its overnight rate this year. But that’s not the case. Many forecasters are projecting two rate increases this year, while Scotiabank Economics expects three. Such increases will boost the dividend payments of our floaters.

And as it stands, a few of these floaters are yielding nearly as much or more than our fixed perpetuals. BCE Inc. S, BCE Inc. Y and Brookfield Series 2 are all yielding more than five per cent. We continue to recommend you overweight floaters and underweight fixed perpetuals, as rising rates are not good for the latter, but better for the former.

This is an edited version of an article that was originally published for subscribers in the February 15, 2019, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

Money Reporter, MPL Communications Inc.
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