Floating-rate preferred shares have advantages and disadvantages. You earn higher income, along with the potential for capital gains, when interest rates rise. But the opposite can occur when rates fall.
We’ve been cautious on floating-rate preferred shares in recent years. But we’ve changed our stance on floaters now that interest rates are set to rise, albeit gradually.
On July 12, the Bank of Canada raised its overnight interest rate target to 0.75 per cent from 0.50 per cent. This will cause issuers to increase dividend payments on their floating preferreds when they make their next payments. In fact, BCE has already done so.
The share prices of our floating-rate preferreds have responded accordingly. They’ve risen an average 10.7 per cent since we last updated the table in our July 7 issue. By contrast, our three straight fixed perpetual preferreds, which pay a fixed dividend regardless of whether rates rise or fall, declined an average 2.4 per cent.
When looking for an explanation of why floaters can outperform when interest rates rise, keep in mind that they pay a dividend that varies with changes to a particular reference rate, usually the prime rate. The prime rate, in turn, fluctuates with changes in the Bank of Canada rate.
When the bank raised its overnight rate by 25 basis points on July 12, Canada’s big banks mimicked this move by raising their prime lending rates to 2.95 per cent from 2.70 per cent.
In years past, the prime rate used to be set at two percentage points above the bank rate. But the banks reduced their prime rates by just 30 basis points in 2015, when the Bank of Canada cut its overnight rate by 50 basis points. Now the banks are taking advantage of the central bank’s recent 25-basis-points increase by matching it. Their prime rates, therefore, are now 2.2 percentage points above the prime rate, a move that benefits floating-rate preferred shareholders.
Four of the six floaters we follow pay a dividend that is a fixed percentage of the prime rate. The Power Corp. 1986 (TSX—POW.PR.F), Power Financial A (TSX—PWF.PR.A), Brookfield Asset Management (TSX—BAM.PR.B) and Thomson Reuters (TSX—TRI.PR.B) preferreds pay 70 per cent of the prime rate on the par value of their shares. So in the case of Power Corp., it should now pay 2.065 per cent (prime rate of 2.95×70%) on its par value of $50.00, or $1.0325 a share. Given that the shares currently trade at $39.25, however, that dividend of $1.0325 a share will yield 2.63 per cent on the shares’ market price.
For now, though, Power still officially pays a $0.945 dividend based on the old prime rate of 2.70 per cent, which yields 2.41 per cent on its current $39.25 share price. Note that before the Bank of Canada’s rate hike, in our July 7 issue, the shares traded at $37.50 and the dividend yielded 2.52 per cent. The increased dividend investors will now receive caused them to bid up the share price.
Some issues, such as the two BCE Inc. floaters we follow (TSX—BCE.PR.S and TSX—BCE.PR.Y), contain a ratchet feature in which the dividend payment varies as a percentage of the prime rate. These shares started out paying 80 per cent of prime. But this percentage has varied according to the formula. Consequently, the shares now pay 100 per cent of prime.
(The dividend rate floats in relation to changes in prime and is adjusted upwards or downwards on a monthly basis by an adjustment factor whenever the price is $24.875 or less or $25.125 or more, respectively. The maximum adjustment for changes in the price is +/-4.00 per cent of prime. The annual dividend rate applicable for a month will in no event be less than 50 per cent, or greater than 100 per cent, of prime. The adjustment factor for a month is based on the trading price for the preceding month.)
Whichever floaters you choose, these issues should do well as interest rates rise, boosting their dividends, and, therefore, maybe even their share prices.
This is an edited version of an article that was originally published for subscribers in the August 4, 2017, 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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