The ups and downs of floating-rate preferreds

Floating-rate preferred shares have advantages and disadvantages. You earn higher dividend 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 for some time now. That’s because these shares typically don’t thrive when interest rates are low, or are declining.

In fact, in 2015, the Bank of Canada cut its overnight interest rate target twice, causing a reduction in the dividend payments of floating preferreds. Consequently, the value of floaters fell more than the straight preferreds we recommend. Our floaters declined 29.9 per cent in value in 2015, while our straight preferreds fell 16.1 per cent.

2015, of course, was a poor year for preferred shares in general. But those preferreds that are sensitive to falling rates, such as rate resets and floaters, suffered most.

Floaters, you see, pay a dividend that varies with changes of a particular reference rate, usually the prime rate. The prime rate, in turn, fluctuates with changes in the Bank of Canada rate.

Last year, the bank cut its overnight rate twice. Each time it cut the rate by 25 basis points. So the rate declined 50 basis points during the year, to end at 0.50 per cent.

In years past, the prime rate used to be set at two percentage points above the bank rate. So prior to the central bank’s cuts last year, the prime rate was 3.00 per cent, two percentage points above the bank rate.

When the bank cut the overnight rate in 2015, however, the banks chose not to cut their prime rates by a similar amount. Instead, they reduced their rates by 30 basis points for the year. So the prime rate now sits at 2.70 per cent, or 2.2 percentage points above the bank rate.

Four of our six floaters pay a dividend that is a fixed percentage of the prime rate. The Power, Power Financial, Brookfield and Thomson Reuters preferreds pay 70 per cent of the prime rate on the par value of their shares. So in the case of Power Corp., it pays 1.89 per cent (prime rate of 2.70 x 70%) on its par value of $50.00, or $0.945 a share. Given that the shares currently trade at $27.50, however, that dividend of $0.945 a share yields 3.44 per cent on the shares’ market price.

At the end of 2015, when the prime rate was 3.00 per cent, the shares paid 2.10 per cent (3.00 x 70%) on their par value, or $1.05 a share. At that time, the shares traded at around $38.60. The yield, therefore, was 2.72 per cent ($1.05 x 100/$38.60). The subsequent decline in the share price, then, partly reflects the lower dividend the shares paid after the Bank of Canada rate cuts.

Some issues, such as two BCE floating-rate preferreds, contain a ratchet feature in which the dividend payment varies as a percentage of prime rate. These shares started out paying 80 per cent of prime. But this percentage has varied. Consequently, the shares now pay 100 per cent of prime.

Whichever floaters you choose, these issues should do better when interest rates rise, boosting their dividends, and, therefore, their share prices.