Preferred shares are an interesting synthesis of debt and equity, retaining unique aspects of both securities. Two overnight rate cuts by the Bank of Canada and global macroeconomic instability, has seen rate reset preferred shares tumbling, closely following the 5-year yield. I entered positions in ZPR, a preferred shares ETF, in mid-January and will discuss the bullish view for the Canadian rate reset preferred share asset class.
In 2015, the Bank of Canada cut rates 50 basis points, weighing heavily on the 5-year bond as well as relatively muted inflation even in the face of significant Canadian Dollar devaluation, both due to further collapse in oil prices. This saw an exodus from ZPR, as the fund’s holdings were rate-reset preferred shares, which re-adjust to pay a predetermined number of basis points above the 5-year yield at reset date. As the 5-year yield adjusted to lower short term interest rates, the underlying value of the preferred shares fell significantly, but at this point are pricing in an overly pessimistic scenario.
On ETF structure
ZPR is structured as a laddered ETF, meaning the rate-resets that occur over 5 years are supposed to be blended. I extracted the underlying portfolio of holdings using Bloomberg and created a model to forecast and illustrate some unique aspects of the ETF. The chart below summarizes my findings regarding the “laddered” nature of the ETF, which show a relatively equally weighted distribution between reset years, with a much large allocation to 2019 and 2020 than 2016 and 2017.
In a bear case scenario, rates will be low for the next year or so, and will likely rise above 0.5% by 2017/2018, this perfectly corresponds with 60% of the preferred reset dates which occur in 2019 and beyond.
Approximately 95% of the ZPR portfolio uses the 5-year Canadian bond as their benchmark for their reset. I decided to create a model to see the price sensitivity of the holdings to interest rates. After analyzing historic dividend yields from preferred shares in a stable interest rate environment for multiple securities, it was found that underlying holdings remain relatively unchanged between 4.15% to 4.75%, with an average of 4.45% between all methods used.
Instead of undertaking the impossible task to predict every movement in interest rates in the next 5 years, I assumed an average yield for the 5-years and assumed that every share reset at that rate, after finding the exact basis point spread paid and weighting for each of the 100+ preferred shares, I adjusted the value of the subsequent coupon to match the historic yield preferred shares have traded at historically, an average of 4.45%. The results based on a share value of $9/share are shown below:
The percentage represents the current upside total potential for the underlying in a 5-year scenario. The two cells highlighted by the black box represent a very conservative bear case return scenario,as Canadian bond yields are unlikely to average 75 basis points in the next 5-years, interest rates will likely will average between 1% and 1.5%, resulting in a close to 40% total appreciation, this is without factoring in reinvested dividend income, which will conservatively be 4-5%. To sweeten the proposition, ZPR’s dividend is also tax deductible, with the ability to earn up to $50,000 CAD tax free.
Imperfect Assumptions of Model
1) Average 5-year interest rates will perfectly coincide with reset dates. This is impossible to predict and can work both in advantage and disadvantage. The portfolio value can gain significantly if yield spikes correspond to a large number of resets.
2) Market participants will continue to price Preferred shares at a constant yield range (4.15%-4.75%)
Using Derivatives to Boost Returns
The main reason I chose ZPR over CPD (which has a few fixed rate preferred shares and is subsequently less sensitive to interest rates) is that options are available for more interesting strategies and return profiles.
ZPR currently yields 6%, and the yield will continue to deteriorate towards 4.5 to 5% as rates remain low and more of the preferred shares reset. After analyzing historic returns of both ZPR and CPD, the highest 3 month return in the history of both securities is around 10-12%. Keeping this in mind, I will boost the yield by selling 3 month ~10% OTM covered calls. The current calls 3 months out for ZPR are selling for $0.1. This means instead of making $.15/quarter the position can be making $.25/quarter. If history is any guide, this position will almost never be exercised, and a bit of savvy timing can eliminate the issue entirely.
The difference this makes can be seen above in a 5-year total return analysis with an investor that starts with $10,000. This assumes a 21% underlying return over 5 years, $0.05/month for 2016, followed by a constant 4.5% yield (the average that was found in the previous study), as well as a very conservative $0.10 per quarter for the covered calls.
Market Conditions: The Perfect Storm
This year began as the worst year ever for equities, and spooked many investors; Chinese market plunge and currency depreciation lead to global growth concerns, creating selling pressure across all risky asset classes which worsened as oil broke to 12-year lows. This panic was helped by articles in mainstream like this one, in which an RBS analyst urged clients to “sell everything”, 2 weeks after the S&P 500 had fallen ~150 points.
I believe a large portion of the selling was by “weak-handed” retail investors and some institutional players turning to cash as the specters of the past recession returned and safe haven demand for bonds increased, sending yields lower. At the same point, lower oil also prices reduces inflation expectations for longer term debt securities and also raised the chances of another BOC rate cut, causing the Canadian 5-year yield to scrape against historic levels.
The chart below illustrates the 1-year rolling correlation between 5-year bond yields to WTI oil price and 5-year bond yields to the S&P TSX.
It’s clear low oil prices and high volatility explained a significant proportion of movement of interest rates in 2015 to all of the movement of ZPR throughout 2015, as the Bank of Canada surprised markets with a rate cut in January, causing the 5-year bond yield to fall: a lower bond yield means lower coupons after reset. In the latter half of 2015 and early 2016, the TSX began correlating higher with ZPR’s decline, possibly offering some evidence of increased bearish sentiment in markets.
I attempted to create a multiple regression to predict ZPR’s sensitivity to various factors. Although I was able to create a model with an adjust-R squared of over .95 (using 5-year Canadian bond yields, oil price, TSX Composite level and the BOC Policy rate), I decided against using the model as there was a high degree of multicollinearity between the variables. The Summary Output is displayed below:
The Canadian Rate Cut that got away
Talks of a 3rd Bank of Canada rate hike persisted throughout the week preceding the January 20th decision. A rate cut was unlikely, even considering Stephen Poloz’s dovish tone and would actually hurt Canada’s economy.
It’s important to remember the BOC only controls short-term nominal interest rates, which limits their actual power on the cost of money. The banks are the ones responsible for over 85% of lending to consumers and stated publicly they wouldn’t lower the prime rate and pass savings onto consumers. With consumer sentiment focused on their lower purchasing power of foreign made goods, a rate cut down to emergency rates would send the Loonie lower and lead to a serious deterioration in sentiment without providing any tangible financial benefits. Although the below chart shows that expectations for a BOC cut are significant for 2016, it remains unlikely the BOC will cut, as Canada’s economic situation is currently far from catastrophic.
Outlook and Positiong
Canada has continued to exhibit resilience in the face of lower oil prices and stagnating growth, with unemployment ticking 0.3% higher from 6.8% to 7.1%, it only represents an increase to 2014 levels and driven largely by Alberta lay-offs. A significant driver of Canadian economic growth has been the elephant in the room, real estate.Real estate accounts for about 20% of Canadian GDP and a negative shock in this sector would likely see the Bank of Canada employ all possible tools in their war chest. It is difficult to predict how bond yields would react in a worst case Canadian scenario, as the CMHC is insured by Canada, and with a Liberal government promising to deficit spend, bond yields could be unpredictable.
Keeping all of the above in mind, I began adding positions between 01/15/16 and 01/19/16 at a VWAP of $8.7 and will continue throughout 2016. I will trim down positions in ZPR above $9.5 as there remains a possibility of the Bank of Canada cutting rates further. There is likely another attractive entry point coming in early to mid-2016 as oil re-tests January lows and Canada’s economic condition becomes clearer. My recommendation would be to add a small position below $9/share, with more aggressive purchasing closer to and below $8.50.