After recommending the BMO Laddered Preferred Share ETF (ZPR.TO) in January, there has been an unexpectedly aggressively rally which saw the security rise from a low of $8.49 to the current price of $9.91. This post will serve an update on the security and future outlook on the performance of these shares.
With global markets recovering from their January/February lows, the general market sentiment has noticeably improved. This has been on the back of a weaker USD, following the FED’s decision in their March meeting as well as the excessive FED verbiage underscoring the central banks accommodative stance and reduction of expected rate hikes in 2016. The recovery of crude prices also largely drove the market rally, but more importantly it reduced the chances of a BOC rate cut, which was likely the key drivers of a recovery in the Canadian rate reset preferred shares market.
ZPR Mispricing: Visualized
In my original post, I created a sensitivity analysis that compared the implied yield investors would be comfortable holding preferred shares and the 5-year Canadian government bond yield. I wanted to create an indicator that would better illustrate this relationship over the preceding 12 months and help make a more informed decision (how I spend my Friday nights).
As the rate reset preferred shares reset based on a spread on top of the Canadian 5-year yield, I found the weighted average spread for the whole ZPR portfolio to be 262 bps. Using this information I implied that investors would be satisfied with a 4.45% yield on preferred shares, representing an average taken from various sources. The results displayed in the chart below, showing ZPR.TO was undervalued even given 5-year yield expectations through the Government of Canada 5-year bond. As Canadian government bonds have fallen and yields increased, the discount for ZPR has become a 3% premium – the market is now fairly valuing the security.
Laddered Reset Schedule continues to favour longer term rates
Another key development has been the reset of a number of the preferred shares in the portfolio at the end of March, when the 5-year bond yield remained at relatively reasonable levels. ZPR’s laddered preferred rate reset schedule continues to be leveraged to rate resets occurring in 2019 and 2020 – representing more than half of all resets. Less than 10% of preferred shares remain to be reset in 2016, all of which will occur after June 30th.
Here are a few other key highlights:
- The Canadian Government budget projected deficit of $29.4 Billion. Generally governments are notorious for having overly optimistic picture. Further deficit spending will produce upward pressure on yields.
- Oil could still head lower, but the trend will now be decisively higher in the coming years as a lack of CAPEX investments will lead to lower prices in the future. This will lead to rising inflation, which will trickle into the 5-year yield
- Market fundamentals continue to remain weak and I expect further market volatility leading to a lower 5-year yield
- Risks remain to the Canadian economy, which has been saved from an oil collapse largely by a booming (for now) housing market.
ZPR.TO has performed exceptionally well in the past 3 months, even more so considering the sustained low yield environment present in Canada and across global markets. Currently, I believe the risk reward profile of ZPR.TO is balanced and would not recommend adding to a position. I will likely be holding ZPR and slightly trimming the position as the security heads higher.
If you have missed this most recent rally, I recommend waiting out the next few months, as there is still a possibility of a major market correction and retracement in ZPR.
Lower growth and lower rates are here to stay, but make no mistake – higher rates are coming, even if that only means ~1% increase in the 5-year yield in the next few years, the effect on the Canadian economy and rate resets will be significant.