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Why preferred shares just got pounded – again

John Heinzl is the dividend investor for Globe Investor's Strategy Lab. Follow his contributions here. You can see his model portfolio here.

Just when it looked like the slaughter in the preferred-share market was subsiding – BAM!

And I mean that literally.

When Brookfield Asset Management (a.k.a. BAM) announced a $250-million rate-reset preferred-share issue last week, the sell-off that ensued was extreme, even for the beaten-up preferred-share space.

"It was total carnage," said preferred-share expert James Hymas, president of Hymas Investment Management in Toronto.

It's difficult to pin down exactly what triggered the rout, which from Thursday through Monday wiped more than 5 per cent from the already battered S&P/TSX preferred-share index. But Brookfield's new issue – which is expected to begin trading on Oct. 2 under the symbol BAM.PF.H – was probably a central factor, for a couple of reasons.

First, it offers a juicy initial yield of 5 per cent, which is generous for an issue with an investment-grade credit rating. While that undoubtedly made the issue an easier sell – Brookfield boosted the size of the offering from an initial $150-million – it made everything else look worse by comparison. Essentially, prices of existing preferreds had to fall to make their market yields more competitive.

"A big fat yield like that could well have caused some repricing of the market as a whole," Mr. Hymas wrote on his PrefBlog.com.

Second, aiming to soothe investors who were blindsided by the massive drop in government bond yields – which are used to determine yields on rate-reset preferreds – BAM.PF.H contains a novel provision: It will maintain a yield of at least 5 per cent when the dividend resets in 2020 (and every five years thereafter), regardless of how low government bond yields might go.

Specifically, the dividend will be reset such that BAM.PF.H's yield – based on its par value of $25 – will be 4.17 percentage points higher than the five-year Government of Canada bond yield at the time. For example, if the five-year Canada yield (currently about 0.78 per cent) rises to 1.5 per cent five years from now, BAM.PF.H's dividend (currently $1.25 annually) will be reset at $1.4175 to yield 5.67 per cent (1.5 per cent plus 4.17 per cent), assuming Brookfield doesn't call the issue.

However, if the five-year Canada yield drops to, say, 0.25 per cent, BAM.PF.H's dividend won't be reduced; it will stay at $1.25 to maintain the minimum 5-per-cent yield. It's a good deal for BAM.PF.H investors, because they are protected from falling bond yields. But again, it makes other rate-reset preferred shares that don't have such a feature relatively less attractive.

Brookfield wasn't the first to put a floor under its rate-reset yield. Earlier this month, Canadian Utilities Ltd. issued preferred shares (CU.PR.I) with a reset spread of 3.69 percentage points over five-year Canada bonds, subject to a minimum yield of 4.5 per cent.

In an interview, Mr. Hymas said it's unlikely the provision will even come into play because he expects the five-year Canada yield will rise – not fall – from its current depressed levels. Still, given the jangled nerves of investors who have watched the S&P/TSX preferred-share index plunge about 24 per cent this year (excluding dividends), Brookfield and Canadian Utilities may well have set a precedent.

"I think it's going to be very difficult for the next while to come out with an issue that does not offer a floor," he said.

After such an extended drop, is it finally safe to invest in preferreds? Certainly, the market has fooled everyone who has called a bottom so far. Given the unpredictable and complex nature of many preferred shares and the propensity for retail investors (who dominate the preferred space) to panic at the first hint of volatility, the market could well tumble again.

But with prices down so sharply – and yields up as a result – Mr. Hymas is seeing some compelling values emerge among rate-resets and straight perpetuals, particularly when the dividend tax credit is taken into account. His advice to anyone thinking about buying preferred shares: Allocate no more than half of your fixed-income holdings to preferreds, and focus on the long-term income they produce, not the price.

Also, it's important to be mindful of bid-ask spreads, which can be exceptionally wide for some thinly traded preferred shares, creating some dramatic price swings.

"Right now the problem is there is no demand," said Nicolas Normandeau, vice-president with Fiera Capital in Montreal and manager of the Horizons Active Preferred Share ETF (ticker: HPR). Although he considers preferred shares "extremely attractive" at current levels, he's being "really picky about what I'm buying."

Over the long term, buying now could prove to be a wise move if the five-year bond yield rises, which would give battered rate-resets a lift. But in the short term, the preferred market faces several risks, including year-end tax-loss selling, potential new supply and volatility across financial markets in general, he said. By November, when much of the tax-loss selling will likely be over, it might be a better time to jump in, he said.

"It's tough to call the low, but we're close – really, really close," he said.

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Editor's note:

In the original version of this article, Brookfield Asset Management's new rate-reset preferred-share issue was incorrectly referred to as BAM.PR.H. The correct symbol is BAM.PF.H, as shown.

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