The fixed income market has ridden a 30-year bull market off the strength of a secular decline in interest rates globally. This market has provided fixed income investors with attractive returns, low volatility, and strong diversification benefits for one’s overall portfolio.
With interest rates at historical lows, they will eventually rise. Many economists believe that 10-year Government of Canada bond yields will rise to ~4.5% in the next couple of years (an increase of approximately 2%). Rising rates will cause bond prices to fall and will increase the volatility in the overall market.
Duration (the sensitivity of a bond’s price to interest rates) will be a key source of risk to monitor in the future. The longer duration for a bond, the higher its sensitivity to interest rates.
For example, a corporate bond with a duration of 8.4 years (10 year maturity, 3.5% coupon) could lose 15% of its market value if interest rates were to rise 2%. Many Investors are unprepared for the rockier road ahead for fixed income and the possibility of losses.
The preferred share market is a complex market with multiple unique structures and embedded options in underlying issues. The two largest preferred structures are rate resets and perpetuals.
Rate resets have a 5-year fixed rate after which the yield resets at a predetermined spread over the 5-year Government of Canada bond. Perpetuals, as the names implies, are a long duration preferred share and, therefore, could potentially suffer material loses if rates were to rise.
In addition, there are a number of factors that will impact the preferred share market in the future which include:
- Effective duration of the overall preferred market is ~8 years versus 6.8 years for the DEX Universe; therefore, preferred shares will face a larger headwind in a rising rate environment.
- Expect low single-digit returns in the next 3 years if 10-year government bonds rise by 200 bps.
- The whole preferred share market is $63 billion; we anticipate $8.6 billion will be called in 2014 from high rate resets.
- Shrinking supply in the market place will create short-term support for prices for the rate reset market.
- Royal Bank issued the first NVCC (non-viable contingent capital) preferred share at 4%. This priced in a yield pick-up of 40-60 bps for the convertible risk. Insurance companies will face similar regulatory risks in the future.
The diversification benefits of preferred shares and fixed income in general still exists; however, strategies need to change to address the upcoming headwinds from rising rates. Specifically, mandates need to be less restrictive, benchmark agnostic, and aggressive in duration management.
For the NWM Preferred Share pool we will look to opportunistically reduce our positions in long duration perpetuals (~25% of the current portfolio) and increase our allocation to rate resets which have a maximum duration of 5 years. Additionally we will look to enhance yield through credit opportunities.
The changes to the fund are not without risks. Although we are reducing duration risk, we are increasing credit risk and the fund’s returns could deviate from the benchmark (i.e., we could underperform the overall market if yields came down even further). However, there remain significant opportunities in the preferred share market for the following reasons:
It is a complicated market where we have a better understanding than most market participants, particularly modeling the optionality involved with rate resets.
- New bank issues for contingent convertible shares (“coco’s”) will have higher coupons to compensate investors for the equity conversion risk.
- There continues to be select rate resets that are very attractive (Transcontinental with a yield-to-worst 6.8%, Element Financial yield-to-worst 6.5%).
Overall, we believe that addressing duration risks by reducing perpetuals in NWM Preferred Share will allow our investors to continue to achieve attractive tax-efficient returns in spite of rising rates.This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Please speak to your advisor regarding your unique situation and investing needs. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.