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Given the outlook for interest rates, and given the contrasting objectives of issuers and investors, the stage has been set for greater battles over the terms of new issues in the rate-reset preferred market.

That’s the view of John Nagel, a former preferred share market practitioner and now an independent consultant on those securities, whose analysis is, in part, predicated on an increase in short-term interest rates in October.

“From an issuer’s standpoint, today is a good time to issue. From an investor’s perspective, now is not as attractive a time as it was one year back when spreads were higher,” said Nagel, who argues that 380 basis points is about the minimum spread investors should consider. “Where the spread is above that level, the likelihood is that the issue will be called on the next reset date is fairly high,” he said, with one caveat: that there is no unforeseen deterioration in the credit quality of the issuer.

Nagel argues a better approach is for investors to buy issues trading in the secondary market and that are within two or three years from being reset. “Investors can look at those issues that are low (in terms of spread) and which, if extended in 2019 and beyond, will do so when rates will be higher,” a scenario, he says, that allows for a capital gain and a higher coupon. A focus on those issues, Nagel argues, is likely to be more attractive than those prefs, which will be reset next year.

Rate-reset prefs

But Nagel is a firm believer in rate-reset prefs, arguing an issue that provides high spreads over five-year Canada bonds allows the holder “to adapt to rising interest rates in the future while having protection on the downside.” In short, he says they are suited to investors who want “dividend income from strong corporations with attractive structure and yields.” But investors sleep better at night, he said when they buy securities with a rating above Pfd-2.

Of course issuers will try and find a way around the normal situation by offering investors a carrot in the form of a minimum yield when the rate-reset period rolls.

That feature was included in the most recent rate-reset issue, a $125 million offering by Capital Power Corp. Investors participated in that deal — which came with a spread of 412 basis points above the yield on five-year Canada bonds — knowing that in five years the minimum yield will be at least 5.75 per cent. (To show how five-year Canada bonds have moved — they are up by about 100 basis points in the past year — Capital Power raised $200 million at 6 per cent last year representing a spread of 526 basis points.)

Minimum yield

Offerings that feature a minimum yield have grown in popularity over the past 18 months, indeed they are almost the norm, and have been used by a variety of non-financial issuers including Brookfield Office Properties, Alta Gas, Pembina Pipelines, TransCanada Pipelines, West Coast Energy and ECN Capital Corp.

But a minimum yield won’t be the norm for all issuers: banks are not allowed to offer minimum yield guarantees.

This year, there have been 11 rate-reset pref issues raising almost $3.7 billion with $100 million deals by Element Fleet Management and ECN Capital being at one end of the spectrum and an $800 million transaction by TD Bank being at the other. The spreads have ranged from 301 basis points (TD) to 519 basis points (ECN Capital.) The coupons on those 11 issues has varied from 4.40 per cent (CIBC) to 6.25 per cent (ECN.)

Financial Post


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