A question we often hear is “what will happen to preferred shares when bond yields rise?” While investors have been anticipating rising bond yields for many years, it appears that Canadian yields finally hit bottom two years ago, in the summer of 2016, and have been moving higher since then. With the Bank of Canada in the midst of a series of interest rate increases, further increases in bond yields seem likely. Hence the need to address the impact on preferred shares has become less theoretical and more practical.

The simple answer is that preferred shares are unlikely to react significantly to rising bond yields. The different structures of the Canadian bond and preferred share markets and the lack of linkages between them suggest that the two markets move in unrelated ways. Indeed, analysis of the historical performance of yields and returns of preferred shares and bonds suggest that the two asset types do not follow one another.

Many people assume that all yields move in the same general direction. After all, when the Bank of Canada makes changes to its overnight target rate, money market and bond yields generally move in the same direction as the Bank. So, why wouldn’t preferred share yields also move in the same direction? The primary reason is that the bond and money markets are dominated by large financial institutions such as banks, insurance companies and pension funds, while the preferred share market is used primarily by individual investors. In addition to having very different participants, there is no dynamic linkage between the markets. The relatively low liquidity of preferred shares means no fund or institution can arbitrage between bonds and preferred shares.

The following chart shows the average yield of Canadian preferred shares since 2003 as well as the yield of benchmark Government of Canada bonds maturing in 10 years. Other than the volatile period of the financial crisis, preferred share yields have fluctuated around the 5.00% level for the last fifteen years. In contrast, the level of bond yields fell steadily until 2016, with some rebound since then.

JH July.2018 chart EN

Analysis of the historical returns of preferred shares and bonds confirm the lack of correlation between the two asset types. Comparing the monthly returns of the S&P/TSX Preferred Share Index since 20071 with those of Canadian bonds, using the FTSE TMX Canada Universe Bond Index, the correlation is exactly zero.

The lack of correlation between bonds and preferred shares has important implications for investors. If rising bond yields are a concern because they would result in lower bond prices and reduced portfolio values, preferred shares offer valuable diversification benefits in addition to their higher and more tax-efficient yields. The lack of correlation means that preferred shares could hold their values, or even appreciate, if bonds decline.

To learn more about how Fiera Canadian Preferred Share Funds may help you in a rising rate environment, talk with your financial advisor.
1 While preferred shares have been around for many decades, the Toronto Stock Exchange only created a preferred share total return index in June 2007.

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The views and opinions expressed may change based on market and other conditions. This material is provided for informational purposes only and should not be construed as investment advice. There can be no assurance that developments will transpire as forecasted. Actual results may vary.