For many investors, owning preferred shares has been a frustrating experience over the last few years. The generalized feeling is that preferred shares have been mirroring the downside of the equity markets but not reflecting the periods of market recovery. This leaves investors asking ‘why’ and whether preferred shares have the ability to recover. To help understand where preferred shares may head, looking at recent history can be useful.

Currently, the preferred shares market is strikingly similar to that of 2019. By the end of 2018, the Canadian and American equity markets were correcting lower by 15% to 20%, as many expected the end of QE and the accommodative policies that had lasted for over a decade. Ultimately, the Fed Chair, Jay Powell, opted to change course back to looser monetary policy, and markets experienced numerous rate cuts instead of the feared rate hikes. This led to both equity and bond market recoveries, however, the preferred shares market did not participate in the rally. The chart below depicts the Preferred Share market in orange and the TSX equity market in blue.

At that time, most investors accepted that preferred shares were underperforming because yields had dropped rapidly. With much of the asset class consisting of an interest rate reset feature, lower yields became an unfavorable development.  Investors would have to be patient for rates and yields to head higher so that the rate reset feature would be back in their favour. Unfortunately, the higher rates that were experienced over 2022 did not help, as the preferred markets remained sluggish throughout the year. In hindsight, perhaps that previous line of thinking was too simplistic as preferred shares are also impacted by factors such as:

- Lower sensitivity to rate changes depending on the price level of the issue (higher priced issues experience less positive impact when rates increase)

- Duration of the preferred shares impacts prices

- The ability for issuers to call or mature the preferred share at par will impact the upside of higher-priced shares

A more bullish scenario for rate reset preferred shares is for the yield curve to steepen, with long-term yields rising faster than the short and medium part of the curve. Unfortunately, the yield curve inverted so that short-term yields were higher than long-term yields. This poured cold water on the potential for a rally.

Currently, we are seeing the same underperformance from preferred shares relative to equities that was experienced in 2019. Since late 2022,  Canadian preferred shares have lagged equities by over 1000 bps (10%). However, taking a step back, the preferred share market is attractively valued, and the 3 year returns have been fair (approximately 30% cumulative return). Compared to previous years, we are incrementally more constructive on preferred shares due to the following reasons:

- Attractive valuations

- High cash yields with many investment grade issues offering 8%

- A potential for the yield curve to steepen, which can be favorable for rate resets

To determine if preferred shares should be part of your portfolio, we would encourage you to speak with our team to review a customized solution for you.