Rate Reset Preferreds – An Unexpected Risk Becomes Real

Source: Globe and Mail

Source: Globe and Mail

It’s only been a couple of months since we revamped the dividend portfolio to primarily consist of rate reset preferred shares and already we’ve had more excitement than really expected from this security class that’s supposed to act like a fixed income product.  As mentioned, rate reset preferreds seem to have given opportunistic investors a chance to get into a beaten down product with mistaken characteristics that would benefit from interest rates that should eventually rise.

Unfortunately for this investor, looks like I didn’t catch the bottom as the rate reset market dropped yet another 8-10% since my posting.  It didn’t make this investor feel any better when Brookfield issued a new series (Series 44 – BAM.PF.H) of preferred shares that offered an incredible spread: 4.17%!

Two things that were surprising – first is the incredible spread given for what many would consider a pretty secure issuer.  In fact, this spread is greater than any existing preferred shares held in the dividend portfolio.  The other surprise – in what seems to be a feature to create buying interest in rate reset preferred shares, the issue also has a dividend floor – so buying the preferred share will give you the greater of the 5-Year Government of Canada bond yield + 4.17 OR 5.00%!  That’s a guaranteed 5% (or $1.25)  no matter what – which actually makes this a pretty attractive security from an income perspective – and now has the characteristic of a perpetual AND a rate reset.  To date, there is only one other issue that has this similar characteristic.

Thanks to Brookfield, it looks like I ignored one potential risk – that new issues would come out with higher spreads or this yield floor feature.  However, if there was one bright light as I stared in astonishment at the announcement, was that the preferred share prices were so low to begin with, many were already yielding above 5% and would yield close to 5% even if the if the 5-year GOC hit 0%.

Despite the little set back, we’re still being patient with the dividend portfolio – it’s providing great yields (especially when considering the dividend tax credit) and the preferred share market has regained some momentum in the past week.

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